Strategic planning is defined by https://sba.thehartford.com/Links to an external site.

as the
process of documenting and establishing a direction of a small business—by assessing both
where it is and where it is going. It provides an avenue for the company to record its mission,
vision, and values, as well as its long-term goals and the action plans it will use to reach them. A
well-written strategic plan can play a pivotal role in a small business’s growth and success
because it tells the company and its employees how best to respond to opportunities and
challenges.
It can also be defined as the study of functions and responsibilities of general management and
the problems which affect the character and success of the enterprise in the long run.

Elements of Strategic Planning

While there are many definitions given for strategic planning, they contain the following
elements:
1. Study of the functions and responsibilities of general management.
2. Ultimate goal: Success of the total enterprise
3. Time: in the long run

Different Terminologies closely associated with Strategic Planning:

 Corporate Objectives: are those objectives which are set to determine the desired
future direction for the company as a whole.
 Corporate or business strategy: is the means for achieving the business objectives.
 Corporate structure: is the organizational form required to achieve a given strategy.
 Corporate planning: is the process of systematically reviewing the long term future of
the company and would contribute to the formulation of corporate objectives and the
determination of corporate strategy and structure.

Organizational Architecture

What is Strategic Planning?

It follows from the definition that general management is concerned with changes taking place at
the interface between the company and its environment.
In order to adapt successfully to such changes, the two key factors which need to be continually
monitored are products and markets.
Over the past 100 years or so, as a result of the separation of ownership and control, the
increasing size of businesses and the rate of technological change it has become necessary for
firms to develop skills to enable them to cope with the adaption process.
Intuitively, a systematic approach to the problem is considered more likely to achieve long term
success than a random approach.
Consequently, the systematic or planned approach is expected to produce above average
performance for those companies adopting it as a means for coping with decisions concerning
the long term future.
The systematic approach became known as strategic planning, long range planning, corporate
strategy etc.

Strategic Planning Decisions Model

The Strategic Planning Decisions Model

In that strategic planning is concerned with decisions about the long term future of the business,
the steps in the process are the same as for any decisions.
The model goes through the stages of the decisions making process, and a brief description is
given below:

Perception of the Problem: Strategy is either assured through a continuous review process or
identified as a result of some internal or external event which has a major effect on the company.
Appraisal: The first stage in the process is to determine the strengths and weaknesses of the
company and to identify the threats and opportunities in the external environment.
Choice: After establishing the position of the company in relation to its environment it is
necessary to identify, evaluate and choose between alternative courses of action.
Implementation: For strategies to have the best chance of succeeding appropriate implementation
is required.
Evaluation: Regular evaluation of strategies is necessary to monitor progress.
Feedback: Feedback of the evaluation is necessary and can only be achieved if the company is
undertaking a continuous review of its strategic position.

Misconceptions About Strategic Planning (What Strategic Planning Is Not)

1. Strategic planning is a blue print for the future.
It is impossible to forecast the future precisely and the further ahead, the more difficult it
becomes. Thus it is not possible to plan precisely and it follows therefore that flexibility must be
an important part of any plan. The value of planning lies in the process involved in thinking
through corporate objectives, company strengths and weaknesses and potential threats and
opportunities in the environment in which the firm operates.
2. Strategic planning is long term financial forecasting, or forecasting of any nature. However,
forecasting is an essential part of Strategic Planning.
3. Strategic planning is an aggregation of functional plans. Instead, It is the process of altering
the direction of the firm over a period of time.
4. Strategic planning is making future decisions. Instead, it is concerned with making current
decisions about future activities.
5. Strategic planning is an attempt to eliminate risk. Instead, it is to enable the manager to
understand the nature of the risks.

Levels of Strategic Planning

1. Corporate Level Strategy
Corporate level strategy is fundamentally concerned with the selection of businesses that the
organization should compete and with the development and coordination of that portfolio of
business. It includes all the objectives and scope of the organization to satisfy stakeholder’s
expectation. It is an essential level since it is to a great extent affected by investors in the
business and acts to guide strategic decisions across the enterprise.
2. Business Unit Level Strategy
It is responsible for how a business competes successfully and beating rivals in its particular
market. At this level competitive strategy is usually formulated. These are strategic decisions on
the choice of products, satisfying customer needs, gain an advantage over competitors, exploiting
or creating new opportunities, etc.
3. Functional Strategy (Departmental Level or Operational Strategy)
It focuses on how every part of business is organized to present the corporate and also business-
unit level strategic path. Strategy of the functional areas like marketing, financial, productive and
human resources are based on the functional capabilities of an organization. For each functional
area, first major sub-areas are identified and then for each of these sub functional areas,
functional content strategies, important factors, and its importance in the process of
implementing the strategy is identified.
You can search other reading materials about the levels of strategic planning.

M1 Lesson 2: Corporate Objectives

Introduction
Primary and Multiple Business Aims
Till about the mid-1970s that attention has been paid to the nature and structure of business aims.
Until then, it was generally conceded that there was but one aim in business and that was to
maximize profits. However, there has been a growing recognition that all but the smallest
enterprise has multiple aims.

What are Corporate Objectives?

It is necessary, firstly, to discuss what is meant by an objective. Peter Drucker says that the
"primary objective" is to Maximize Shareholder Wealth (in the long-run). This view is now
accepted by those subscribing to the "Shareholder Value" school. Drucker also says that an
objective must be quantifiable and achievable. It is the desired end state of a period of activity.

Reasons for Corporate Objectives

1. Objectives provide motivation. Several studies have shown that clear objectives,
capable of achievement and with satisfactory rewards for achievement do have
beneficial effect on business performance.
2. Guidelines for action. Business objectives create guidelines which will enable
managers to make decisions consistent with overall objectives.
3. Set the style of the business. Creeds, philosophies or statements of belief are often
prepared by Chief Executive to set out those values which will guide the conduct of
the business.
4. Provide the basis for measuring performance. Without a network of objectives, it is
impossible to measure performance.

Conflicting Objectives
It is important, if corporate objectives are to be achieved, that areas of potential conflict are
identified and resolved. Outlined below are some of these potential conflict areas:

1. Degree of priority. The relative importance of the different objectives needs to be

clear and cases of conflict resolved.
2. Short term versus long term. It would be possible for a firm to perform very
satisfactorily in the short run, by neglecting new product development, management
development and training etc. at the expense of long term profitability which depends
on these types of activity.
3. Economic versus non-economic. Companies have to decide levels of importance and
performance in each area and then resolve potential conflict.
 4. Personal versus Organization goals. Companies need to ensure that the goals of
individual employees are monitored in order to resolve conflict between these and the
organizational goals.
5. State versus Multinational Companies. There is sometimes a conflict between the
interests of the state and the objectives of multinational firms, with respect to location
policy, repatriation of profits, etc.

M1 Lesson 3: Financial Aspects of

Corporate Objectives
Levels of Corporate Objectives

(a) The Primary Objective: The Primary corporate objective is that objective that is central to
the business as a whole organization:
- Which should be clearly stated, and
- Capable of being measured and attainable with effort.
- This corporate objective is often stated in the chairman's report as part of the annual published
accounts of a company.

(b) Secondary Objectives: Subsidiary or secondary objectives can be either short-term or long-
term and support the corporate objective, e.g.:
- Reducing labor costs by 10 per cent,
- Reducing material costs by 5 per cent through a revision of product recipes or mixes,
- Developing export sales to Europe by 5 per cent of total sales volume in the coming financial
year.

Examples of Secondary (or Subsidiary) Objectives

Financial Objectives

o To achieve a return on capital employed before tax of 25 per cent, within
the next two financial years.
o To increase the earnings per ordinary share from the present 40 cents to
70 cents per share inside the next three financial years.
Marketing Objectives

o To establish a European market for our spinning yarns by 20x8 to
represent 20 per cent of total sales volume.
o To increase our market share in Asia from 10 to 15 per cent for machine
tools inside the next four years.

Product Objectives

o To develop and market our new drug SIVLE by the year 20x9 for curing
both impotence and AIDS.

Non-economic Objectives

 These are concerned with the effects on corporate objectives of the
personalities and characteristics of managers, and also
 On the changing expectations of the role of business in society

M1 Lesson 4: The State of Strategic

Thinking
The State of Strategic Thinking
Strategic Planning: Unfashionable?
(a) A 'Fad of the 1970 to 1990s?

o
 No self-respecting chief executive could do without strategic-
planning staff during this period.
 No Business School could do without strategic planning in
their curriculum.

(b) Reasons for Falling out-of-Fashion


o
  Other 'concerns' seen as the new tickets to success. Eg:
 Corporate culture
 Intrapreneurship
 Quality, Productivity, Teamwork (Japanese Methods)
 Benchmarking
 Competitive Advantage
 Just-in-Time (JIT)
 Activity Based Costing (ABC)

Reasons for the Demise of Strategic Planning (Mid-1980s)

a. Strategic Planning was not Promoting 'Strategic Thinking'.

o
 Thick binders (plans) instead of improved communication
 Domination of 'form' over 'substance' (form filling)
 Meaningless long-term projections that obscured strategic
insight Line managers considered planning as an 'irrelevant'
ritual

b. Strategic Planning Techniques came under fire


o
 Early techniques (PLC, Experience Curve, product-portfolio
matrix) promised easy answers based on simple concepts of
competition.
1.
I. single - variable re.
competition/experience
II. one corresponding route to success.
III. these techniques were rarely used in
combination (i.e., multiple-variables)


o
 Premises behind the prescriptions did not always hold.

1.
1.
1.
1.
I. market share to profit (Bank of
America)
II. low-cost producer (Texas Instruments)
Thinking Is Strategy
(a) The questions remain the same:

o The future direction of competition?
o The needs of the customer?
o The likely behavior of competitors?
o How to gain competitive advantage?

(b) The problems are with the techniques and organizational processes used to answer them.

o The solution is to improve strategic planning, not abolish it.
o The need to plan formally has not changed - otherwise strategic thinking
will be crowded out by day-to-day pressures.

The Guide to a Good Strategic Plan

1. Analyze the Industry in which the firm competes.
2. Be aware of sources of Competitive Advantage (and Focus on them)
- Lower Cost (Cost Leadership)
- Differentiation relative to competitors (Product Differentiation)
3. Analyze the existing and potential competitors
4. Assess the companies 'Competitive Position'
5. Choose a strategy built on competitive advantage and how it can be sustained
6. Translate the chosen strategy into concrete actions.

Two Views of Strategy

1. External to Internal (Porter)

o External Environment
o Industry Structure
o Competitive Advantage
o Strategic Positioning
 o Implementation

2. Internal to External

o Based on Capabilities
o Resource Based View of the firm
o Organizations reflect on the past of their firms)

Resources and Capabilities

Resources
 Tangible resources:
- Financial
- Physical
- Human Resources
- Organizational resources

 Intangible resources:
- Technology (patents etc)
- Innovation (including capacity to innovate)
- Brand names
- Corporate culture

 Resources that Create Value

- How do we determine which resources create value?
- They must be:

o

o Valuable: The resource must exploit opportunities present in

the firm's environment
o Rare: The resource must be rare among a firm's current and
potential competitors
 o Imperfectly Imitable : Firms must not be able to copy or
imitate the resource
o Substitutes: Strategically equivalent substitutes must not exist.

Capabilities
(a) Capabilities represent the firm's ability to integrate and/or deploy resources to achieve a
desired objective
(b) Capabilities develop over time as a result of complex interactions that take advantage of the
interrelationships between a firm's tangible and intangible resources that are:

 based on the development, transmission and exchange or sharing of
information, and
 knowledge, as carried out by firm's employees.

(c) Examples of Capabilities

Corporate Head Office
- Financial management
- Ability to effectively motivate and coordinate the activities of departmental/divisional etc
managers.
- Management of acquisitions

Information Management
- Ability to integrate activities through MIS
- Research and Development
- Fast-cycle developments in basic research
- Speed of new product development

Resources and Capabilities for Competitive Advantage:

(tangible + intangible) x capabilities = competencies --> competitive advantage

Errors to Avoid In Strategic Planning

1. Restructuring as strategy: structure must follow strategy.

 2. Buying competitors instead of beating them: This may be a quick-fix to market share,
but most great companies have beaten their competitors through innovation and
dynamism.
3. Forming 'Alliances' as a solution to a company's strategic dilemmas: These carry
formidable costs in terms of organizational coordination, and run the grave risk of
dissipating competitive strengths.
4. Imitation instead of Innovation: Most strategic thinking is still imitative (Emulation
of a competitor strategy).
5. Diversification for growth's sake: Most of these acquisitions are in new fields where
they cannot add any value.

EMPOWERMENT
Empowerment is one of the fundamental aspects of strategic management in any company. If
done right, employees can provide valuable inputs in the company's strategic planning.
Empowerment is increasing the decision-making authority and contribution in formulating
strategies of employees. It is aa means of increasing employee effectiveness, confidence and
contribution to the attainment of objectives of the company.

As taken from StrategyBlocks, here are the three ways to empower employees:
1. Facilitate open communication
Many organizations, especially the larger ones, stick to a rigid hierarchy that can make it difficult
for those across the organization to communicate and collaborate.
The typical employee may find it particularly difficult to convey their ideas to upper
management, unsure about how they will react or if it is even possible to communicate with them
at all.
You should make it clear to your employees that their input is valued, and set up channels
through which they can reach out to you with their ideas.
2. Clearly define and delegate roles
One of the pitfalls of poor strategic planning is a lack of clarity surrounding who is tasked with
what. Not only can this confuse everyone, it can also make employees feel devalued as they are
unsure of their place in the organization.
Fortunately, technology such as strategy mapping software can help you get around this problem.
StrategyBlocks, for example, divides your strategy into clear, disparate blocks that group
relevant departments and individuals so everyone involved understands what they have to do.
3. Be inclusive
There is no point in devising a strategy if only a select few are solicited for input.
Make sure you don’t leave anyone out – use business strategy software to include all the relevant
people in strategic planning and allow them to have their say.
Based on the discussion of Dr. Bel Smallwood, these are the four components of empowerment,
namely:
1. Authority. Employees need the latitude to take the initiative to solve problems. They need
standing permission to improve processes and enhance service within certain parameters, without
additional advice or permission from their manager. They must be able to bend the rules
creatively within reasonable limits in order to satisfy a customers needs. Team leaders must
prepare staff to make increasingly more important and responsible decisions.
2. Resources. A second necessary component of empowerment is resources; that is, employees
must be given the means to carry out the authority they have been given. This can include such
things as time, training, money in the budget, equipment, and personnel.
3. Information. In addition, employees require accurate and timely information to make good
decisions. For example, to identify team targets for improving customer service, the customer
feedback systems must be in operation so that timely data about customers’ perceptions are
available. Further, this information must be given to employees to enable them to select these
improvement goals that will give the customer the most perceived “bang for the buck”. In
addition to customer satisfaction information, empowered employees must have the “business
data” in a form they can understand so that they can not only see the big picture, but can also do
team problem solving regarding how to contain costs, operate more efficiently, and generate
more revenue.
4. Accountability. A factor which has received more and more attention as teams come of age is
personal accountability for work. To fail to hold employees accountable is damaging to the
organization and does not promote growth in the employee.

For Employees to "Think Strategically" they must be "Empowered"

The Moment of Truth: Jan Carlzon (1989), the President of the Scandinavian Airline System,
summarizes this approach excellently in his book 'Moments of Truth' as follows:
- Everyone needs to know and feel that he (or she) is needed.
- Everyone wants to be treated as an individual.
- Giving someone the freedom to take responsibility releases resources that would otherwise
remain concealed.
- An individual without information cannot take responsibility; an individual who is given
information cannot help but take responsibility.

Employees will think strategically only when the cost of both baring risk and sharing risk is
reduced, and employee behavior is modified in the long-run by creating a holistic global
ownership culture.
CFOs and Accountants can undertake four influencing-empowerment accounting roles:

 Resource Consultant: This catalyzing role links employees to resources so that it

enhances their self-esteem and problem solving skills, in order to work towards
achieving their own independence and own control over their lives.
 Sanitizer: This enabling role helps employees gain the knowledge necessary to take
control of their own work environment. Here the empowered person recognizes and
identifies their own strengths and the strengths of others.
 Teacher Trainer: This priming role places the CFO as the manager of the learning
process aimed at helping the employees (and other stakeholders) to find solutions for
their situations. The CFO acts as a broker to seek to educate the employees and other
stakeholders about the barriers that people encounter.
 Co-operator: This is a Group linking role where the employee is the one who is self-
determining in achieving self-efficacy and empowerment. The CFO connects the
empowered employee to others who share common histories, issues, and barriers

Introduction
This topic looks at the interface between management accounting and marketing related "product
management" especially in competitive environments. The "product" is the first "P" in the 4-Ps
of marketing, the others being price, promotion and place distribution, which will be discussed in
detail in later topics. It is shown that as a product moves through various stages of its life cycle,
there are differing financial aspects that need to be focused on for competitive positioning. It is
demonstrated that the company's management accountant possesses the tools and techniques
required to provide the product managers with decision-orientated information.

M2 Lesson 1: Marketing
Management: The Terminology and an
Overview-2
1.The Production - Sales Era
(a) Production-Oriented Industry
-Sources and Supply of goods were limited.
-Customer demands were relatively unsophisticated.
-Limited Competition meant that goods were generally bought and not sold.
-People dealing in such products were termed to have a "Sales Orientation".
(b) Marketing-Oriented Industry - The Marketing Concept
-Competition intensified.
-More attention paid to needs of customers.

o
 Start with customer
 Work towards product

-People in such industries were termed to have a "marketing orientation".

(c) Steps in the Marketing Concept

1.
1. Define customer "Needs" (Marketing Research needed)


o
 How are products bought?
 Who is doing the buying?
 Why do people buy?

2. Define "Target Segments"


o
 Broad Market (size, growth rate vs. company capability)
 Market Segment (similarity of needs)

Economy --> Income

Quality --> Taste
Function --> Use
Use --> Image

o
 The above is known as "psychographic segmentation"

3. Create a "Differential Advantage"

 
o
 process of creating a monopoly for the company.
 use any/all "Marketing Mix" variables:
o Product
o Price
o promotion
o physical distribution
 the company must have an ADVANTAGE (look at the
consumers)
 the company must be able to create a DIFFERENTIAL (Look
at the competition)

4. Formulate Company's "POSITIONING STRATEGY".


o
 Look at all possible 'differential advantages'.
 Make a choice of exactly where it hopes to specialize in.

Note: This will depend on the company's "product-market combination".

2. Product life cycle

This is a concept that has evolved due to the 'changes' that take place in the product-market
combination of a firm.

(a) The STAGES in the progress of a product:

1. Research and Development (R&D)


o Marketing Research Costs
o Product Prototype Research Costs

2. Introduction


o Very high 'death' rate
o Lots of initial problems to solve

3. Growth
 
o Customer acceptance-->Market Expansion
o Production experience --> Cost Reduction

4. Maturity


o Demand Peaks
o Competition Intensifies

5. Decline


o Due to Technological; Taste; Cost Factors.
o Must Extend PLC; Divest; or Harvest.

3. "STRATEGIC FOCUS" OF THE PRODUCT-MARKET MISSION

(a) The Main Decision
- whether to aim for:-

o
 Increased Productivity
 Increased Volume

- They have very clear cut FINANCIAL IMPLICATIONS

(b) Increasing "Productivity"

This decision is usually required for existing products. Productivity increases may be obtained
by:
- Increasing Prices
- Improving Sales Mix
- Reducing Costs

(c) Increasing "Volume"

This decision could pertain to both Existing and New products.
The main Volume-Growth alternatives for achieving long-term profitability are given in the
following model.

(d) The Model:

New Market Market Development Diversification

Present Markets Market Penetration Product Devt
Present Products New Products


o Market Penetration: Increasing volume to present customers
o Market Development: Finding new customers for present products
o Product Development: New and different characteristics to serve
company's existing customers and applications
o Diversification: Simultaneous departure from existing products and
existing markets.

(e) a detailed look at the strategic focus of present products

- the strategic focus shifts along with the PLC
- as the focus shifts, the various combinations of the marketing mix must also change
(usually the focus shifts from left to right as one moves from one stage of the life cycle to the
next)

M2 Lesson 2: The Financial

Dimensions of Marketing Planning
1. The Factors that Affect "Profitability" in a Business
(a) Extending the "Learning Curve" phenomenon.
If costs decline predictably with units produced, the competitor who has produced the most units
will probably have the lowest costs.
Thus, since products of all competitors in a certain segment have about the same market price -
the competitor with the most "unit experience" should enjoy the greatest profit. (Thus highest
ROI)
(b) This can lead to the hypothesis that there is a close relationship between:
Market Share and Profitability
(c) The close relationship between MARKET SGHARE and PROFITABILITY has been
accepted as a result of the PIMS Study
ROI goes up steadily as market share increases.
The study seems to indicate that if a company maximizes its market share, it will maximize ROI
as well.

(d) The "Maximize-Market Share" Goal

For the Controller, the implications of the PIMS Study seem to be ... "Forget all controls
initially and allow the new product manager to go for market share at all costs."

Reasons why this would be a "Recipe for Disaster":

- Investment in Market Share generally requires large cash resources.

o
 Such cash is usually "internally generated"
 Therefore, must have a "balanced" Product Portfolio
 i.e. Have cash generating products that are able to finance
new products that are usually cash absorbers.

- The nature of the 'Competition' and the 'Structure of the Market' must be considered.
It is easier to obtain leadership in a growth market, than take it away from someone who "owns"
it in a non-growth market (e.g. if a company maintains volume when the market is growing, it
will actually be losing market share).
Therefore, before segment managers go about blindly seeking "Maximum Market Share" - the
Controller must make them aware of the relationship between:

o Market Share;
o Market Growth, and
o Cash Flow

This relationship is very clearly displayed in a chart that is known as ... "THE PRODUCT
PORTFOLIO MATRIX".
2. The Portfolio Matrix
This shows the relationship between "Market Share", "Market Growth" and Cash Flow.
a. Cash Cows (High Market Share; Low Market Growth)

o
 Position of some strength
 Large generation of cash
 Must maintain market share

b. Stars (High Market Share; High Market Growth)


o
 Potential market must be grown into
 Must at least hold market share in a growing market.

c. Wildcats (Low Market Share; High Market Growth)


o
 Needs investment to keep a foothold in a market dominated by
others
 Expand a few (having 'differential advantages')

d. Dogs (Low Market Share; Low Market Growth)


o
 Produce very little cash - if any.
 Expansion possible only by 'improving efficiency' and 'cutting
prices'
 Put on 'milking status' - if they don't use valuable resources
 If they do - slaughter.
M2 Lesson 3: Budgeting for
Marketing Activities
1. Segmental Direct Costing
There is a large amount of marketing costs which one has to regard as "unallocable overhead". It
is not that management is unable to influence them but, because they are not objectively
allocable to marketing segments (such as PRODUCTS; CUSTOMERS etc.)

Traditionally accountants use arbitrary (or subjective) "bases" of allocation. These allocation
bases are often Volume-base (e.g ., % Revenue). In other instances the cause - effect relationship
may be questionable (e.g ., number of calls made). This causes problems for marketing
managers who need unambiguous information for decision making. Thus, the method of direct
costing at differing segmental levels has been suggested.
The Segmental Levels of a Company

Steps for Budgeting Marketing Activities

(a) Map 'Natural Expenses' into 'Functional Expenses'.
(b) Assign Functional expenses to marketing segments.

o Start with lowest level segment.
o Attach/Allocate only if expensed fully for that level.
o If not, see if they attach/allocate at next level.

The Marketing Budget Model (For Sales Segments)

This is a 'multiple regression formulation' incorporating:

 Product and Customer related VARIABLES; and

 Constants representing ATTACHABLE/ALLOCABLE FIXED COSTS (i.e .,
Segmental Fixed Costs)
The Model is expressed as:

Segmental Contribution = C1X1 + C2X2 + C3X3 - e1y1 - e2y2 - FC

- PC
Where:
C1-3 = the product contribution per unit.
X1-3 = the product unit sales.
e1-2 = variable expenses which behave as a function of a variable other than product units (i.e .,
Complexity Costs)
y1-2 = Non-product-related factors of variability (such as gram-kilometers shipped or invoices
processed) (i.e ., Structural Cost Drivers)
FC = Specific Fixed Costs attachable/allocable to the segment being analyzed.
PC = Promotional Costs to be used to secure the segment contribution.

M2 Lesson 4: Others and Example

This marketing budget model is based on the Economic Value Added (EVA) or Residual Income
approach. Thus, a charge for COST OF CAPITAL is levied against the segment. This includes:

 Variable Cost of Capital (Debtors; Stock)

 Fixed Cost of Capital (Fixed Assets)

Promotional Costs are shown separately because they are considered the "ammunition" and at
least the partial cause of sales. Thus, it is desirable to 'test results' of various levels of
Promotional Costs.

M2 Segment Reporting
SAMPLE PROBLEMS:
1. The Casket Division of Roybal Corporation had average operating assets of $750,000 and net
operating income of $86,700 in March. The company uses residual income to evaluate the
performance of its divisions, with a minimum required rate of return of 13%. What was the
Casket Division's residual income in March?
ANSWER: NOI $ 86,700
 Min Req. Return ( 13% x $750,000) 97,500
Residual Income ($10,800)

2.
Wryski Corporation had net operating income of $150,000 and average operating assets of
$500,000. The company requires a return on investment of 19%.

Required:

a. Calculate the company's current return on investment and residual income.

b. The company is investigating an investment of $400,000 in project that will generate annual
net operating income of $78,000. What is the return on investment of the project? What is the
residual income of the project? Should the company invest in this project?
ANSWERS:
A. Return on investment = Net operating income Average operating assets = $150,000
$500,000 = 30%

Residual income = Net operating income - (Average operating assets x Minimum required rate of
return) = $150,000 - ($500,000 x 0.19) = $55,000

B. Return on investment = Net operating income Average operating assets = $78,000

$400,000 = 19.5%

Residual income = Net operating income - (Average operating assets x Minimum required rate of
return) = $78,000 - ($400,000 x 0.19) = $2,000

The company should invest in this project since its rate of return exceeds the minimum required
rate of return. In other words, its residual income is positive.
Introduction
This topic looks at the interface between management accounting and marketing related "product
management" especially in competitive environments. The "product" is the first "P" in the 4-Ps
of marketing, the others being price, promotion and place distribution, which will be discussed in
detail in later topics. It is shown that as a product moves through various stages of its life cycle,
there are differing financial aspects that need to be focused on for competitive positioning. It is
demonstrated that the company's management accountant possesses the tools and techniques
required to provide the product managers with decision-orientated information.
M3 Lesson 1: The Product Manager
and Management Accountant
The Two Divisions of Product Management
Marketing product management is an 'on-going' activity: from the collection of ideas for new
products to the maintenance of existing products or the abandonment of products from the range.
Therefore there are two natural divisions in the application of control to product management:

1. New product development (NPD)

2. Current mix - maintenance and abandonment.

Product Management and the Life Cycle

Marketing product managers need to consider these divisions in terms of volume and
productivity decisions as their products proceed through what is known as a 'life cycle'.
As with any life cycle, be it in organizations, marketing segments or products, there are the
stages of pre-introduction, introduction, growth, maturity and decline associated with a
marketing segment.
At each stage of this life cycle, there is a significant range in the functions associated with the
product manager.
At one end, he or she has the pure staff function of advising and coordinating the activities of
manufacturing, advertising, promotion, field sales, pricing, research, packaging, etc.
At the other end the manager has full line responsibility for the profit of a group of products, i.e:

o Using his or her own sales force, and
o Operating as the manager of a completely decentralized profit center.

The range in responsibility of the product manager reflects the changing role of his or her
activity.

Implications for Management Accounting

The implications of the above to the management accountant are quite clear:

 In the first place, since product managers have specific responsibilities, reports must
be designed with an eye on these arrangements, e.g:
- Segmental Contributions Reports
- Life-Cycle Costing Reports

 This means that standardized product profitability reports may not be adequate and
flexibility may be required.

The management accountant must be aware that:

 As the product manager's functions approach profit responsibility.

 The need for effective financial information and analysis increases.

This need can be filled by an accountant who recognizes what is needed and then provides
adequate information.

M3 Lesson 2: The Financial Aspects

of the Product Line
One of the first steps an accountant should take in the marketing product management area is to
understand the financial aspects of the product line. There are some basic questions that have to
be asked when studying product lines. These are detailed below.

'Is the Sales Volume of the Product (or Product Line) Rising or Falling?"
This depends on the product's life cycle, and the stage in the 'Product Portfolio' of the
organization. Basically, if a product is losing money and past its peak, and it is using up valuable
scarce resources, then it should be put to sleep quickly.
Costs of production, storage, etc ., could then be spent on a product that is on its way up.
Variety reduction should be the key word.
Pareto analysis or the 80/20 rule could be used to eliminate low-margin product lines that
represent a substantial part of volume. (An ABC Costing System with Customer-Product
Profitability Analyses could be used).
A good coding and classification system would also be necessary to recognize and isolate the
low-margin lines.
'Is the Product Making a Profit?'
To answer this, the company should have adequate product-line cost information. (In complex
organizations, ABC is essential). Accountants must design marketing oriented reports (such as
the Segmental Contribution Reports illustrated earlier) that not only provide action-oriented
information to product managers, but also resist temptations by managers with poorly
performing products to put forward arguments (excuses) that a product is:

 really doing better than the figures show because it carrying more than its share of
overhead as allocated to it.
 not using as much overhead as allocated to it.

Another popular argument put forward is that it is a product line that the company has had for
years, and that if a few changes in the mix were done it would again start making money.
Remember that if a product cannot offer a distinct differential advantage - it is better to abandon
it than spend limited resources trying to revive it.

'What are the Product-contributions of the Different Products?'

If product-contributions are low, consider increasing selling prices. If this is not possible, there is
a long upward struggle to improve operating efficiency (i.e. Porter's Cost Leadership Strategy);
Because, while a company battles to reduce manufacturing costs - it can be sure that the
competitors are ploughing the field too. A company's hard won improvements may only keep it
from losing more ground.
If the contribution of a product (that is not in a low-contribution industry) cannot be improved, it
is better to abandon the product.

'Is the Sales Department Determining the Pricing?'

If so, then almost certainly, the prices are bound to be too low. Salesmen rarely believe that they
can get a higher price for the product until they are told by the management that they have no
choice. It is amazing how often the customer will pay more with little or no complaint despite all
the salesman's warnings that to raise price is suicide.

'Does your Sales Program Offer a Wide Variety of Options and Extras?'
Customized products always cost more (i.e. adds to the 'Cost of Complexity'). Therefore, unless
the volume is large enough (so that economies of scale can be realized) they are certain to lose
far more money than the cost analyses show. This is due to the increasing complexity such
products bring.
Once satisfactory answers have been obtained to these overall financial aspects of the product
line, a more in-depth study of the products and their life-cycle stages canbe carried out.

M3 Lesson 3: The Financial Aspects

of the Product Life Cycle
Life cycle is a useful model for conceptualizing conditions and forces at work in the firm's
several markets. It applies equally well to all kinds of segments, such as products, product lines,
brands, markets or organizations.
A product is seen as passing through five phases: research and development (pre launch);
introduction, growth, maturity and decline. There are financial aspects to be considered in each
phase of this life cycle, and these are detailed below. It will be seen that an understanding of how
the financial focus changes as a product moves through its life-cycle is invaluable for 'Life Cycle
Costing' exercises.

The Pre-launch Phase

The important characteristics of this phase are given in Table One.

Table One: Financial Aspects of the-

Pre•launch Phase
Problems 1. Clear definition
Clear description of elements of
2.
identifiable costs
3. Capitalize or expense decisions
Determination
1. Individual
Bases
2. Industry guidelines
Product
1. Importance in terms of usefulness?
Evaluation
2, Viability in the market place?
3, What are the expected benefits?
4. How much will it costs to develop?
Target Costing and Value Engineering
5.
considerations
Cost 1. Basic research
Classification
2. New product development
3. Product improvement
4. Cost and capacity improvement
5. Safety, health and convenience
Some Incurred with expectation that primary
1.
Characteristics economic benefits will be derived in
future periods.Concerned with
2. improving or developing future benefits
for itself.
Some Budget Discounted net future cash flow equals
1.
Consideration future gain.
What is the source of capital (cash cow;
2.
loans; new issue)?
Capital equipment - what should be used
3. during; what should be done with it
after?
Ongoing research; technological
4.
changes.
Marketing Examine needs of the market and find
1.
Strategy means of satisfying it.
Establish market potential through
2.
salespersons.

It is suggested that it would be useful to classify costs into five categories (see 'Cost
Classification' section of Table).
These costs are usually incurred with the expectation that the primary economic benefits will be
derived in future periods.
There are huge costs involved in this phase:
First, there is the cost of maintaining a new product development and a research and
development team (e.g. salaries of R&D and NPD staff).
Second, there is the cost of marketing research.
Third, the return on assets generally declines when undertaking extensive product development
strategies.
For example, in Table Two three periods for a company are shown. In each of the latter two
years, new products Y and Z are launched. Usually in the first year a new product returns a loss.
Even when assuming that product Y breaks even in the second year, one can see that the ROA is
declining. The actual results of a large confectionery manufacturer when it started a countrywide
diversification program are given in Table Three to illustrate the point further.

Table Two: New Product

Development and ROA
Specific RO
Product Year Return
assets A

$m $000’s %

Present
x 1 1.0 150 15.0
product
x 1.0 150
New
Y 0.2 -20
product
Total 2 1.2 130 10.8
x 1.0 150
New Y 0.2 0
product z 0.2 -20
Total 3 1.4 130 9.3

Table Three: ROCE of

Confectionery Manufacturer
Year Sales Profits ROA
$m $m %
1 83 8.0 18
2 84 8.5 16
3 87 9.0 15
4 94 8.6 13
5 102 7.7 10
6 131 10.6 13
7 149 10.6 11

The accountant must be aware that as return on capital employed declines and investors lose
confidence, the company may become vulnerable to a takeover bid.
Further, if the company is trying to diversify in a time of crisis, there will be a severe liquidity
problem. (Note: that simultaneously moving to both new markets and new products, i.e.
diversification is a high-risk strategy).

 The management accountant is the person who is in the best position to analyse what
the expected future net cash flows are going to be, and ensure that there are current
cash generating products (cash cows) to provide the cash being absorbed by the new
products.
 Capital budgeting models, particularly those that discount future cash flows to the
present and compare such with the investment are particularly useful in such
analyses, especially when extended to 'Strategic Value Analysis' models).

The marketing strategy assumptions required for such models necessitate a very close
examination of the needs of the market.
Individual company and industry guidelines can be used to establish market potential as a basis
for guiding R & D expenditures (i.e. the basis of Target Costing exercises).

Risk and Uncertainty

The problem that the marketing manager, and therefore the accountant has at this stage is the
'uncertainty' about future conditions. The difference between a 'risk' situation and an 'uncertainty'
situation is that in the former situation (risk) a company has the experience to assign probabilities
to future events, in the latter case (uncertainty) it does not have the experience to do so.
Figure One: Product Market Growth Options
The type of situation (i.e. risk or uncertainty) that a launch of a particular product would bring
about depends on the position of the product on the ‘new products classification chart’ given in
Figure Two.

If the new product is in categories 1,2,4, or 5 this means that the company has some relevant
experience in both the market and the technology of the new product.
Therefore, it most probably will be able to assign probabilities to the possible outcomes of such a
launch (i.e. a risk situation).
For example, if a company has a choice between new products A and B of categories 4 and 5
respectively, the marketing manager, due to past experience and current knowledge may be able
to assign the following probabilities to the possible competitor reactions if these products are
launched (Table Four):
Making Decisions in Risk Conditions
The ability of the marketing manager to assign probabilities indicates that this is a risk situation.
The accountant can therefore use the concept of expected-value to help the marketing manager to
make the required decisions. The marketing manager may look at the pay-off matrix and come to
the conclusion that product B is better because:

 it has the highest contribution if the competition does nothing; and

 if he adds all the possible contributions ($99,000) it is better than the addition of
product A's contributions ($90,000).

These are, however, the wrong conclusions. However using the probability tables (Table Five)
one can see that the expected value of product A ($29,000) is better than that of product B
($26,700).

Making Decisions under Uncertainty Conditions

Now supposing the products were in categories 6 and 8 then, it is unlikely that the marketing
manager will be having adequate previous experience to assign probabilities to the various
possible states of nature. Therefore, although he or she will be able draw a pay-off matrix, it will
not contain any probabilities.
This is then an uncertainty situation and the accountant has three available criteria to apply to the
pay-off matrix (Table Six) given below:

The first criteria assumes that the worst outcome will always come about. Therefore, the
alternative is to select that which gives the largest minimum payoff. The philosophy behind this
reasoning is that the actual outcome can only be an improvement. Therefore, under this first
criterion of 'pessimism-maximin', the firm will launch product A as it will get more than product
B in the worst situation of each product ($25,000 vs $19,000).
The second criterion, that of 'optimism-maximax' is the converse of the above, and is based on
the assumption that the best payoff will result from the selected strategy. In this case, product B
will be chosen as the maximum profits out of the two in each product's best situation is from B
($70,000 vs $50,000).
The last criterion is that of 'regret'. This is based on the fact that, having selected a strategy that
does not turn out to be the optimal one, the decision maker will regret not having chosen another
strategy, when he or she had the opportunity. Under this criterion, one must first draw a 'regret
matrix' (Table Seven). This is done in the following manner:
Using the 'maximin' criteria, if product A was chosen; but the competition actually introduced
only a comparable product, then product B would have been better.
Therefore the 'regret' of launching product A is ($40,000 - $20,000, or) $20,000.

This is done for all states of nature and the 'regret totals' are added.
The choice is the product with the least 'regret total'.
This would be product B ($6,000 vs $30,000).

Ideally, the management accountant would be able to use such criteria for every year of the
projected life-cycle of the product, and discount the cashflows using an appropriate cost of
capital rate. Such a discount rate should be the risk-free interest rate, as using the various
matrices would have already adjusted the (numerator) cash flows for risk or uncertainty.
In reality, the accountant may have reasonably reliable information for only (say) five years, for
such a 'Life Cycle Costing' exercise.
It would still be worthwhile undertaking a capital budgeting investment appraisal with this
limited information prior to a product launch, because it will at least ensure that the launch was
not doomed for financial failure from the start.
The use of the matrices is a method of adjusting the cash flows (numerators) for risk and
uncertainty.
Another approach is to discount unadjusted cash flows with a risk adjusted discounted rate (the
denominator).
A 'risk-premium' can be added to the risk-free interest rate, with a larger premium for the early
'high-risk' product launch phase.
It must be emphasized that all these methods output figures that are based on subjective inputs.
Further, there are other factors that will affect the final decision - such as needing a complete
product line - that cannot be quantified in terms of profits and losses. Therefore, the figures
generated must only be used as starting points for decisions. Once the final decisions are made,
one can proceed to introduce (launch) the product chosen.

The Introductory Phase

Here the primary areas of concern will be with:

 the creation of demand,

 the funding of the costs of introducing the product,
 the attempt to selectively reach an optimum number of segments without spreading
too thin,
 the establishment of a relatively high initial price (especially under a skimming
strategy), and
 the experience of coping with relatively high manufacturing costs (i.e. the Learning
Curve).

Listed below in Table Eight are the important financial characteristics of this phase:

The Growth Phase

Special consideration is required in the growth phase to monitor rapid increases in sales as they
begin to occur. This means that prime attention is on the rates of change in demand in each of
these segments.
These rates of change will need to be carefully coordinated with the contribution approach (CVP
Analyses are especially useful here).
This coordination is to ensure that the cost inputs will be aimed at the target markets (i.e.
volume) which will produce a maximum contribution to profit.
From a capital funding point of view, a fairly large investment will probably be required in
current assets in the form of stock and debtors (e.g. Stars and Problem Children in the product
portfolio can be cash absorbers).
Some capital funding will probably be required for equipment to achieve efficiencies in
production.
The promotional expense may be relatively high in the initial part of the growth stage; however,
the unit cost may become lower as the volume of sales grows in the middle and end of stage.

o This particular phase will probably have the highest funding for both expenses and
capitalized asset values of the five stages of the life cycle, as products at this stage
absorb funds until their potential market is grown into.
o Therefore, it is particularly important that there is synchronization between the
growth of sales volume and the availability of capacity.
o This means that the company must have a balanced product portfolio.

Listed in Table Nine are the important financial characteristics of this phase:

The Maturity Phase

In this phase of the segment life cycle, sales tend to become stable (i.e. Cash Cow products).
Careful consideration should be given in planning to devote inputs to those segments that will
maximize contribution.

 The emphasis in this mature market stage need not be so much on the rate of change
(as in the growth stage);
 However, careful attention should be devoted to those accounts that may be heading
for decline or reduction in sales (i.e potential Dogs).

Segmental reports on contribution to profit can indicate where promotional inputs particularly
advertising and personal selling - need to be realigned.
The major capital problem to be considered in this stage of the life cycle is whether or not to
reinvest capital with the hope that product improvement or differentiation can reinvigorate the
sales curve to a new cycle, especially to obtain "cost leadership" benefits.

 If differentiation does become possible, it may be possible to extend the life of the
product; the increased capital investment could result in a profit contribution for the
short run and possibly the long run.
 If differentiation is not possible, then no capital investment should be made. (EVA
calculations highlighting marginal capital investments are particularly useful here).
Special attention should be paid to the profitable use of assets, particularly in those segments
where there is an indication of a decline of sales.

 Marginal assets/products should be decreased.

 A minimum range should be established for acceptable margins in the various
segments.
 Opportunity costs for investment in other segments should be viewed very carefully
at this particular stage.

Table Ten lists the important financial characteristics of this phase:

The Decline Phase

This is a very important stage of the life cycle from the control viewpoint.

 It is a real art to be able to know when to withdraw a product from the market.
 Certainly, marketing productivity is maximized when we invest capital in segments at
stages when they are making maximum contributions to profit.

Many companies are reluctant to phase out yesterday's breadwinners:

1. sometimes due to not recognizing the situation; and
2. sometimes due to sentimental reasons.
Shrinking the number of "dog" products or product lines is, however, usually the surest route to
better profit and higher return on investment. Therefore it is vital to obtain some indicator of the
point at which we begin to enter the decline of the life cycle.
Possible indicators which include both financial and non-financial measures include:

o trends in contribution margin,
o sales volume,
o price levels, and
o comparison of present versus potential use of capital funds.

The financial characteristics of the decline phase are listed in Table Eleven:
M3 Lesson 4: Product Abandonment
Approaches
Product Review Teams

It has been suggested to appoint a high-level and broadly representative management team which
holds meetings at least once a year (or more frequently depending on the industry):

 to set objectives and procedures for identifying weak products,

 to evaluate them, and
 to develop a phasing out program for product pruning.

The steps suggested were:

1. preparing a data sheet on profitable/unprofitable products and customers;

2. determining candidates for abandonment;
3. developing a management rating and review of the dubious products lists;
4. obtaining a 'retention index' depending on above rating and weighting;
5. deciding on what products to abandon;
6. formulating phasing-out policies.

Contribution to Resources Ratio

This approach that has been proposed is to assist in product abandonment decisions. A fully
developed and up-dated cost accounting system (ideally based on ABC principles) is the critical
requirements for such an approach. It also relies heavily upon marketing performance data for its
inputs.
Only costs and revenues for which an acceptable 'cause-effect' relationship can be found or are
directly associated with the product or sales of a specific product are considered relevant to the
analysis. Therefore, segmental analysis based on the residual income (EVA) approach is
appropriate for such an approach.
The basis for product comparisons is a Contribution to Resources Ratio (CRR) which can be
expressed as follows:

C.R.R. = (Net Contribution of Product A + Contribution of all Products)

(Use of Resources by Product A + Use of Resources by all Products)
For example, assume product A's net contribution towards the profits of the next level was 5% of
the total contribution of all products in its level; and its use of resources were 10% of all the
resources specific to that segment level.

Then: C.R.R. = 5%/10%= 50%


o The contribution of product A is reduced because of its disproportionate
use of the segments resources. (This is closely aligned to the EVA
concept).
o It may be a candidate for abandonment.

The approach is expanded at this point to allow managers to insert subjective estimates of the
financial effects of a price change with accompanying volume and cost changes (i.e. Sensitivity
Analyses).

 Also, an exponentially weighted moving average is used to extrapolate sales for the
year.
 Finally, managers are asked to estimate any interaction effects with complementary
or substitutable products.
 The various financial estimates are employed within a contribution accounting
framework.

For effective implementation of this system, an appropriate cost-information data base needs to
be installed.
The segment manager can then use C.R.R as an indicator, on a real-time basis, of the
comparative levels of contribution between products in a particular segmental level.

Methods of Dropping Product Lines

A. Sell off the line to a competitor, or someone who wants to get into the business;
B. If this is not possible, one could simply stop making it;
C. Another alternative is to put into effect a large, across-the board price increase.

Then, if the line has been grossly underpriced, one may not lose much business, and may have
turned a bad line into a good one. Even if most sales are lost, a few may continue to buy for a
while; thus enabling one to favorably dispose off one's inventory.

Consequences of Dropping a Product Line (Costs vs. Benefits)

The loss of contribution (if any).

Because sales volume has dropped, however, a number of hidden benefits accrue:

o the debtors in that line turn to cash;
o the purchase of raw materials and direct labor is stopped, and this saves
more cash;
o the personnel working on the line are transferred or made redundant
(except those needed for the final salvage operation), saving more cash;
o the total operations become less complex, and more savings happen;
o the machinery may be sold, for second-hand value or scrap, and both cash
and space are freed.

M3 Lesson 5: Inflation and the PLC

The PLC in an Expanding Economy

The financial aspects of the product life cycle can be studied in even more detail by analyzing
what is likely to be the impact on the PLC of a high rate of inflation.
In an expanding economy the higher initial investment in new products is less likely to deter the
introduction of such products than in conditions of recession.
For existing products, there will be increased investment in working capital but bank finance
should be available for this purpose.

 Although such buoyant markets could slow down the ageing of products and extend
their market lives,
 The rate of innovation and technological change is likely to accelerate - and this may
push established products more rapidly into the decline stage of their life cycles.
(Thus there are differing possible impacts on the PLC).

The constant pressure of rising costs on profit margins will mean that prices have to be
continually under review and increasing constantly.

The selling price thus becomes a more important variable in the marketing mix, than in a stable
economy, and should be continuously monitored.

The PLC under Stagflation

In a stagflationary situation (i.e. stagnation with high rates of inflation) companies are likely to
face a combination of rising costs, falling demand and declining margins.

It becomes more difficult to pass on higher costs in the form of higher prices, and cost control
increases in importance.

Many companies, particularly those supplying industrial markets, find themselves in a buyer's
market with excess capacity being a common characteristic.

While the high rate of inflation squeezes profit margins and internally generated cash flows, the
access to external finance becomes restricted.

Thus companies solve their liquidity problems by running down stocks and cutting back R & D
and capital-expenditure programs.

The higher initial investment, cost of financing, and risk and uncertainty are likely to slow down
the rate of new product introductions and competitive innovation.

For existing products there will be increased investment in working capital when cash inflows
are being squeezed.

These factors, in addition to falling demand, may push products into the decline stage and
shorten their economic life cycles.

On the other hand, the slowing down of the rate of innovation and technological change may
lengthen the market life of existing products. (Again there are differing possible impacts on the
PLC).

Under these circumstances the management accountant must consider more the innovations that
extend the life of existing products than new product innovations because the degree of risk is
less.
M3 Lesson 6: The Use of CVP in
Product Planning
Cost Volume Profit (CVP) analysis is a study of the interrelationship between cost, the volume
of activity, and profit.
The perspective of this study is limited to the short range time period; and the purpose is
twofold:
to understand the effect of cost in response to changing volume of activity, such as sales or
production; and to discern the resulting impact of cost on profitability.
The objective is to manipulate the variables of cost, price and sales volume, and determine how
this changes profit before choosing a level of activity where the operations are likely to result in
optimal profit. (This is under the 'profit maximizing' objective).

SAMPLE PROBLEMS
1. Akerley, Inc., produces and sells a single product. The product sells for $140.00 per unit and
its variable expense is $42.00 per unit. The company's monthly fixed expense is $393,960.
Required: Determine the monthly break-even in unit sales.
Answer: Unit sales to break even = Fixed expenses/Unit CM = $393,960/$98 = 4,020 units

2. Yundt Corporation produces and sells a single product. Data concerning that product appear
below:
Selling price per unit $100
Variable cost per unit $46
Fixed expense per month $82,080
Determine the monthly break-even in total dollar sales.
Answer: Dollar sales to break even = Fixed expenses/CM ratio = $82,080/0.54* = $152,000

3. The following monthly budgeted data are available for the International Company:
Budgeted net operating income for the month is $220,000.

Required:

a. Calculate the break-even dollar sales for the month.

b. Calculate the margin of safety.

c. Calculate the operating leverage.

ANSWERS:

a. Dollar sales to break even = Fixed Expenses CM Ratio = $250,000 0.28 = $892,857

b. Margin of safety= Total sales - Break-even sales = $1,700,000 - $892,857 = $807,143

c. Operating leverage = Contribution margin Net operating income = $470,000 $220,000

= 2.14

M3 Lesson 7 Packaging and After-

Sales Service
PACKAGING
Aspects of Packaging
Packaging should be treated as an essential part of product development:
  since the 'pack' has more significance than being merely a means of enabling a
product to be transported from the point of manufacture to the point of sale,
 along with product features, packaging and after-sales-service feature at the top of the
order of marketing decisions, and these all form part of product management.

There are three aspects to packaging - functionalism; convenience; and image. The first two
aspects are physical, the third, promotional.
Of the physical aspects, 'functionalism' merely packs a product safely, while 'convenience' takes
the following factors into account:

o opening and closing ease;
o size; shape and storability;
o adequacy of instructions;
o ease of carrying;
o Subsequent use of container for storage;
o ease of disposal.

The promotional or 'image' aspects of packaging are equally important as the convenience
aspects.

 This centers around the ability of the package to attract the customer's attention.
 This is especially important in the case of packaged foodstuffs and other frequently
purchased items which retail in supermarkets and self-service stores.

Here, several brands of a product will probably be displayed next to one another on the shelves,
and if the packaging does not prompt the consumer to pick the company's brand in this situation,
then all previous promotional efforts to differentiate the brand are wasted.

Cost Aspects of Packaging

The controller must be aware of the 'costs' and 'economic factors' of packaging. These are:

o material costs;
o packaging labor and capital investment;
o the impact of storage;
o distribution costs (handling; shipping);
o allowances or refunds for returned containers and damaged packs;
o risks associated with 'trends' (in materials, methods, machinery, marketing
requirements);
o designing and testing costs.
AFTER-SALES SERVICE
The importance of after-sales service cannot be overemphasized. The Japanese, for example,
have been continually stressing good design, quality and after-sales service. They have worked
very hard to build up a world-wide reputation for reliability. This reputation, allows them to
enter new markets with ease and confidence.
Before offering any such service, however, the accountant must ask the product manager some
basic questions:
1. 'Is the Service Given with a View to Creating Goodwill?'
If this is the reason, then 'customer satisfaction' is more important than pure profit. However,
even here control is needed to prevent customers from taking undue advantage of facilities.
Decisions, regarding which services to provide; how fast should it be; and what limits to set must
still be made. This will be based on both the customer's purchasing objectives and the activities
of competitors in the service sphere. (The concept of 'Differential Advantage' is applicable here
too).

2. 'Is it Intended to Make a Profit or Breakeven?'

The management accountant must remind the product manager that no service is free. It must be
costed with price; or be recovered by a 'special charge'. Maintenance of adequate cost data is
essential so that one can forecast the expected cost of services. This sort of information was
collected in some companies in their 'Total Quality Management' programs. Such forecasted
costs can be incorporated into the price of the 'total marketing offer'.
If the cost is not incorporated into price this has the effect of increasing demand for a product
(similar to when one grants a longer credit period).
The accountant must evaluate the cost-benefits of such an increase in sales, using analyses such
as CVP and Sensitivity Analysis.

3. 'What is the Scope of the Service?'

Does it include installation, repairs, warranty claims, instruction manuals, distributor training,
etc? The accountant must be aware of what the salespersons are promising, as not only do the
above cost money to provide, but also if not provided, the cost of any legal action that may be
taken against the company may be expensive.

4. 'What are the Services that have to be Rendered Before the Order is Placed?'
These may be present in large industrial orders such as computer sales. Here, the marketing
manager will have to provide the controller with probability estimates of securing particular
orders. These probabilities can be provided under the 'risk' situations. These probabilities might
differ with different combinations of service and price; and with what the competition is
offering.
The controller can use the expected value concepts to analyze which combination can lead to
profit optimization.

5. 'How does one Evaluate a Service Policy?'

In the final analysis, a service policy must be evaluated taking its objectives into consideration.
For example, a warranty policy must be evaluated by determining the cost of claims versus its
promotional benefits. It is far simpler to determine the former than the latter, because one is
having to evaluate the cost of the warranty against qualitative benefits - promotion and customer
goodwill.

M4 Lesson 1: The Importance of

Pricing Decision
The Conventional Marketing-Accounting Link

Pricing is the conventional link between marketing and accounting. The traditional accountant
helps the pricing decision by quoting manufacturing and selling costs (i.e. cost of goods sold).
But this is never enough for proper marketing decisions because:

 It fails to consider customer reactions to different price levels, and

 how these reactions affect the customer’s decision to buy or not to buy.

Prices must be reasonable in order to maintain a sales level against competition, and yet yield a
satisfactory profit as well. Pricing policies must seek to reconcile these conflicting needs.
The pricing decision is thus a complex one, and mistakes can be difficult to rectify.

ASPECTS OF PRICING DECISIONS

The importance of the decision needs no stress. The price of a product is a statement of:

 The extent to which the owners of a business, or their representatives, require to

replenish and increase their purchasing power,
 in return for the surrender of their stock-in-trade or the performance of a service.
For this reason, the pricing decision is generally the responsibility of top management, with the
accountant providing much of the quantitative financial input.
Price is the financial basis of exchange, hence, the pricing decision can seldom be made without
reference to other parties in the exchange, namely: prospective buyers and competitors. Further,
there is increasing intervention from a third source – the Government, acting on behalf of what it
sees to be in the public interest, hence price controls.

THE INFLUENCES ON PRICE

It is important for the accountant to understand the influence on the price of a particular product
before he or she makes any pricing decision recommendations. The internal lower limit in the
short run may be marginal costs. However, the upper limit is set by a multitude of external
factors such as:

o the value of the product to the buyer,
o the range of buyer choice,
o the number of buyers and sellers in the market;
o the degree of buying skill,
o the substitutes available, and
o the image of product.

All these may be represented in the economic concept of the elasticity of demand. Further, the
Government influences mentioned above also have to be taken into consideration. Although it is
outside the scope of this module to discuss these influences in any detail, what we will try to
address are the various pricing methods and pricing strategies available, and the accountant's role
in such.

M4 Lesson 2: Pricing Methods

The first requirement for an accountant who wants to provide marketing-oriented pricing
information is to have an understanding of the various methods used to arrive at a selling price.
Next, he or she must be able to recognize the marketing situation relevant to the product being
priced, in order to know what pricing strategy is appropriate. Different pricing methods will be
used with different pricing strategies. Let us, therefore, first look at sense of the pricing methods
used in practice.

Cost-Plus Pricing
This is the standard, almost universal, method of pricing; and is based purely on internal
costs. This method is adequate in fairly stable markets and if basic costs are known. It is
commonly used by retailers and wholesalers who know what their basic costs generally are.
However, manufacturers have many methods by which they calculate basic costs such as
absorption or marginal costing, and activity-based costing.

Cost Allocation and Cost Behavior Issues in Pricing

It is well known that there are cost allocation problems associated with these methods,
especially for marketing. He or she must cover variable costs in the short-run and all costs in the
long run. Therefore, the accountant must be aware of the limitations involved when he or she
uses a mark-up on costs as a basis for pricing.
In deciding on the percentage by which to mark-up the product, the accountant must consider
the ‘differential advantage’ factors such as:

o

 the economic characteristics of the product;
 the present stage of its product life cycle;
 the demand and competition.

Even when these factors are considered, the cost-plus method fails to take into account the cost-
volume price relationships among costs, i.e. cost behavior issues (which is considered in the next
pricing method).

Target Pricing
This is a more sophisticated version of cost-plus pricing and takes into account:

o the volume fluctuations, and
o the cost of capital involved in the business.

This method fixes a definite “rate of return” on an investment for a certain period. To fix this,
one must be able to forecast for the particular period:

o The sales level (a knowledge of the product’s life cycle is needed for this),
and
o the “average cost” during that particular period.
However, target rates of return prices are still based on “internal costs” and not on the market –
thus taking very little account of competition.

Competitive Based Pricing

This is basically “fixing a price that slots into the market’s competition”, thus, external factors
are specifically considered. This method is needed in highly competitive markets – where “price
sensitivity” is so great that anyone moving above the going rate is likely to go bankrupt.
There are two sub-methods in competitive based pricing:

o The first is termed “head-on pricing” where the price is set exactly at that
which the competition is offering.


o The second is “percentage differential pricing” where one bases
one’s own price on a percentage difference (higher or lower) from that of
some level of competition.

In “normal conditions” this method becomes very mechanistic and does not allow managers to
build on their product’s (or company’s) unique strengths or adjust for their unique weaknesses.
The “problem period” is when one needs to change the price of a product for reasons other than
those caused by competition. Such reasons may be increased costs and low market penetration;
etc.

Estimating Reactions
In most pricing decisions, it then becomes necessary to estimate:

o
 What will be the reaction of the consumer?
 What will be the reaction of competition?
 What will be the result of the above two reaction-interactions?

This shows that much of the skill required in this pricing method revolves around the ability
to predict reactions. This predictive ability is very often judgmental, and thus, requires the
experience (if relevant) of the product manager. Probability estimates may be used in ‘Risk’
situations, and gone-theory in ‘uncertainty’ situations.
Thus, the management accountant’s role is basically to use the tools available to him or her, such
as:
 
o
 Cost-volume-profit (CVP)
 Sensitivity and risk analysis,
 to quantify the predictive data in some manner (e.g. expected
value or segmental analyses) and provide the product manager
with information on which to base decisions.

Generally, the reaction of consumers will depend on brand loyalty and the elasticity of demand
for the product. It is only if one’s product is relatively elastic can competitors gain an advantage
due to one’s own price increases. The reactions of competitors on the other hand will depend on:

o
 If the product has an elastic or inelastic demand;
 If one is a price leader or a price follower;
 If they think that the change is merely a short-run “tactical”
move or a long-range change of policy.

The reactions also depend on:

- the characteristics of competition; i.e. is the competition perfect; imperfect; monopolistic or
oligopolistic?
- the feelings of middlemen in the channels of distribution, and of government authorities,

Customer (Value) Based Pricing

Here, the analysis takes into account not only the internal cost factors and competition, but also
the “value” customers place on the product. This “value” is very difficult obviously for an
accountant to quantify. Fortunately, the opportunity for the application of customer based pricing
has been advanced by the emergence of new concepts and techniques, as outlined below.
A product may have several different “values”:

 Cost Value; which is the sum of all the costs incurred in providing the product.
 Exchange Value; which is the price a purchaser will offer for the product. This is the
conventional purchase price, and it can be assumed to be the sum of two parts:
o
 Use value; which is the price the purchaser will offer in order
to ensure that the purpose (or function) of the product is
achieved.
 Esteem value; which is the price which is offered for the
product beyond the use value.
Therefore, the following equations can be put forward:

Profit = Exchange Value – Cost Value

Exchange Value = Use value + Esteem Value
Cost Value: The costs a customer perceives are just as diverse. They include:

o


 The clearly defined acquisition costs
such as the seller’s price;
incoming freight; installation and order-
handling costs;
 The less clearly defined costs such as
the risk to the customer of
product failure, the fear of late or
inaccurate delivery; the fear of
custom modification after receipt of
item; etc.

The “use value”: This is a subjective judgement and will differ depending on the decision
maker. In an industrial buying situation, where there are many people influencing the
decision, there can be different aspects to this subjective judgement. For instance:

o


 The “functional” utilitarian benefits
might be attractive to the
production engineer;


o


 The “operational” benefits relating to
the product’s reliability and
durability would be important to
manufacturing and the operating
managers;


o

 
 The “financial” benefits will be
attractive to purchasing agents and
accountants.

Therefore, the cost-benefit trade-off an industrial buyer makes in arriving at the “use value” is
an exceedingly complex process perceptions and not merely hard and fast realities.
The consumer product buyer also goes through a similar process: Such a buyer, however, is
better able to arrive at one figure (i.e. it is not a team decision), This is illustrated in the common
remark …”l reckon that is worth..."
In a purchasing situation the seller’s price (exchange value) less the use ‘value will arrive at the
esteem value. (Esteem Value Price – Use Value). If this value is (say) $100,000 then one must
ask the question, “Is this product required so much that $100,000 must be paid in excess of its
usefulness?” Many affluent people will say “yes” to such a question say if they are considering a
Rolls Royce motorcar against a Mercedes Benz.
In a marketing situation, however, as we are trying to determine the exchange value, both the use
value and esteem value will have to be estimated. Most of the methods used in behavioral and
motivational research have been aimed towards such estimations.
The importance of the above for the accountant is that he or she must know “the highest
exchange value a customer would be willing to pay for the product”. It is only once this is known
that he or she can structure a pricing policy that would:
- Take maximum advantage of the company’s internal cost structure;
- Build, whenever possible, on the company’s distinctive competitive competence.

M4 Lesson 3: CVP Analysis in Pricing

Cost-Volume-Profit (CVP) analysis has a key role to play in overall pricing analysis. The
economic concepts of marginal revenue, marginal costs, and fixed costs are generally recognized
as useful for pricing decisions. In the profitability planning exercise the tool accountants find
most helpful in decisions regarding the raising and lowering of selling prices is CVP analysis.
However, the basic CVP analysis technique has the following limitations:

Rationality
The decision maker is assumed to be a rational profit-maximizer. Many times, however, the top
management decision makers make satisficing, rather than optimizing decisions.
Multiple Reactions
The model does not consider the reactions of people other than immediate customers.
Competitors may change prices, thus changing the demand schedule facing the firm. The
reactions of middlemen and government officials must also be considered.
Single vs Multiple Products
The model considers decisions which are made for only a single product. However, the price
which is set for one product in a multi product company may affect the demand schedules facing
the other products, Hence, the price which maximizes profits in one product category may
subtract from the overall performance of the firm. This may be:

o due to the interrelated nature of the sales potentials of various products, or
o due to the limitations of the resource capacity to produce these products.

Non-price Variables
No consideration is given in the CVP model for non-price variables. But the price which is set
might have to take into account:

o
 advertising strategies
 distribution policies, and
 other marketing mix characteristics.

If one of these is changed, a whole new demand curve may have to be estimated, and a new price
decision made.

Solutions to Limitations
Finding solutions to these limitations through modified CVP analysis or other techniques such as
sensitivity analysis is not easy. The assumption of rational profit maximization must be made for
there to be any quantitative analysis, unless sales maximization or market share maximization is
used.

 The latter two objectives are more what only marketing managers want,
 while profit maximization is usually the objective of top management.

Therefore, it is reasonable that the accountant tries to achieve the overall objective of profit
maximization using sales and market shares as strategies (or secondary objectives).
The second limitation, that of not considering the changing demand schedules facing the firm,
can be partially solved by modifying the basic CVP graph to incorporate a demand curve.
Table I looks at how demand changes for various levels of price, and how this affects the overall
profit
The profit-volume graph given in Figure 1, is drawn by:

o
 using the fixed costs of $25,000 that have to be expended even
when volume is zero as one point; and
 the net segment margin to demand intersection as the other
point.

The curve that joins these latter points is termed the "contribution chart", and as the graph
indicates, the maximum profits can be obtained at a price of $18.50. Although this is the profit
maximizing price taking into consideration competitive and middleman reactions that affect
demand curve - it does not take into account the reactions of government officials.
If the product is an economic necessity then a "satisfying" price of $18.00 may have to be chosen
to placate the interested officials. Thus, once an approximate price level is determined, the actual
price becomes a tactical decision.
The limitation of this modified C VP approach is that it assumes that the cost and demand
schedules are available to the firm. Cost curves are difficult enough to derive, particularly where
semi-fixed marketing costs are involved, but demand-curve estimation is even more difficult.
Further, inherent in the assumption of a demand schedule lie many of the other limitations
mentioned earlier.
However, there are sophisticated techniques available to meaningfully estimate the demand
curves. Even where demand is only loosely estimated, other things being equal, price theory has
shown the general effects of the various forces acting on the marketplace. Even where “other
things being equal” does not apply, insight is gained into the direction which movement in each
kind of variable may be expected to move the firm’s sales and profits. This insight can be used to
improve marketing decisions.

M4 Lesson 4: Pricing Strategies

Having understood the various pricing methods used in practice, and how such familiar
accounting techniques such as C VP and Sensitivity analysis could be used in the pricing area, let
us now consider the pricing strategies within which such methods and techniques would be used.

Skimming (Short-term Profit Maximization)

This generally applies to new products with a unique character and, therefore, with a demand
curve that is relatively inelastic. Thus price can be kept high so that:
 
o demand can be held within the limits of production, and
o the market is effectively segmented on an income/price basis.

The income, therefore, is very high initially.

This strategy may also be used for:

o Uncertain future demand;
o quick investment recovery; and
o As a hedge against setting a bad price, because it is always easier to
reduce rather than increase a price.

The price is lowered as each segment is exhausted

Penetration (Short-term; Low Price Market Penetration)

This also applies to new products, but under conditions where there is keen competition and a
price sensitive market. Prices are kept deliberately low, even at negative or nil profits, in order to
“capture” a good slice of the market. This “going for market share” policy has advantages
according to the PIMS study, which found that there was a positive correlation between
increased market share and increased return on investment.
The limitation is that penetration is worthwhile only if:

o Economies of scale are available, and
o the life cycle of the product is fairly long.

The firm should also have a range of low-priced products and after a certain period, remove the
cheapest model from the range and replace it with a so called “deluxe” model. This cycle is
repeated, and thus the average price of the range is gently edged up.

Product-line Pricing
This forms part of the penetration strategy, but can be used separately and need not apply only to
new products, This strategy is based on the concept that different products pull others. Thus, the
whole product line is seen as a single unit and as long as the average revenue of the entire line is
above average cost, the profitless situations of individual products within the line are ignored.
Therefore, “loss leaders” are established to make the brand familiar, which may be made good
by others in the line that are highly priced.

Variable Pricing
 This is a variation of the above strategy. The firm’s prices may vary according to outside factors
such as:

 seasons
 rationality,
 raw material availability.

Therefore, the year’s profit is seen as a whole – and the product is expected to return an average
profit. Thus, high priced periods, regions, etc. make up for low priced periods and regions within
that year.

Odd Pricing
This is a psychologically based method (Figure 2) where the price is shown at (say) $29.99
instead of S30.00.
The quantity demanded is supposed to fall dramatically (from Q) to C02) due to this one cent
difference in price.
Prestige Pricing
This too is psychology based method (Figure 3) where the price is taken as an indicator of
quality.

If the price is very high, the item is considered prestigious. The Rolex watch company initially
met the Japanese quartz-watch threat by raising the price of their mechanical watches. This was
despite the fact cheapest quartz watch keeps better time than the best mechanical watch and
incorporates functions that a mechanical watch cannot match. Thus the “use value” of Rolex may
only be based on its ruggedness, and the use of gold which makes it an attractive
accessory. However, the high exchange value and image building promotion has given it a very
high esteem value.
 Such pricing strategies will not work for all products. The FACIT mechanical calculator
company could not have adopted this strategy when the electronic calculators hit the mechanical
calculator market. Similarly, increasing the price of ‘video recorders will not help in a market
dominated by DVD players.

Pricing Cutting
This is the strategy that is most frequently encountered in the struggle against competition. It
represents the deliberate attempt to undermine the existing established price, and either steal a
march on the competitor or drive him from the market.
This is a negative approach unless the company has made the price cut from a position of
strength and anticipates growth in the total market. If not, this strategy can degenerate into a
price war with progressively lower margins.
Pricing of Special Orders
This strategy is used when special orders such as the “one-off’ in engineering or the individual
roll of cloth woven into a special pattern in a textile mill is received.
With such orders:

o
 the benefit of scale operations is lost, and
 additionally, extraordinary costs may be incurred such as
design or experimental work, set-up time and the like.

Special invoicing or warehouse problems may also arise, due to increases in the complexity of
operations,
Faced with a demand for a small order, the first essential is that the accountant should recognize:

o
 that a special situation has arisen,
 that the resultant product is going to cost more to produce, and
 that complexity is going to be added to the whole operation.

The customer must, therefore, pay the full cost plus a substantial mark-up to cover complexity. It
is, therefore, suggested that the full-costing approach is used in this case, especially
incorporating the principles of Activity Based Costing.
However, if a small order were accepted as being in the nature of a trial order, with the
possibility of a larger order subsequently being obtained, then it would not be commercially
sensible to apply the full cost plus complexity mark up approach.
Instead, a token increase should be made to the normal selling price.
Harvesting
This is generally used when one wants to abandon the product. Instead of simply stopping
production, one could also put into effect a large, across-the-board price increase.
If the line has been grossly underpriced, then the segment may not lose much business, and may
have turned a bad line into a good one, and production can resume again.
Even if much market share is lost, some customers may continue to buy at the higher price,
enabling one to favorably dispose of one’s stocks. In this manner one can maximize cash flow
and profit in the short run.

FINANCIAL IMPLICATIONS OF PRICING STRATEGIES

The above strategies are basically related to market share. The management accountant and the
product manager should, therefore, monitor the market situations very closely. When they
recognize the prevailing market situation, then they will know what market share objective
options they have, and be able to apply the appropriate pricing strategy to meet this objective.
The accountant must also be aware of the financial implications of such pricing strategies as
outlined in Table 2.

M4 Lesson 5: Risk Averse Pricing

Strategies
The pricing strategies outlined up to this point were related to market share and profitability.
Many firms, however, do not really consider market share in their pricing decisions. Further,
they are defensive about pricing, probably because its ramifications are not well understood.
Improved knowledge of this aspect of marketing will be of significant benefit in attempts to deal
with current problems.

“Cost-Oriented” Risk-averse Pricing Strategies

1. Adoption of “Delayed Quotation Pricing”
Especially manufactures of custom-made products such as machine tools adopt this
method. Under this strategy, the final price is quoted only when the item has reached the stage of
finished product.
2. Elimination of Low-margin Products and Customers
Probably using Pareto analysis or the 80,10 in contribution (ABC based) ‘customer profitability
analyses’. Harvesting can also be applied.
3. Adoption of “Escalator” Clauses
Here prices are increased automatically based on a previously formula. The objective is
to alleviate the risks involved in cost increases. The bases for such escalations include s:nvle
factors such as listed price increases of raw material suppliers, or highly formulae that
incorporate increased costs of labor, energy, and several material inputs. The effective use of
such escalators depends on the willingness of customers to accept them, on the fin’s ability to
chance the formula over time as cost structures change and to measure variations in cost changes
across products.

“Selling-Related” Risk-averse Pricing Strategies

1. Unbundling of Services
A major product may have been priced to include special peripheral equipment; or replacement
parts. By unbundling such, the sum of the prices may exceed the old single price. Thus,
unbundling represents the elimination of a form of product-line discount to buyers’ purchasing
the full mix.
2. Reduce Cash and Quantity Discounts
Because discounts represent direct reductions in grogs margins earned by sellers. There is a
temptation to arbitrarily eliminate many cash and quantity discounts as a means of improving
margins.
3. Elimination of Price “Shading”
Shading is where reductions from list price is made as a result of negotiations between buyers
and salesmen. However, many firms use a ‘{one-price” policy and this can be attributed to the
desire to maintain gross margins, to centralize control over pricing, or to attempt to generate
more sales effort in non-price attributes of the product.

THE LIMITS OF PRICING STRATEGIES

The Impact of Price on the Buying Decision
These limits arise because price is:

 not the only influencer of the buying decision, and

 not the only variable in the marketing mix.
For example, special problems exist in pricing where distributors are used as part of the total
marketing strategy.
It is the end price to the user which governs the volume throughout the whole chain, and the
most countries now prevent the manufacturer from fixing a resale price through distributors or
other resellers.
The distributor is thus free to fix a price volume position which maximizes its total gross
contribution, and this sub-optimizes the position for the manufacturer, usually because the end
price is too high and the volume is too low to suit the manufacturer. In these conditions, a critical
factor affecting marketing success has passed from the control of the manufacturer to that of the
distributor.
This is particularly so in applying risk-averse pricing strategies. For example, distributors may
react negatively to the elimination of discounts

 because in some cases this may eliminate part of their competitive advantage;
 because it typically violates traditional trade practices, and
 because it reduces possible bases for promoting the product to final buyers.

Similarly, they will react negatively to any changes that influence the total effectiveness of a
product line (such as the elimination of an important low-margin, sales-leading product).
Consequently the degree of reseller support may be influenced by such pricing policies.
Under these circumstances, the only weapon which remains to the manufacturer to influence the
distributor on price is that of exclusivity of distribution.

Product-line Considerations
The accountant must be aware that where arbitrary elimination of low margin items or
unbundling takes place, product line considerations on both the production and demand sides
become important, and low-margin items may significantly stimulate sales of complementary,
high margin items, especially where items are bundled.
Accordingly, care must be taken to ascertain the competitiveness of each element of the mix
when unbundling takes place. Many of these risk-aversive responses also lead to a serious
alteration in the role of the company sales force.
The elimination of price shading diminishes the role of the salespersons, while giving him or her
the task of smoothing over customer reactions to price increases and backlogs of products.
This role change is likely to lead to increased sales force dissatisfaction and staff turnover.

Escalators
Probably no pricing problems are as pervasive to the controller as those associated with
escalators. The fundamental problem with such a cost-based pricing strategy is the assumption
that demand is inelastic. Such assumptions gain credence if recent price increases have not
resulted in any major loss of sales.
However, the following problems pertaining to escalators must be considered by the accountant:

o The demand for the product may not be related to the -demand for the
raw materials it uses. For example, it is absurd for a home improvements
firm (door handles, light fittings etc.) to raise prices to reflect steel and
aluminum cost increases, during a period when housing construction
remains low.
o The demand estimates may become confounded if economic forces (such
as recessions) result in a downward shift in the demand curve. Smaller
quantities are demanded at all (or most) price levels as either the rate of
use or number of users diminishes.
o The sensitivity of the prices of raw materials may change, but a change in
the formulae will not be permitted

For example, a manufacturer in the electronics industry in U.S.A. developed a cost escalator
based heavily on the price of copper. When copper prices fell, its customers demanded sharp
price decreases; yet other cost elements not originally considered sensitive (and thus not
incorporated into the escalator formulae) had recently risen significantly.

Links with Advertising Strategy

Another limitation is that once a particular pricing strategy is decided upon, the advertising
strategy must be consistent with it. By consistency it is meant that:

 if the product is priced high, then advertising expenditure must also be high; and
 if the price is low, then advertising must also be low.

The need for such consistency has been demonstrated in many research studies of consumer
businesses. A consistent pattern has been found in that companies with relatively high prices and
high advertising expenditure had higher profits than companies with relatively low prices and
high advertising budgets. One may find that the findings are nothing but common sense and the
accountants should be aware of the need for consistency in advertising and pricing. But the fact
that a substantial number of businesses are not pursuing consistent strategies is what enabled
researchers to uncover the ‘price-advertising’ relationship.
One could put forward the argument that the low profit impact of inconsistent pricing and
advertising strategies is only short-term, and that the businesses with low prices and high
advertising expenditures are building market share (i.e. penetration) while businesses with high
prices and low advertising budgets are milking their companies (i.e. harvesting)
Various studies have, however, shown some interesting and challenging results. In market share
building (penetration) situations low ROIs, as expected, have been found, therefore, the high
ROIs expected with high market shares (as per the PIMS study referred to earlier) would have to
be long-term expectations,
However, in the case of harvesting – the results of some studies have shown low ROIs, although
one should have observed the opposite, indicating that this type of harvesting strategy does not
succeed.
In contrast, various examples have been provided where there was an inconsistency between
advertising and pricing but still the companies were highly profitable (e.g. Timex, L’eggs,
Decore, Swatch). Compared with the total market, these brands were definitely highly advertised
and relatively low priced. They also became profitable fairly quickly.
Many of these products, however, were accompanied by:

 major changes in the markets,

 shifts in distribution channels,
 product characteristics, and
 favorable socio-economic trends.

L’eggs and Swatch helped create new markets and were not competing in established
segments. (In fact L’eggs came in at a price higher than other pantyhose brands being sold
through supermarkets, even if lower than department store brands).
Thus, the patterns found in the analysis of both management behavior and profitability are strong
enough to suggest that businesses should have very good reasons for deviating from the rule of
“consistency” before they do so. Further, such consistency remains important when one is
developing a total marketing strategy, and considering the impact of factors such as product
quality, stages in the product life cycle, product risk, and market share on the price-advertising
relationship.