1 Unit 1 Developing new business ideas
1
Unit 1
Developing new
business ideas
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Section 1: Characteristics of successful entrepreneurs
Characteristics of entrepreneurs
What motivates entrepreneurs?
Leadership styles
Section 2: Identifying a business opportunity
What makes a market?
What should firms supply?
Identifying what consumers want or need
Section 3: Evaluating a business opportunity
Researching demand for the business idea
Is there a market for the business idea?
Positioning the business idea
Product trial
Opportunity costs (developing one business idea as opposed to another)
Section 4: Economic considerations
Current economic climate
Section 5: Financing the new business idea
Sources of finance
Section 6: Measuring the potential success of a business idea
Estimation of sales levels, costs and profits
Break-even revenue level
Measurement of profit
Section 7: Putting a business idea into practice
Creation of a business plan
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Resources
http://www.s-cool.co.uk/
http://www.businessstudiesonline.co.uk/
http://www.tutor2u.net/
http://www.thetimes100.co.uk/
http:// www.bized.co.uk
6
Section 1
Characteristics of entrepreneurs
Identifying an Opportunity
It is vital for the success of a business
that it manages to identify an
unsatisfied consumer need in a market
and then produce a product, or provide
a service, which meets the consumers'
needs. The new product / service can
be protected against competition by
the use of copyrights and patents.
These protect the owner / inventor
from having their products, ideas, etc.
copied and reproduced by other
people without their permission.
Some of the most common reasons for
starting up a new business include the
need for independence; to achieve
your personal ambitions; being bored
with your current job; links with your
hobbies and interests; redundancy
from your previous job.
Many businesses which have started
in the UK over the past 25 years have
failed within the first 3 years of trading.
To reduce the probability of failure, it is
vital that businesses carry out market
research in order to establish if a
profitable gap exists in a market and to
see if their business is in a strong
enough position to fill this gap.
In order to make a success of the new
business venture, the entrepreneur
must be hardworking, ambitious, firm,
decisive, organised, a good negotiator
and must be able to recognise an
opportunity when it arises.
Keywords: Initiative, creative,
resilient, risk-taker, hard-worker, self-
confident.
Find out what these
words mean.
Watch the dragon´s
den videos.
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Motives for being an entrepreneur
Keywords: Profit motives: survive,
sales maximization, profit
maximisation
Non-profit motives: being your own
boss, working from home, helping
others (ethical)
What are the benefits of being ethical?
– good publicity, additional sales,
helping others.
Why start a business? (Motives)
The skill involved in wanting to start
and run a business is called
enterprise. The individual who sets up
their own business is called an
entrepreneur.
There are several reasons why
entrepreneurs are willing to take a
calculated risk and set up a business.
Possible motives include:
Making a profit. A business does
this by selling items at a price that
more than covers the costs of
production. Owners keep the profit
as a reward for risk-taking and
enterprise.
The satisfaction that comes from
setting up a successful business
and being independent.
Bei
ng able to
make a
difference
by offering
a service
to the
community such as a charity shop
or hospice.
A new business needs its own
name and a product. The
challenge is to make goods and
services that satisfy customers, are
competitive and sell at a price that
more than covers costs.
(Risk)
Problems of Start-ups
Most new businesses will face a
number of problems when they are
starting up and if these problems are
not tackled immediately, then they may
lead to the insolvency and failure of
the new venture. Below are listed
some of the major problems faced by a
new company:
Raising finance and meeting the repayments
Raising finance and meeting the
repayments is often cited as the major
reason for the failure of many new
business ventures. It can often be
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difficult for a budding entrepreneur to
persuade banks and other financial
institutions to lend money to a new
business, and often they will only lend
the money at a high rate of interest.
These repayments can cripple the
business and eventually lead to its
insolvency.
As well as the repayments, the bank
will insist that some security (or
collateral) is provided by the business,
so that if the business defaults on the
loan repayments, then the bank will
take ownership of an asset of the
business which will cover the amount
of the outstanding loan.
Having a positive cash flow
Leading on from this previous point,
having a positive cash flow is vital for
the survival of the business. Liquidity is
the financial term given to express the
ability of a business to raise cash at
short notice. Any new business must
have sufficient cash available to meet
its short-term needs (such as paying
employees, paying suppliers, rent,
utility bills, etc.).
Many businesses have a lot of cash
tied up in stocks, which are often
difficult to sell and therefore the
business may find it difficult to raise
cash quickly. Further to this, if the
business gives its customers credit
(i.e. buy now, but pay us at a later
date) then this will simply add to any
cash flow problems
that the business is
facing.
Paperwork and legal requirements
All businesses face a variety of
paperwork and legal requirements,
and if any of these are overlooked or
completed inaccurately, then this could
lead to the failure of a new business.
Taxation and insurance payments are
vital for the smooth running and
survival of new businesses. Any
oversight on these payments could
land the entrepreneur with a large tax
bill or, perhaps worse, property and
stock which will not be insured against
fire, theft, etc.
Enticing consumers to try the new product
Enticing consumers to try the new
product / service can also be a major
problem for any new business,
especially if there are already a
handful of established businesses
which dominate the market. Ensuring
that consumers try your product and
then buy it again at a later date
(consumer loyalty) can often only be
done through extensive (and costly)
advertising and promotional
campaigns.
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Leadership
Leadership is the process of
influencing people so that they will
perform a variety of tasks in an
effective manner. It is, therefore,
crucial to have a strong leader who
can inspire and motivate the
employees.
A leader is different to a manager,
since a manager is often appointed to
a position of power, whereas a leader
may often emerge as the best to cope
in a given situation (i.e. an employee
who is very competent at computing
may well be viewed as a leader, even
though he may be towards the bottom
of the organisational hierarchy).
There are a number of styles of leadership:
Autocratic
This is often referred to
as an authoritarian
leadership style, and it
basically means that the
people at the top of an
organisation make all the
decisions and delegate very little
responsibility down to their
subordinates.
Communication is top-down, with no
opportunity for feedback to the leader.
It can cause much resentment and
frustration amongst the workforce and
it is not very common in today's
business world.
Democratic
This involves managers
and leaders taking into
account the views of the workforce
before implementing any new system.
This can lead to increased levels of
morale and motivation amongst the
workforce, but it can also result in far
more time being taken to achieve the
results since many people are involved
in discussing the decision.
Laissez-faire
This is where
employees are set
objectives, and then
they have to decide how
best to achieve them using the
available resources. This method of
leadership can result in high levels of
enthusiasm for the task in-hand, but it
can at times rely too much on the skills
of the workforce.
Paternalistic
This is fairly autocratic in its approach
to dealing with employees, although
their social and welfare needs are
taken into account when a decision is
made that will affect them. The leader
is likely to consult the workforce before
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implementing any decision, but he is
unlikely to listen to much of the
feedback.
What makes a good leader or manager?
For many it is someone who
can inspire and get the most
from their staff.
Be able to think creatively to
provide a vision for the
company and solve problems
Be calm under pressure and
make clear decisions
Possess excellent two-way
communication skills
Have the desire to achieve
great things
Be well informed and
knowledgeable about matters
relating to the business
Possess an air of authority
Managers deal with their employees in
different ways. Some are strict with
their staff and like to be in complete
control, whilst others are more relaxed
and allow workers the freedom to run
their own working lives (just like the
different approaches you may see in
teachers!). Whatever approach is
predominately used it will be vital to
the success of the business. “An
organisation is only as good as the
person running it”.
Summary of management styles
Description Advantages Disadvantages
Autocratic Senior managers
take all the important
decisions with no
involvement from
workers
Quick decision making
Effective when
employing many low
skilled workers
No two-way
communication so can be
de-motivating
Creates “them and us”
attitude between
managers and workers
Paternalistic Managers make
decisions in best
interests of workers
after consultation
More two-way
communication so
motivating
Workers feel their social
needs are being met
Slows down decision
making
Still quite a dictatorial or
autocratic style of
management
Democratic Workers allowed to
make own decisions.
Some businesses
run on the basis of
majority decisions
Authority is delegated to
workers which is
motivating
Useful when complex
decisions are required
that need specialist skills
Mistakes or errors can be
made if workers are not
skilled or experienced
enough
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McGregor
Examined how managers´ attitudes affect how workers behave. He
identified 2 extreme types of managers.
TASK: Find out about McGregor´s theory
1.1.1
Characteristics of Entrepreneurs: Self-confident, creative, resilient, risk-taker, initiative hard-worker.
Text 1-5
pp questions may 2009 q1 may 2010 q1
1.1.2
What motivates Entrepreneurs? Profit & non-profit motives
1-5
Jan 2009 q2 Sample paper q9
May 2010 q9
1.1.3
Leadership Styles: Effective leader, styles, factors affecting, theory x and y
244-247
Jan 2009 q8 May 2010 q2
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Past paper questions
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14
Section 2: Identifying a business opportunity
What is a market?
A shop is an example of a market
Businesses sell to customers in
markets. A market is any place where
buyers and sellers meet to trade
products - it could be a high street
shop or a web site. Any business in a
marketplace is likely to be in
competition with other firms offering
similar products. Successful products
are the ones which meet customer
needs better than rival offerings.
Markets are dynamic. This means that
they are always changing. A business
must be aware of market trends and
evolving customer requirements
caused by new fashions or changing
economic conditions.
The theory of demand
At higher prices, a lower quantity
will be demanded than at lower
prices, ceteris paribus. At lower
prices, a higher quantity will be
demanded than
at higher prices,
ceteris paribus.
Basically, when
the price is high demand is low and
vice versa. Ceteris paribus means 'all
other things being equal'. It is very
important that you state this condition
when using demand curves. I will
explain why under "determinants of
demand". First, let's have a look at the
normal downward-sloping demand
curve:
In the diagram above, the demand for CDs is fairly low at the relatively high price of fifteen pounds, but at the bargain price of five pounds demand is much higher.
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The determinants (factors) of demand
It is fairly obvious so far
that the price of a good
is a pretty strong
determinant of its
demand, but there are
many other things that will affect
demand too.
Real income. If one's real income rose
(real means 'allowing for inflation'), one
should be able to afford more CDs.
The price of other goods. If the price
of CD players rose then one would
expect demand for CD players to fall,
and so would the demand for CDs.
These goods are complements. If the
prices of rock concerts rose then one
would expect the demand for these
concerts to fall. Perhaps those who
decided against the concert might buy
a CD instead. These goods
are substitutes.
Tastes and preferences. A slightly
obscure but very important
determinant. As you get older, you
may lose interest in the repetitive
music currently in the charts and try
some original sounds from the 60s,
70s or 80s. Changing preferences will
affect your demand for a product
regardless of its price.
Expectations of future prices. If you
think that the price for CDs is likely to
fall in the near future, perhaps
because of reduced production costs
or competition from the US, you may
delay some purchases which will
reduce demand in the current time
period. Alternatively, you may feel that
CD prices are likely to rise in the near
future, perhaps due to the lack of
competition in the retail market, so you
may increase your demand in the
current time period.
Advertising. Although many of you
probably doubt the effectiveness of
some of the appalling adverts on the
TV, one assumes that these
companies would not spend fortunes
on these adverts if they did not expect
to see a significant rise in demand for
the product in question (Virgin and Our
Price are always trying to sell you CDs
via the TV.)
Population. Quite obviously, a
significant rise in the number of people
in a given area or country will affect
the demand for a whole host of goods
and services. Note that a change in
the structure of the population (we
have an ageing population) will
increase the demand for some goods
but reduce the demand for others.
Interest rates and credit
conditions. If interest rates are
relatively low then it is cheaper to
borrow money that can then be spent.
This is not so applicable to CDs, but
will certainly affect the demand for 'big
ticket' items such as cars and major
electrical goods. In boom time (like the
late 80s) it is often easier to obtain
credit regardless of the rate of interest.
The normal downward-sloping demand
curve shows the relationship between
the price of the good and its
demand, all other things being
equal. Those 'all other things' are the
list above: incomes, prices of other
goods, etc. If you do not make this
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assumption, then you could have a
situation when the price of CDs falls,
but at the same time one's income falls
by such a large amount that one
actually demands fewer CDs. In other
words, one does not want to
confuse shifts in the demand
curve and movements along a
demand curve.
The theory of supply
Just like with demand, where it only
became effective if it was backed up
with the ability to pay, supply is
defined as the willingness and ability of
producers to supply goods and
services on to a market at a given
price in a given period of time. With
demand, the downward-sloping curve
reflected an inverse relationship
between price and quantity demanded.
The opposite is true of supply. In
theory, at higher prices a larger
quantity will generally be supplied
than at lower prices, ceteris
paribus, and at lower prices a
smaller quantity will generally be
supplied than at higher prices,
ceteris paribus. So this time we have
higher supply at higher prices and vice
versa. Again, in is important to assume
that 'all other things remain constant'.
Any change in one of the other
determinants of supply will cause the
curve to shift
While it is fairly obvious why the
demand curve is downward sloping, it
is not so clear why the supply curve
should be upward sloping. Basically,
the producer will make higher profits
as the price per unit sold increases.
Imagine that a brewer produced a
lager and a bitter. Assume, not
unreasonably, that the costs of
production are the same per pint
produced, whether it is a pint of lager
or a pint of bitter. If the price of lager
then rose relative to the price of bitter,
it would seem sensible for the brewer
to transfer resources from making
bitter towards the production of lager,
thereby increasing the supply of lager
as its price rises.
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The determinants (factors) of
supply
As with the demand curve, there are
many things that affect supply as well
as the price of the good in question.
Notice how similar many of these
factors are in comparison to the factors
that affect demand. Notice also that
nearly all of these factors affect the
firms' costs. Given that the firms'
supply curve is its marginal cost curve
(see the 'costs and revenues' topic)
then it is of no surprise that a cost
changing measure will shift the supply
curve.
Prices of other factors of
production. An increase in the price
of, say, hops, will increase the costs of
a brewing firm and so for any given
price the firm will not be able to brew
as much beer. Hence, the firm's supply
curve will shift to the left. The same
would be true for changes in wage
costs or fuel costs.
Technology.
The supply curve
drawn above
assumes a
'constant' state of technology. But as
we know, there can be improvements
in technology that tend to reduce firms'
unit costs. These reduced costs mean
that more can be produced at a given
price, so the supply curve would shift
to the right.
Indirect taxes and subsidies.
When the chancellor
announces an
increase in petrol
tax, it is the firm who
actually pays the tax. Granted, we end
up paying the tax indirectly when the
price of petrol goes up, but the actual
tax bill goes to the firm. This again,
therefore, represents an increase in
the cost to the firm and the supply
curve will shift to the left. The opposite
is true for subsidies as they are
handouts by the government to firms.
Now the firm can make more units of
output at any given price, so the
supply curve shifts to the right.
Labour productivity.
This is defined as the output per
worker (or per man-hour). If labour
productivity rises, then output per
worker rises. If you assume that the
workers have not been given a pay
rise then the firm's unit costs must
have fallen. Again, this will lead to a
shift to the right of the supply curve.
Price expectations.
Just as consumers delay purchases if
they think the price will fall in the
future, firms will delay supply in they
think prices will rise in the future. It's
the same point but the other way
round.
Entry and exit of firms to and from
an industry.
If new entrants are attracted into an
industry, perhaps because of high
profit levels (much more on this in the
topic 'Market structure'), then the
supply in that industry will rise at all
price levels and the supply curve will
shift to the right. If firms leave the
industry then the supply curve will shift
to the left.
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Case Study
US alcohol retailers find law changes
hard to swallow
Jon Genderson is gearing up for a big increase in internet sales
The US consumes more bottles of wine than any other nation in the world. But almost 80 years after the end of Prohibition, buying a drink can still be tricky.
It's illegal, for instance, to buy vodka in Delaware to take to a party in Pennsylvania. And retailers in Maryland are not allowed to ship alcohol to anybody living in another state.
That's because of the 4,000 or so different laws that govern the alcohol industry and give individual states unprecedented rights to regulate sales and consumption within their borders.
The protections have often favoured small businesses, but many now fear they're under threat from cross-border wine sales on the internet, and the end of state monopolies that could lead to deregulation.
'Scary' "The worst-case scenario is that you have a reduction of competition, removal of small businesses from the marketplace or potentially not having small businesses in the marketplace at all," says John Bodnovich, executive
director of the American Beverage Licensees, which represents 20,000 small retailers across 34 states.
Prices of alcohol are below sale cost all over England, sometimes less than a bottle of water. And there's terrible binge drinking. We look at that and say: 'What's different about our system?'”
Craig WolfWine and Spirits Wholesalers of America
He's particularly concerned about new laws in the state of Washington which take effect in June. State controlled off-licences are closing, and grocery stores and supermarkets will be allowed to sell alcohol instead.
But the biggest threat to small businesses comes from a measure which says an alcohol retailer must operate from stores no smaller than 10,000 sq feet.
"What's happened in Washington state is scary," says Chuck Ferrar, owner of Bay Ridge Wine and Spirits in Annapolis, Maryland.
"[The alcohol industry] is the last bastion of small businesses, 50% of our businesses are owned by Asian minorities because it's one of the few remaining industries where somebody can start a small business and see it grow and thrive.
"But Washington will drive the small business under. And I think it will eventually happen here, that alcohol
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will be sold in groceries and supermarkets."
Public demand
Another big change affecting the industry is the internet. In 2005 the Supreme Court ruled that wineries could ship direct to their customers anywhere in the country, regardless of individual state legislation. That left many states scrambling to change their laws.
Chuck Ferrar says small retailers will be driven out of alcohol sales in Washington
"It's coming because the consumer wants it," says Joe Conti, chief executive of the Pennsylvania Liquor Control Board. "Consumers will be able to buy from a winery in California and have it sent to their home in Pennsylvania - that will be happening within months. That's a good thing for the consumer and we embrace that type of competition."
But the Supreme Court ruling did not include small retailers, and the Wine and Spirits Wholesalers of America (WSWA) remains opposed to direct shipping.
"It's a black market because you don't have the regulatory power to find out who is ordering from where," says WSWA president Craig Wolf.
"Once you open the door to direct shipping and you don't go through a licensed wholesaler, you don't know whether taxes are being paid, whether minors are getting alcohol, and you don't know if it's an illegal source," he says.
But Jon Genderson, managing director of Schneider's of Capitol Hill, a wine and liquor store in Washington DC, believes wholesalers are opposed because they're worried about increased competition in their tier of the market.
"The wholesalers are worried about these things, but it's change that benefits the consumer and that's why I think it's going to happen," he says.
"It's the natural evolution of the business. It just makes sense and when things make sense and the current laws don't make sense I think that eventually they'll be changed. I think we're smart enough to make those changes," he says.
He says the internet still represents a small percentage of sales, but his business is gearing up for the anticipated change.
"We're in the process of revamping our website for a third time, modernising and making it more interactive. I'm hoping it will be easier and easier, and that there will be more and more states we'll be allowed to ship to," he says.
'Checks and balances' Moves to deregulate alcohol in the US go to the heart of debates about its role in society and the concerns that led to prohibition. Mr Wolf says many
Americans have grandparents who
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remember what the country was like before controls were established.
Californian wineries will soon be able to ship direct to homes in Pennsylvania
"There is a fear that if you tinker and mess with it, you don't know what you're going to end up with - and it could be very bad," he says.
"We don't want to cast aspersions on England - but if you look very carefully at what happened, there was deregulation. There are now 24/7 sales there, there's vertical integration there with big box stores controlling the retail operation - or
big retailers controlling the suppliers.
"Prices of alcohol are below sale cost all over England, sometimes less than a bottle of water. And there's terrible binge drinking. We look at that and say what's different about our system?
"Our's is a much more regulated system. There are many more checks and balances, not only between market players but also from government on the market players."
1.2.1 What makes a market?
Buyers & sellers
13
may 2009 q1
1.2.2
What should firms supply?
Supply, factors of supply
14-15
Jan 2009 q1
1.2.3
Identifying what consumers want or need:
Demand, factors of demand,
market-orientation.
13-17
May 2009 q3/q4
Jan 2009 9d
Sample paper q8
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Past paper questions
22
Section 3: Evaluating a business opportunity
Market Research
Market research involves gathering
and analysing data from the
marketplace in order to provide goods
and services that meet their needs.
A wide variety of information used to support marketing decisions can be obtained from market research. A selection of such
uses are summarised below:
Information about the size and competitive structure of the market
• Analysis of the market potential for existing products (e.g. market size, growth, changing sales trends) • Forecasting future demand for existing products • Assessing the potential for new products • Study of market trends • Analysis of competitor behaviour and performance • Analysis of market shares
Information about Products
• Likely customer acceptance (or rejection) of new products • Comparison of existing products in the market (e.g. price, features, costs, distribution) • Forecasting new uses for existing products
• Technologies that may threaten existing products • New product development
Information about Pricing in the Market
• Estimates and testing of price elasticity • Trends in pricing over recent years • Analysis of revenues, margins and profits • Customer perceptions of “just or fair” pricing • Competitor pricing strategies
Information about Promotion in the Market
• Effectiveness of advertising • Effectiveness of sales force (personal selling) • Extent and effectiveness of sales promotional activities • Competitor promotional strategies
Information about Distribution
in the Market
• Use and effectiveness of distribution
channels
• Opportunities to sell direct
• Cost of transporting and
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warehousing products
• Level and quality of after-sales
service
Primary research
This is research designed to gather
primary data, that is, information which
is obtained specifically for the study in
question. It can be gathered in three
main ways - observation,
questionnaires and experimentation.
Observation involves watching people
and monitoring and recording their
behaviour (e.g. television viewing
patterns, cameras which monitor traffic
flows, retail audits which measure
which brands of product consumers
are purchasing).
Questionnaires are a means of direct
contact with consumers and can take a
variety of forms. Personal
questionnaires (such as door-to-door
interviewing), postal questionnaires,
telephone questionnaires and group
questionnaires (such as asking for the
attitudes of a group of consumers
towards a new product).
Questionnaires can be a very
expensive and time-consuming
process and it can be very difficult to
eliminate the element of bias in the
way that they are carried out. It is
important that every respondent must
be asked the same questions in the
same order, with no help or emphasis
being placed on certain questions /
responses.
Experimentation involves the
introduction of a variety of marketing
activities into the marketplace and then
measuring the effect of each of these
on consumers. For example, test
marketing, where a new product is
launched in a small, geographical area
and then the response of consumers
towards it will dictate whether or not
the product is launched nationally.
Secondary research
This is the collection of
secondary data, which
has previously been
collected by others and
is not designed
specifically for the study
in question, but is
nevertheless relevant. Secondary data
is far cheaper and quicker to gather
than primary data, but it can be out-of-
date by the time that it is researched.
The main sources of secondary data
are reference books, government
publications and company reports.
The primary and the secondary
research will provide the business with
much data relating to its markets and
its consumers. This data can then be
used to describe the current situation
in the marketplace, to try to predict
what will happen in the future in the
marketplace, and to explain the trends
that have occurred.
The business may also use the market
research data to segment the market.
This involves breaking the market
down into distinct groups of consumers
who have similar characteristics, so as
to offer each group a product which
best meets their needs.
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The main ways of segmenting a
market are:
By consumer characteristics:
this involves investigating their
attitudes, hobbies, interests,
and lifestyles.
By demographics: their age,
sex, income, type of house, and
socio-economic group.
By location: the region of the
country, urban -v- rural, etc.
Effective segmentation of the market
can lead to new opportunities being
identified (i.e. gaps in the market for a
product), sales potential for products
being realised and increased market
share, revenue and profitability.
Quantitative vs Qualitative research
Quantitative research
Quantitative research is
about measuring features of a market
and quantifying that measurement with
data. Most often the data required
relates to market size, market share,
penetration, installed base and market
growth rates. However, quantitative
research can also be used to measure
customer attitudes, satisfaction,
commitment and a range of other
useful market data that can tracked
over time.
Quantitative research can also be
used to measure customer awareness
and attitudes to different
manufacturers and to understand
overall customer behaviour in a market
by taking a statistical sample of
customers to understand the market
as a whole. Such techniques are
extremely powerful when combined
with techniques such segmentation
analysis and mean that key audiences
can be targeted and monitored over
time to ensure the optimal use of the
marketing budget.
At the heart of all quantitative research
is the statistical sample. Great care
has to be taken in selecting the sample
and also in the design of the sample
questionnaire and the quality of the
analysis of data collected.
Market research involves the collection
of data to obtain insight and
knowledge into the needs and wants of
customers and the structure and
dynamics of a market. In nearly all
cases, it would be very costly and
time-consuming to collect data from
the entire population of a market.
Accordingly, in market research,
extensive use is made of sampling
from which, through careful design and
analysis, marketers can draw
information about the market.
There are several types of sample
that can be used to gather
quantitative data:
Market research involves the collection
of data to obtain insight and
knowledge into the needs and wants of
customers and the structure and
25 | P a g e
dynamics of a market. In nearly all
cases, it would be very costly and
time-consuming to collect data from
the entire population of a market.
Accordingly, in market research,
extensive use is made of sampling
from which, through careful design and
analysis, marketers can draw
information about the market.
Designing the sample
Sample design covers the method of
selection, the sample structure and
plans for analysing and interpreting the
results. Sample designs can vary from
simple to complex and depend on the
type of information required and the
way the sample is selected.
Sample design affects the size of the
sample and the way in which analysis
is carried out. In simple terms the more
precision the market researcher
requires, the more complex will be the
design and the larger the sample size.
The sample design may make use of
the characteristics of the overall
market population, but it does not have
to be proportionally representative. It
may be necessary to draw a larger
sample than would be expected from
some parts of the population; for
example, to select more from a
minority grouping to ensure that
sufficient data is obtained for analysis
on such groups.
Many sample designs are built around
the concept of random selection. This
permits justifiable inference from the
sample to the population, at quantified
levels of precision. Random selection
also helps guard against sample bias
in a way that selecting by judgement or
convenience cannot.
Defining the Population
The first step in good sample design is
to ensure that the specification of
the target population is as clear and
complete as possible to ensure that all
elements within the population are
represented. The target population is
sampled using a sampling frame.
Often the units in the population can
be identified by existing information;
for example, payrolls, company lists,
government registers etc. A sampling
frame could also be geographical; for
example postcodes have become a
well-used means of selecting a
sample.
What size should the sample be?
For any sample design deciding upon
the appropriate sample size will
depend on several key factors
(1) No estimate taken from a sample is
expected to be exact: Any
assumptions about the overall
population based on the results of a
sample will have an attached margin of
error.
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(2) To lower the margin of error usually
requires a larger sample size. The
amount of variability in the population
(i.e. the range of values or opinions)
will also affect accuracy and therefore
the size of sample.
(3) The confidence level is the
likelihood that the results obtained
from the sample lie within a required
precision. The higher the confidence
level, that is the more certain you wish
to be that the results are not atypical.
Statisticians often use a 95 per cent
confidence level to provide strong
conclusions.
(4) Population size does not normally
affect sample size. In fact the larger
the population size the lower the
proportion of that population that
needs to be sampled to be
representative. It is only when the
proposed sample size is more than 5
per cent of the population that the
population size becomes part of the
formulae to calculate the sample size.
Random sampling - this gives each
member of the public an equal chance
of being used in the sample. The
respondents are often chosen by
computer from a telephone directory of
from the Electoral Register.
Quota sampling - this method
involves the consumers being grouped
into segments which share certain
characteristics (e.g. age or gender).
The interviewers are then told to
choose a certain number of
respondents from each segment.
However, the numbers of people
interviewed in each segment are not
usually representative of the
population as a whole.
Cluster sampling - this normally
involves the consumers being grouped
into geographical groups (or 'clusters')
and then a random sample being
carried out within each location.
Stratified sampling - the consumers
are grouped into segments again (or
'strata') based upon some previous
knowledge of how the population is
divided up. The number of people
chosen to be interviewed from each
'strata' is proportional to the population
as a whole.
Qualitative research
Qualitative market research is about
investigating the features of a market
through in-depth research that
explores the background and context
for decision making. There are two
main qualitative methods - depth
interviews and focus groups. However
qualitative research can also include
techniques such as usability testing,
brainstorming sessions and “vox pop”
surveys.
Depth Interviewing
Depth interviews are the main form of
qualitative research in most business
markets. Here an interviewer spends
time in a one-on-one interview finding
out about the customer’s particular
circumstances and their individual
opinions.
The majority of business depth
interviews take place in person, which
has the added benefit that the
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researcher visits the respondent’s
place of work and gains a sense of the
culture of the business. However, for
multi-national studies, telephone depth
interviews, or even on-line depth
interviews may be more appropriate.
Feedback is through a presentation
that draws together findings across a
number of depth interviews. In some
circumstances, such as segmentation
studies, identifying differences
between respondents may be as
important as the views that customers
share.
The main alternative to depth
interviews - focus group discussions -
are typically too difficult or expensive
to arrange with busy executives.
However, on-line techniques
increasing get over this problem.
Focus Group Discussions
Focus groups
are the
mainstay of
consumer
research. Here
several
customers are
brought
together to take
part in a discussion led by a
researcher (or “moderator”). These
groups are a good way of exploring a
topic in some depth or to encourage
creative ideas from participants.
Group discussions are rare in business
markets, unless the customers are
small businesses. In technology
markets where the end user may be a
consumer, or part of a team evaluating
technology, group discussions can be
an effective way of understanding what
customers are looking for, particularly
at more creative stages of research.
Niche Marketing
This involves a business selling its
product(s)
in small,
often
lucrative,
segments
of a
market. It
is the
opposite strategy to mass marketing.
Many small businesses can identify
unsatisfied consumer needs in a
particular segment within a large
industry, and they can develop
products to meet these needs.
This allows the small businesses to
exist in industries that are dominated
by large businesses (e.g. Classic FM
in the radio broadcasting industry,
SAGA in the holiday industry).
However, if larger rivals appear within
the niche market, the smaller
businesses will often find it difficult to
compete effectively with these well-
resourced businesses.
It is also dangerous for a business to
offer just one product within the
market, since any larger rivals are
likely to be more diversified and have a
wider product portfolio. Theses larger
businesses could, therefore, reduce
their prices to such a low level that the
small business cannot compete
profitably.
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Nevertheless, during periods of
economic growth and higher consumer
spending, then niche markets can offer
a very lucrative opportunity to many
small businesses to offer a
personalised, high value-added
service/product.
What is the difference between
niche and mass marketing?
In most markets there is one dominant
(mass) segment and several smaller
(niche) segments…
For example, in the confectionery
market, a dominant segment would be
the plain chocolate bar. Over 90% of
the sales in this segment are made by
three dominant producers – Cadbury’s,
Nestle and Mars. However, there are
many small, specialist niche segments
(e.g. luxury, organic or
fair-trade chocolate).
Niche marketing can
be defined as:
Where a business
targets a smaller
segment of a larger
market, where customers have
specific needs and wants
Targeting a product or service at a
niche segment has several
advantages for a business (particularly
a small business):
• Less competition – the firm is a “big
fish in a small pond”
• Clear focus - target particular
customers (often easier to find and
reach too)
• Builds up specialist skill and
knowledge = market expertise
• Can often charge a higher price –
customers are prepared to pay for
expertise
• Profit margins often higher
• Customers tend to be more loyal
The main disadvantages of marketing
to a niche include:
• Lack of “economies of scale” (these
are lower unit costs that arise from
operating at high production volumes)
• Risk of over dependence on a single
product or market
• Likely to attract competition if
successful
• Vulnerable to market changes – all
“eggs in one basket”
By contrast, mass marketing can be
defined as:
Where a business sells into the
largest part of the market, where
there are many similar products on
offer
The key features of a mass market are
as follows:
• Customers form the majority in the
market
• Customer needs and wants are more
“general” & less “specific”
• Associated with higher production
output and capacity (economies of
scale)
• Success usually associated with low-
cost operation, heavy promotion,
widespread distribution or market
leading brands
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Competitive Advantage
Definition: A competitive advantage is
an advantage over competitors gained
by offering consumers greater value,
either by means of lower prices or by
providing greater benefits and service
that justifies higher prices.
How: Location, Value for money,
Brand name, Facilities, Image ,Taste,
Customer service .
Competitive Advantage
Choose one of the methods of how a
company could gain a competitive
advantage over its competitors. Select
a well-known product or brand.
Create a poster identifying how the
product (Mercedes Class M) or
brand (Gilette) has gained this
competitive advantage.
Eg Apple Ipod and image
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Adding Value
The increase in the
benefits of a good or
service which are
created at each stage
of production.
Methods – changing
raw materials,
packaging, branding (using
personalities or famous logos)
For example, businesses can add
value by:
Building a brand – a reputation for
quality, value etc that customers are
prepared to pay for. Nike trainers sell
for much more than Hi-tec, even
though the production costs per pair
are probably pretty similar!
Delivering excellent service – high
quality, attentive personal service can
make the difference between
achieving a high price or a medium
one
Product features and benefits for
example, additional functionality in
different versions of software can
enable a software seller to charge
higher prices; different models of
motor vehicles are designed to
achieve the same effect.
Offering convenience – customers
will often pay a little more for a product
that they can have straightaway, or
which saves them time.
A business that successfully adds
value should find that it is able to
operate profitably. Why? Remember
the definition of adding value: where
the selling price is greater than the
costs of making the product.
By definition, a business that is adding
substantial value must also be
operating profitably.
Quite simply, it can make the
difference between survival and
failure; between profit and loss.
The key benefits to a business of
adding value include:
- Charging a higher price
- Creating a point of difference from
the competition.
- Protecting from competitors trying to
steal customers by charging lower
prices
- Focusing a business more closely on
its target market segment
31
Positioning the Business Idea
This is the process of creating an image for the product in the minds of customers.
Identify the competition.
Identify their strengths and
weaknesses.
Identify how to differentiate your
product.
Identify Gaps in the market –
market mapping.
Try to gain a competitive
advantage.
Add value
Market mapping consists of identifying key variables about a product, plotting where existing brands or suppliers are in terms of combining the variables, then identifying any gaps in the market”.
P o s i t i o n i n g a n d M a r k e t m a p p i n g
Once an entrepreneur has identified an appropriate segment of the market to target, the challenge is to position the product so that it meets the needs and wants of the target customers.
One way to do this is to use a “market map” (you might also see this called by its proper name – the “perceptual map”).
The market map illustrates the range of “positions” that a product can take in a market based on two dimensions that are important to customers.
Examples of those dimensions might be:
High price v low price Basic quality v High quality Low volume v high volume Necessity v luxury Light v heavy Simple v complex Lo-tech v high-tech Young v Old
Let’s look at an illustrated example of a market map. The map below shows one possible way in which the chocolate bar market could be mapped against two dimensions – quality and price:
32
How might a market map be used?
One way is to identify where there are “gaps in the market” – where there are customer needs that are not being met.
For example, in the chocolate bar market, Divine Chocolate (a social enterprise) successfully spotted that some consumers were prepared to pay a premium price for very high quality chocolate made from Fairtrade cocoa. Green & Black’s exploited the opportunity to sell premium chocolate made from organic ingredients. Both these brands successfully moved into the high quality / high price quadrant (see above) before too many competitors beat them to it.
The trick with a market map is to ensure that market research confirms whether or not there is actually any demand for a possible “gap in the market”. There may be very good reasons why consumers do not want to buy a product that might, potentially, fill a gap.
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Complete a Market Map for a local shop or restaurant in Valencia.
34
Product trial
The first
step for a
new
business or
product is to
attract trial
purchases.
A new
magazine may run special offers to get
customers to try the first issue, hoping
that repeat sales are generated. The
magazine will soon close if customers
fail to buy future issues. The aim of a
special offer scheme is to convert trial
purchases into repeat sales.
Repeat business is all about
encouraging customers who buy for
the first time to buy again and again!
A business invests a lot of effort and
cash in trying to get a customer to
purchase a product for the first time.
This is known as product trial. Much
advertising is aimed at encouraging
customers to try a new product, or
switch from an existing competitor.
After a new product has been tried
once, its success can be measured in
how quickly, how often, and in what
quantity it is repurchased. Repeat
purchase refers to the number or
percent of customers who purchase a
second time, or to how often they buy
again.
The problem with advertising is that it
is very expensive. A business is
unlikely to be successful and profitable
if it has to keep advertising heavily in
order to generate demand from new
customers. It is much better if
customers can be encouraged to
become loyal to the product – even
better, to recommend the product to
their friends and family!
Achieving a high level of repeat
purchase is good news for a business.
So what is required?
Firstly, the product should be of the
right quality. A sub-standard or low
quality product is sure to disappoint
first-time customers. They are unlikely
to buy again or recommend the
product to others.
Secondly, a business should do all it
can to develop an effect relationship
with existing customers. This includes
activities such as:
- Regular communication (e.g. email
newsletters)
- Incentives for loyalty (e.g.
promotional discounts)
- Research into customer needs and
wants (e.g. through customer surveys)
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Stakeholders
There are many groups of people
who have an interest, financial or
otherwise, in the performance of
a business - these different
groups are known as
stakeholders. The main
stakeholders are considered to
be:
Shareholders
These people have a clear financial
interest in the performance of the
business. They have invested money
into the company through purchasing
shares and they expect the company
to grow and prosper so that they
receive a healthy return on their
investment. The return that they
receive can come in two forms. Firstly,
by a rise in the share price, so that
they can sell their shares at a higher
price than the purchase price (this is
known as making a capital gain).
Secondly, based on the level of profits
for the year, the company issues a
portion of this to each shareholder for
every share that they hold (this is
known as a dividend). The
shareholders are also entitled to vote
each year at the A.G.M. to elect the
Board of Directors, who will run the
company on their behalf.
Employees
This group also has an obvious
financial interest in the company, since
their pay levels and their job security
will depend on the performance and
the profitability of the business. It is
employees who perform the basic
functions and tasks of the business
(producing output, meeting deadlines
and delivery dates, etc.) and over
recent years their traditional role has
started to change. They are often now
encouraged to become involved in
multi-skilled team-working, problem
solving and decision making - thus
having a significant input to the
workings of the business.
Customers
Customers are vital to the survival of
any business, since they purchase the
goods and services which provides the
business with the majority of its
revenue. It is therefore vital for a
business to find out exactly what the
needs of the consumers are, and to
produce their output to directly satisfy
these needs - this is done through
market research. The goods and
services must then be promoted in
such a way as to appeal to the target
market and to inform them of the
availability, price, etc. Once the goods
and services have been purchased by
the customer, it is essential that after-
sales service is offered and that the
customer is happy with his/her
purchase. The business must try to
keep the customer loyal so that they
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return in the future and become a
repeat-purchaser.
Suppliers
Without flexible and reliable suppliers,
the business could not guarantee that
it will always have sufficient high
quality raw materials which they
require to produce their output. It is
important for a business to maintain
good relationships with their suppliers,
so that raw materials and components
can be ordered and delivered at short
notice, and also so that the business
can negotiate good credit terms from
the suppliers (i.e. buy now, pay at a
later date).
The Government
The government affects the
workings of businesses in many
ways:
1. Businesses have to pay a variety of
taxes to central and local government,
including Corporation tax on their
profits, Value-Added Tax (V.A.T) on
their sales, and Business Rates to the
local council for the provision of local
services.
2. Businesses also have to adhere to a
wide-ranging amount of legislation,
which is aimed at protecting the
consumers, the employees and the
local environment from business
activity.
3. Businesses will be affected by
different economic policies, (for
example, if interest rates are
increased, then this will discourage
businesses from borrowing money
since the repayments will now be
significantly higher). However,
businesses can also benefit from
government incentives and initiatives,
such as new infrastructure, job
creation schemes and business
relocation packages, offering cheap
rent, rates and low-interest loans.
The Local Community
Businesses are likely to provide
significant amounts of employment for
the local community and often will
produce and sell much of their output
to the local residents. The sponsorship
of local events and good causes (such
as local charity work) can also help the
business to establish itself in the
community as a caring, socially
responsible organisation. Many
businesses develop links with local
schools and colleges, offering
sponsorships and resources to these
under-funded institutions. However,
businesses can also cause many
problems in local communities, such
as congestion, pollution and noise, and
these negative externalities may often
outweigh the benefits that the
businesses bring to the community.
Disagreements between stake holders
Due to the demands placed on
businesses by so many different
stakeholders, it is no surprise that
there are often disagreements and
conflict between the different groups.
Some of the more common areas of
conflict are:
Shareholders and management
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Profit maximisation is often the over-
riding objective of shareholders -
resulting in large dividend payments
for them. However, it is far more likely
that the managers of the business will
aim to profit satisfy rather than profit
maximise (that is, they will aim to earn
a satisfactory level of profits, and then
use the remaining resources to pursue
other objectives such as diversification
and growth). This conflict between
these two groups is often referred to
as divorce of ownership (the
shareholders) and control (the
management).
Customers and the business
Customers are unlikely to remain
loyal and repeat purchase from the
business if the product that the have
purchased is of poor quality and/or is
poor value for money. More customers
are prepared to complain about the
quality of products and after-sales
service than ever before, and the
business must ensure that it has in
place a number of strategies designed
to satisfy the disgruntled customer,
reimburse any financial loss that they
may have incurred and persuade them
to remain loyal to the business.
Suppliers and the business
Suppliers are often quoted as
complaining about the lack of prompt
payments from businesses for
deliveries of raw materials, and if this
became a regular problem then the
suppliers may well refuse credit to the
businesses or may even cease all
dealings with them. On the other hand,
many businesses have been known to
complain about the late deliveries of
raw materials and components from
suppliers, and the dubious quality of
the parts once they have been
inspected.
The community and the business
As outlined previously, the local
community can often suffer at the
hands of a large company through the
negative externalities of pollution,
noise, congestion and the building of
new factories in areas of outstanding
beauty. However, if the business faces
strong protests from residents and
from pressure groups concerned about
its actions, then it may decide to
relocate to another area, causing
much unemployment and a fall in
investment in the community it leaves
behind.
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Market segmentation - targeting strategies
Once a firm has successfully identified
the segments within a market, the next
step is to target these segments with
products that closely match the needs
of the customers within that segment.
There are a number of targeting
strategies, including:
Niche/concentration marketing –
this is concerned with targeting one
particular, well-defined group of
customers (a niche) within the overall
market.
Jordan’s, the cereal company, adopted
this approach by targeting groups of
customers interested in organic
products at a time when this group of
consumers represented a relatively
small proportion of the overall market.
Niche markets can be targeted
profitably by small firms who have
relatively small overheads and,
therefore, do not need to achieve the
volume of sales required by larger
competitors.
The main disadvantages of niche
markets are that the potential for sales
growth and economies of scale may
be limited, and the survival of the firm
may be seriously affected if sales
begin to decline.
Mass marketing – this is concerned
with selling a single product to the
whole market. This strategy is based
on the assumption that, in respect to
the product in question, customers’
needs are very similar if not identical.
The main benefit for the firm is that it
can produce on a large scale,
benefiting from low unit production
costs via economies of scale. These
lower costs can be passed on to the
consumer in the form of lower prices
because, although profit margins on
each item sold may be lower, high
sales volume should generate large
profits overall.
The main disadvantage of mass
marketing is that, increasingly in
today’s markets, consumers are less
interested in standardised products
and often prepared to pay premium
prices for products that cater for their
specific needs.
market segmentation - bases of segmentation
Geographic
• Region of the country
• Urban or rural
Demographic
• Age, sex, family size
• Income, occupation, education
• Religion, race, nationality
Psychographic
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• Social class
• Lifestyle type
• Personality type
Behavioural
• Product usage - e.g. light, medium
,heavy users
• Brand loyalty: none, medium, high
• Type of user (e.g. with meals, special
occasions)
why segment markets?
There are several important reasons
why businesses should attempt to
segment their markets carefully. These
are summarised below
Better matching of customer needs
Customer needs differ. Creating
separate offers for each segment
makes sense and provides customers
with a better solution
Enhanced profits for business
Customers have different disposable
income. They are, therefore, different
in how sensitive they are to price. By
segmenting markets, businesses can
raise average prices and subsequently
enhance profits
Better opportunities for growth
Market segmentation can build sales.
For example, customers can be
encouraged to "trade-up" after being
introduced to a particular product with
an introductory, lower-priced product
Retain more customers
Customer circumstances change, for
example they grow older, form
families, change jobs or get promoted,
change their buying patterns. By
marketing products that appeal to
customers at different stages of their
life ("life-cycle"), a business can retain
customers who might otherwise switch
to competing products and brands
Target marketing communications
Businesses need to deliver their
marketing message to a relevant
customer audience. If the target
market is too broad, there is a strong
risk that (1) the key customers are
missed and (2) the cost of
communicating to customers becomes
too high / unprofitable. By segmenting
markets, the target customer can be
reached more often and at lower cost
Gain share of the market segment
Unless a business has a strong or
leading share of a market, it is unlikely
to be maximising its profitability. Minor
brands suffer from lack of scale
economies in production and
marketing, pressures from distributors
and limited space on the shelves.
Through careful segmentation and
targeting, businesses can often
achieve competitive production and
marketing costs and become the
preferred choice of customers and
distributors. In other words,
segmentation offers the opportunity for
smaller firms to compete with bigger
ones.
40
Opportunity cost
Opportunity cost is one of the most important and fundamental
concepts in the whole of economics. Given that we have said
that economics could be described as a science of choice, we
have to look at what sacrifices we make when we have to make a choice. That is
what opportunity cost is all about.
The definition of opportunity cost is: The cost expressed in terms of the next
best alternative foregone or sacrificed
Take the following example:
I recently bought a new pair of shoes which cost me
£40.
The cost here is being expressed in terms of the amount
of money you had to give up to acquire those shoes.
Because we all have a common understanding of
'money' as being notes and coins that we use to
exchange for the things we want, we can pretty much understand this sentence.
We have to remember that money is merely bits of paper or
metal that we use as a convenient and accepted method of
facilitating exchange - getting what we want. Expressing 'cost' in
terms of the amount of money we have to give up to get what
we want is always helpful in giving us the true 'cost' of
something. For that, we need to use 'opportunity cost'.
What statements like this fail to convey, however, is the true picture of what you are
sacrificing by choosing to buy the shoes. It is more accurate to say something like
'the price I paid for these shoes was £40.' To get an idea of the true 'cost', we would
really need to know something of the sacrifice made in giving up that £40.
£40 can buy a number of things - let us assume that it can also buy the following:
When thinking about how to dispose of your money, you have to make choices and
these represent the choices at this moment in time. These choices represent
different aspects of value. Each of the items might represent some value to you but
they may be different. It is important to remember that you might, in an ideal world
where there were no scarce resources, want all these things.
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TRADE OFFS
In business there are many occasions when one factor has to be traded off against another.
An entrepreneur might get huge help at the start from friends, yet realise that these same friends lack the professionalism to help the business grow.
The needs of the business may have to be traded off against the friendships. Other trade-offs may include – giving up a good job and prospects to be your own boss, giving up the most enjoyable things for profit etc.
1.3.1
Researching demand for the business idea: Market research: Methods-primary/secondary Quantitative/qualitative problems.
143-149
may 2009 q5 jan 2009 q6
sample paper q7
1.3.2
Is there a market for the business idea? Market size & share, growth, mass marketing niche, segmentation.
152-155
Sample paper q3 May 2010 q 3
May 2010 q 10
1.3.3
Positioning the business idea. Competition, market mapping, competitive advantage, adding value. differentiation
7-10 May 2009 q8 May 2009 q11
Jan 2009 q3 Sample paper q9b
May 2010 q6
1.3.4 Product Trial Testing, expense, methods, benefits, disadvantages.
166
Jan 2009 q9a Sample paper q1
May 2010 q7
1.3.5 Opportunity Costs Trade-Offs Choice – factors, stakeholders.
48-50
Jan 2009 9e Sample paper 9e
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Past paper questions
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44
Soft drink project
Design a “new” soft drink to be
readily available from December
2012.
Your Project should include
An advert
Marketing Mix:
Identify price, product, place and
promotional aspects
Questionnaire/Interviews/Surveys –
to determine through market
research, the current fashion/tastes
of the soft drinks markets.
Segmentation – whose is your
market/customers? Which groups
would buy your product?
Market Mapping – who are the
competitors and what are the
strengths and weaknesses.
Product trial – How are people
going to try it?
Additional information – market
size, recent trends etc
Added value – how do you
convince people to pay a price for it
when they know it only costs x
amount to produce.
When complete you will have
completed a business plan!
45 | P a g e
Section 4:
Economic considerations
The Economic Environment
Economics is concerned with the
process of satisfying the needs and
wants of the population, by using the
limited resources of the economy
(land, labour, capital and enterprise,
otherwise known as the 'factors of
production') in the most efficient way.
There are generally considered to be
four main objectives of an economy:
1. A low level of unemployment
2. A low level of inflation
3. A high level of economic
growth
4. A good foreign trading
position
Unemployment is defined as the
number of people in the workforce in a
country who are looking for a job, but
cannot find one.
The two major measures of
unemployment are the 'claimant
count' (where people must declare
that they are out of work, capable of
working, available to work and actively
seeking work) and the 'International
Labour Force' count (where people
must be out of work, have been
looking for work in the past 4 weeks
and must be available to start work in
the next 2 weeks).
Unemployment can be very damaging
to an economy because it can lead to
falling output, high government
spending, and falling aggregate
demand.
There are several methods that a
government can use to reduce the
amount of unemployment in an
economy:
Policies to increase demand: such
as reducing taxation or reducing
interest rates.
Retraining incentives offered to the
unemployed.
Helping new businesses to set-up,
and offering incentives to existing
businesses to relocate to areas of high
unemployment.
Inflation is defined as a general and
sustained rise in the average prices of
goods and services within an economy
over a period of time. It is calculated
by reference to the Retail Price Index
(R.P.I), which is a weighted index,
designed to indicate any changes in
the average price level in the UK.
Inflation can be very damaging to an
economy because it leads to the
reduced purchasing power of the
pound, uncertainty about the future, a
fall in investment and savings, and
increasing costs for businesses.
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There are several methods that a
government can use to reduce the
rate of inflation in an economy:
Increasing interest rates to discourage
high levels of customer spending.
Reducing the amount of credit
(borrowing) that is available to
customers.
Incomes policies, where pay increases
are limited, so to deter high levels of
costs and expenditure.
Economic growth. This term refers to
a real growth (i.e. accounting for the
effects of inflation) in the income per
capita (or income per head) of the
population over a given period of time.
It is normally measured by reference to
Gross Domestic Product (G.D.P)
and Gross National Product (G.N.P).
Gross Domestic Product is the total
value of a country's output over a
period of time (usually 12 months).
Gross National Product is calculated
by adding G.D.P. to the net income
from abroad (i.e. the income earned on
overseas investments by UK citizens
and businesses, minus the income
earned by foreigners investing in the
UK).
Economic growth is likely to lead to an
increase in the amount of investment
in the economy, as well as an increase
in the number of new businesses
starting up, leading to increases in
output, expenditure and income.
In order to improve the G.D.P. or the
G.N.P. per capita (i.e. in order to
achieve a faster rate of economic
growth), then the government must
ensure that the workforce is
adequately educated and trained to
perform their jobs effectively,
significant amounts of investment in
new machinery and production
techniques are undertaken, and
natural resources must be used to
their optimum efficiency.
Balance of payments. This is a
record of a country's financial
transactions with the rest of the world
over a given period of time (normally
12 months).
The current account of the balance of
payments measures both 'visible' trade
(that is, the imports and exports of
tangible goods such as furniture and
cars) and 'invisible' trade (that is, the
imports and exports of intangible
services, such as banking, shipping,
and insurance). The capital account of
the balance of payments measures
any flows of capital between the UK
and other countries (purchase of
shares and other forms of investment).
The exchange rate is the external
price of a country's currency,
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expressed in terms of another
currency.
For example, £1 = 1.5 euros
A free-floating exchange rate system
involves the value of the currency
being allowed to float (fluctuate)
according to the supply and demand
for the currency.
A demand for sterling is created when
the UK exports goods and services
(foreigners must pay for these goods
and services using sterling, which they
purchase in exchange for their own
currencies).
A supply of sterling is generated when
the UK imports goods and services
(i.e. the UK must pay for these imports
using the foreign currency of the
country concerned). These foreign
currencies are purchased in exchange
for sterling on the world currency
market.
An increase in the value of the pound
is known as an appreciation, and a
fall in the value of the pound is known
as depreciation.. A strong pound
makes goods and services produced
in the UK more expensive for
foreigners to purchase, but makes
foreign goods and services cheaper to
import.
A fixed exchange rate system
involves the value of the currency
being fixed against other currencies
and not being allowed to fluctuate in
response to the demand and supply
for it. This involves government
intervention on a regular basis, buying
the currency when its value is
threatening to fall, and selling the
currency when its value is threatening
to rise.
Under this system, the government
can devalue the currency if it feels that
its value is too high against foreign
currencies, making their goods and
services uncompetitive. This
devaluation of the currency boosts the
international competitiveness of the
country's exports, by making them
cheaper for other countries to
purchase.
Alternatively, the government can
revalue the currency if it feels that its
value is too low against foreign
currencies, making the level of
demand too high for their goods and
services and leading to inflation.
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Exchange Rates
The exchange rate is the price of a
currency. That’s often a very difficult
concept to get your head around,
particularly as ‘common sense’ is
misinformed by “exchanging” or
“swapping” currencies when you go
abroad on holiday. But if you get
some Euros before heading off for
France, you aren’t swapping your £s
for €s. You’re buying them.
So the £ is quite literally on sale in the
foreign exchange market. The graph
above points out the basic history you
need to understand. The £ broadly fell
in value (it ‘depreciated’) from the
1980s until the early 90s. Our
currency then sharply appreciated in
the mid 90s, where it stayed (with
some fluctuations) before plunging
again in 2008.
What does this mean for UK
businesses?
- In general, a lower value £ means
that imports are more expensive.
That’s part of the reason why there’s
been upward pressure on inflation
recently. Anything that comes from
abroad is now more expensive: parts,
components, finished goods, stocks,
oil, food. Almost all firms import
something, and are therefore likely to
face higher costs. UK customers may
move away from imports and foreign
holidays as they are relatively more
expensive.
- That leads to a wider benefit: the UK
is now relatively cheaper to foreigners,
providing UK firms with better export
opportunities, as well as more
domestic demand.
Evaluation points
- The impact of changing exchange
rates will be different on different
businesses. Firms with big import bills
will be hit hard. Other businesses that
are seeking to expand exports may
find demand increasing for their
products or services. Firms that were
planning to ‘offshore’ some of their
production might reconsider (check out
the links below).
- The uncertainty of exchange rate
change is a big headache for firms,
and tends to undermine overseas
investments and makes UK firms think
twice before embarking on any
overseas project.
- Exchange rates might not make such
a big difference if firms or their
customers are not price sensitive, of
course.
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1.4.1
Current Economic Climate: Economic Growth, Exchange Rates, Inflation unemployment
text 46-50
may 2009 q6 may 2009 q12
jan 2009 q7 may 2010 q 13
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Section 5: Financing the new business idea
Legal Structure
Sole Trader
A sole trader is a
one-person
business, commonly
found in trades
where only small
amounts of finance
are required to set
up and where there
are very few advantages to the
existence of larger organisations (e.g.
hairdressing, newsagents, market
traders).
Sole traders often employ waged
employees, but they alone have to
provide all the finance (often savings
and bank loans) and bear all the risks
of the business venture. In return, they
have full control of the business and
enjoy all the profits.
A sole trader faces unlimited liability
for his/her debts and it is referred to as
an unincorporated business - this
means that there is no legal difference
between the business and the owner.
Examples of Sole Traders
Partnership
To overcome
many of the
problems of a
sole trader, a partnership may be
formed. A partnership is an association
of individuals and generally there will
be between 2 and 20 partners.
Each partner is responsible for the
debts of the partnership and therefore
you would need to choose your
partners carefully and draw up an
agreement on the responsibilities and
rights of each partner (known as a
Deed of Partnership or The Articles
of Partnership). The most common
examples of a partnership are doctor's
surgeries, veterinarians, accountants,
solicitors and dentists.
As stated earlier, most partners in a
partnership face unlimited liability for
their debts. The only exception is in a
Limited Partnership. This is where a
partnership may wish to raise
additional finance, but does not wish to
take on any new active partners.
To overcome this problem, the
partnership may take on as many
Sleeping (or Silent) Partners as they
wish - these people will provide
finance for the business to use, but will
not have any input into how the
business is run. In other words, they
have purely put the money into the
business as an investment. These
Sleeping Partners face limited liability
for the debts of the partnership. A
partnership, just like a sole trader, is
an unincorporated business.
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Private Limited Company
This is a type of
joint-stock
company (that is, it
is an incorporated
business - where
the business has a
separate legal
identity from the owners). Often
private limited companies are small,
family run businesses which are
owned by shareholders.
Each shareholder in a private limited
company MUST be a part of the
business and under no circumstances
can any shares be sold to members of
the general public. Each share entitles
the owner to 1 vote at the company's
Annual General Meeting (A.G.M.) and
also to a share of the company's profit
at the end of the financial year (a
dividend).
Each shareholder has
limited liability for the
company's debts and can,
therefore, only lose the
value of their investment
in the company. A
company is run by a
Board of Directors (who are elected
by the shareholders) and this is
headed by a Chairman.
Before a company can be formed, a
number of legal documents must be
completed - most important are the
Memorandum of association and the
Articles of Association. These cover
details such as :
the objectives of the business
its headquarters and registered office
the amount of capital to be raised from
the sale of shares
details concerning meetings within
the business
the arrangements for auditing the
accounts of the business.
When these are completed, they
are sent to the Registrar of
Companies, who will then issue the
business with a Certificate of
Incorporation which allows the
business to trade as a Private Limited
Company. The company's name must
finish with the word Limited and it
must raise less than £50,000 of share
capital.
It can be very difficult for a shareholder
in a private limited company to sell
their shares, since a buyer must be
found within the framework of the
company.
Public Limited Company (P.L.C.)
This is the
other, much
larger, type of
joint-stock
company and,
just like a
private limited
company, a PLC is an incorporated
business, is run by the Board of
Directors on behalf of the
shareholders and has an A.G.M. at
which shareholders vote on certain key
issues relating to the company.
The main difference between a PLC
and a private limited company is that a
PLC can sell its shares on the Stock
Exchange to members of the general
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public and can, therefore, raise
significantly more finance than a
private limited company.
If a private limited company wishes to
become a PLC, then it must change its
Memorandum and Articles of
Association and re-submit them to the
Registrar of
Companies.
If the
company is
considered to
have acted
legally and for
the best interests of its shareholders,
then it will be issued with a new
Certificate of Incorporation and also
with a Certificate of Trading, which will
allow it to sell its shares on the Stock
Exchange. The price of the shares will
then fluctuate according to investors'
perceptions of the PLC.
It is often the case with a PLC that the
owners of the company (shareholders)
will wish the PLC to make as much
profit as possible, so that the
shareholders will receive a very
handsome dividend per share.
However, the Board of Directors and
the management will often wish to
devote some of the PLC' s resources
to growth and diversification (such as
the introduction of new products) and
this will clash with the shareholders'
desire for maximum profits. This is
known as the divorce of ownership
and control.
The PLC has to publish its annual
accounts (known as disclosure of
accounts) and therefore is extremely
vulnerable to investors' and bankers'
perceptions about its progress and
success. Following on from this, a PLC
is also at risk from a takeover from an
outside body, if they manage to
accumulate over 50% of the shares in
the PLC.
Franchising
Franchising has led to a rapid growth
in the presence of many high-street
stores in the UK over the past 10 years
(e.g. McDonalds, Tie Rack, Perfect
Pizza, and The Body Shop). A
business franchise involves the
franchisor (the owner of the business)
selling a business format to a
franchisee (the purchaser of the
business name) in return for a fixed
sum of money and a percentage
royalty on sales revenue.
The franchisee
will be based
locally and is
likely to be
making his
initial business
venture. He
buys the
business format, which has been tried
and tested in other areas, and it is
therefore a far less risky venture than
setting up his own business.
The franchisee has a licence to trade
under the franchisor's name and also
to use the logos, trademarks, etc. the
licence that the franchisee buys is
usually restricted to a specific
geographical area and for a limited
period of time.
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This process of selling the rights to use
a company's name, logo, etc. can
result in the parent company
experiencing rapid expansion in a
country, with little of the investment
that would have been required had the
company bought the outlets itself. The
franchisee is provided with a ready-
made product, financial and
management help and advice, lower
start-up costs than for a business of
his own, and help with the store layout.
However, the royalty must be paid to
the franchisor even if a loss is made
and the franchisee can have strict
restrictions placed on their actions and
promotions within the store, not
leaving the franchisee much room for
initiative and flair.
Sources of finance
Why business needs finance
Finance refers
to sources of money for a business.
Firms need finance to:
Start up a business, eg pay for
premises, new equipment and
advertising.
Run the business, eg having enough
cash to pay staff wages and suppliers
on time.
Expand the business, eg having funds
to pay for a new branch in a different
city
or
coun
try.
New
busi
ness
es
find it difficult to raise finance because
they usually have just a few
customers and many competitors.
Lenders are put off by the risk that the
start-up may fail. If that happens, the
owners may be unable to repay
borrowed money.
Some sources of finance are short
term and must be paid back within a
year. Other sources of finance are
long term and can be paid back over
many years.
Creditors and debtors
A creditor is
an individual
or business
that has lent
funds to a
business and
is owed
money. A
debtor is an
individual or business who has
borrowed funds from a business and
so owes it money.
There is a cost in borrowing funds.
Money borrowed from creditors is paid
back over time, usually with an
additional payment of interest. Interest
54 | P a g e
is the cost of borrowing and the reward
for lending.
A business owner's house could be
used as collateral
Creditors often ask for security before
lending funds. This means sole traders
and partners may have to offer their
own house as a guarantee that monies
will be repaid. A company can offer
assets, eg offices as collateral.
The type of finance chosen depends
on the type of business. Start ups and
small firms are considered very high
risk and find it difficult to raise external
finance. The only source of funds
migh
t be
the
own
er's
own
savi
ngs,
retained profits and borrowing from
friends. Companies can issue extra
shares to raise large amounts of
capital in a rights issue.
Internal and External Sources of
Capita The amount of finance required
by a business will depend on a range
of factors, including the age of the
business, the track-record and
profitability of the business, the
industry that it is in and the state of the
economy.
Internal finance is generated from
within the business and is likely to
come from one of three sources:
Retained profit refers to profits made
from previous years, which have
remained after corporation tax has
been paid to the Inland Revenue and
after dividends have been distributed
to shareholders. It is a useful source of
finance to fund new products, etc.
The sale of fixed assets, such as
machinery, vehicles or even land and
buildings which are idle, can also be a
large source of cash to fund new
projects.
Making more effective use of
working capital, such as chasing
debtors for prompt payment, selling off
any available stocks and negotiating
longer credit periods with suppliers all
release cash for use within the
business.
External finance is generated from
outside the business in a variety of
ways:
Bank overdrafts allow the business to
withdraw more money from the bank
than it has in its account. It is a
flexible, short-term method of
borrowing extra cash. However,
interest is calculated on a daily basis
and it can be recalled at very short
notice.
Trade credit involves the business
obtaining goods from another
business, but not paying for them for a
period of time.
Factoring involves a business selling
its debts to a factor company, who will
immediately give the business 80% of
the money owed to it by its customer.
At a later date, having collected the
debt from the customer, the factor
company will give the business the
remainder of the money less a fee.
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Leasing is a common way to fund new
fixed
assets, as
opposed to
purchasing
them
outright.
The
business will sign a contract
committing it to using some vehicles,
machinery, premises, etc. for a fixed
period of time (often 3-5 years) with a
monthly payment made to the
company who owns the assets. The
business leasing the assets cannot put
these items on its balance sheet (since
it never owns them).
Loans and mortgages are often used
to purchase new fixed assets
(machinery, vehicles and land and
property). They require monthly
repayments to be made for a
significant period of time (up to 25
years for a mortgage) and the bank will
also want an item to be placed as
security (collateral) to cater for the
event of the business defaulting on it
loan repayments. The danger is that
too many loans and mortgages will
increase the company's gearing to a
dangerously high level.
Debentures are sold by companies to
investors as a way of raising finance
for use within the company. They are
long-term, marketable securities,
which will pay the holder a fixed
amount of money every year until its
maturity date - at which time the holder
will be able to sell the debenture back
to the company for it market price.
However, debentures, like loans and
mortgages, will increase the gearing
level of a company.
Venture capital is a very risky type of
investment that entrepreneurs (called
venture capitalists) will make in a
small to medium sized business, which
they believe has massive growth
potential. These funds will clearly help
the business to grow and achieve its
potential.
Whichever source of finance is
chosen, the business must ensure that
it is adequate for the needs of the
business (i.e. it is enough to pay for
the new product development, new
buildings, etc.) and that it is
appropriate (i.e. it will not leave the
business with large monthly interest
repayments, when they are already
burdened with high gearing).
The overall objective in raising finance
for a company is to avoid exposing the
business to excessive high
borrowings, but without unnecessarily
diluting the share capital. This will
ensure that the financial risk of the
company is kept at an optimal level.
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Sources of Finance: Activity
Task:
You will be given a variety of different business scenarios. You must decide what type of finance the business in question should go for and why. Of course, there could be more than one appropriate source of finance - you could decide on a combination but again, ensure that you explain why you have decided on this route.
The Cases:
Case 1
A medium-sized engineering firm with an annual turnover of £2.5 million has decided to install a new piece of machinery to help improve its productivity. The equipment needs to be housed in a new building to be constructed on the site. The forecast cost of the building is £150,000 and the equipment £400,000.
Case 2
An individual has been made redundant after 20 years with a major organisation and has received a lump sum redundancy payment of £70,000. The individual is planning to set up a bookmakers and has identified a suitable premises valued at £180,000 near to a major town centre shopping precinct.
Case 3
A large plc is planning on moving a major part of its production facility to Cornwall. It has identified a site near a former chalk pit that is now not used. The estimated cost of the facility is £4.5 million.
Case 4
A local Do It Yourself (DIY) store has experienced problems with acquiring goods from its suppliers because it has been an erratic payer of its bills with them. The reasons it has experienced these problems is that it has contracts to supply building materials to a number of local firms all of whom only pay the bills for their orders every 3 months.
Case 5
A rugby club is anticipating turning fully professional after the team secured promotion
to the Zurich premiership. To take its place in the league, the league committee have insisted that it also improves facilities at the ground. It has been estimated that the cost of these two measures will be £550,000.
Case 6
A major UK plc is planning the takeover of a rival business. The move has been investigated by the Competition Commission and permission has been granted. The
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current share price of the rival firm is 260p and the firm has made an offer of 340p per share. The current market capitalisation of the target firm is £4.5 billion.
Case 7
A small partnership business has developed a new piece of software that would massively improve the efficiency of personnel management processes at large sized business organisations of all kinds. The software has massive potential but at present is not commercially viable because of lack of funds. The partners are contemplating their next move.
Case 8
A small newsagent in a rural village centre has decided to purchase a new freezer cabinet and oven/roasting unit to provide hot meals for village workers and for students at the secondary school which serves the surrounding area which is located half a mile from the village centre. The cost of the units is £3,500.
Case 9
A large charity organisation has followed a consultancy programme on streamlining its records. The consultants have suggested investing
into a software package that will provide a sophisticated database programme that will do all the things that the charity will require for the next 10 years. The cost of the software package is £65,000.
Case 10
Following the construction of a new housing estate on the outskirts of a major city, a group of 10 ambitious young professionals has decided to try to exploit the type of resident moving into the area by setting up a gym and health centre on earmarked land within the development. The building has been bought by the group for £800,000 but needs to be furnished and fitted out for the purpose intended. The cost of the bar, restaurant and gym facilities is estimated at £95,000 but the other major cost is the swimming pool, spa and sauna area. This could be utilised on a separate project to the fitness centre as the local council want to secure use for local school children and elderly residents - this being part of the purchase arrangements associated with the new housing development.
58
1.5.1 Sources of finance: Need for finance Internal/external Appropriateness Finance & time Legal structures of business Liability
101-104 29-33
jan 2009 q5 jan 2009 q9b
sample paper q6 sample paper q9d
may 2010 q 11
Past paper questions
59
Section 6
Measuring the potential success of a business idea
Product
Products can generally be classified
under two headings - consumer
products and producer products...
Consumer products
Purchased and used by individuals /
citizens for use within their homes and
these products fall into 3 categories:
Convenience products. Fast-moving
consumer goods (f.m.c.gs) sold in
supermarkets, such as soap,
chocolate, bread, toilet paper, etc.
These often carry a low profit-margin.
Shopping products. These are
durable products which are only
purchased occasionally, such as
dishwashers, televisions and furniture.
They often carry a very high profit-
margin.
Speciality products. These are very
expensive items that consumers often
spend a large amount of time
deliberating over, due to the large
investment requires to purchase the
product. Examples include cars and
houses. The profit-margins are, again,
very high.
Producer products
Purchased by businesses and are
either used in the production of other
products, or in the running of the
business. For example, raw materials
(timber, steel), machinery, delivery
vehicles, and components used to
make larger products (e.g. tyres and
headlights for vehicles).
A product line is the term used to
describe a related group of products
that a business produces (e.g. a
business may produce televisions, and
its product line may include portable
televisions, 12-inch screen models, 18-
inch screen models, televisions with a
built-in video facility, etc). Product mix
is the term used to describe the
different collection of product lines that
a business produces (eg the same
business may also produce video
recorders, camcorders and computers,
as well as televisions).
Most businesses will wish to change
their product portfolio over time. This
can be the result of changing
consumer tastes, replacing those
products which have entered the
'decline' phase of the product life-cycle
or to try to break into new markets or
new segments within an existing
product. There are generally
considered to be a number of
stages in the development of new
products:
The generation of ideas. A number of
issues need to be considered, such as
will the new product meet the
objectives of the business? Does the
business have the spare capacity to
produce the product? Will the new
product contribute to the continued
growth of the business? Will new
personnel be required, or will the
business have to re-train the existing
staff?
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Testing the
new concept. Is
there a sufficient
market for the
new product?
This stage of the
product
development
process will
involve carrying
out extensive primary market research
to test consumers' reactions to the
suggested product. Consumers may
suggest slight alterations and
modifications to the suggested product
in order to make it more marketable
and desirable.
Analysing the costs/revenues. What
will be the costs of production? How
many units will the business be able to
produce? What will the selling price be
set at ? What will be the profitability of
the new product?
Developing a prototype. The design,
materials, quality and safety of the
product will now become paramount. A
prototype of the product will be
developed using the details that the
market research indicated that
consumers wanted. It is essential to
ensure that this stage of the
development process is detailed and
extensive, since to make alterations
and modifications at a later date will be
extremely expensive and time-
consuming.
Test marketing the new product.
The business may often decide to test
market the new product in a small
geographic area, in order to test
consumer response, before it launches
the product nationally. If the consumer
response is favourable, then the
product is likely to be launched
nationally. However, if the consumers
indicate that some element of the
marketing mix is ineffective (price,
packaging, advertising, etc) then this is
likely to be changed before the
national launch of the product.
National launch. This is where the
product enters the 'Introductory' stage
of its product life-cycle. This is a very
costly operation, since a national
launch needs to be supported by
extensive advertising and promotional
campaigns.
It is inevitable that many new product
ideas will not get to the market place,
and many of those that do succeed in
being launched will fail within a few
months of their commercialisation.
However, the businesses which seem
to be most successful in bringing new
products to the market place tend to
meet a number of vital criteria:
they develop 2 to 3 times the number
of new products as their competitors;
they get the product to the market
place quickly;
they compete in many different
markets;
they provide strong after-sales service.
Price
The price level that a business decides
to sell its product(s) at will affect both
the quantity of sales and the profit-
margin received per unit. There are
many considerations that a business
will need to take into account before it
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decides upon a selling price for a new
product, such as:
The objectives of the business if the
main objective of the business is to
maximise profit, then it is likely that the
product will be priced at a high level.
The degree of competition in the
industry the number of competitors in
the industry will affect the price level
that the business decides upon for its
product(s).
The channels of distribution the
more intermediaries that are used in
getting the product from the factory to
the consumer, then the higher the
selling price is likely to be.
The business image if the image of
the business is prestigious and up-
market, then a higher price is likely to
be charged for the product(s).
There are many methods and
strategies that a business can use in
order to arrive at a selling price for its
products:
Cost-plus pricing. Cost-based pricing
involves setting a price by adding a
fixed amount or percentage to the cost
of making or buying the product. In
some ways this is quite an old-
fashioned and somewhat discredited
pricing strategy, although it is still
widely used. After all, customers are
not too bothered what it cost to make
the product – they are interested in
what value the product provides them.
The most common method of cost-
based pricing is cost-plus (or “mark-
up”) pricing. It is widely used in
retailing, where the retailer wants to
know with some certainty what the
gross profit margin of each sale will be.
Here is an example of cost-plus
pricing, where a business wishes to
ensure that it makes an additional £50
of profit on top of the unit cost of
production.
Unit cost: £100
Mark-up: 50%
Selling price: £150
How high should the mark-up
percentage be? That largely depends
on the normal competitive practice in a
market and also whether the resulting
price is acceptable to customers.
For example, in the UK a standard
retail mark-up is 2.4 times the cost the
retailer pays to its supplier (normally a
wholesaler). So, if the wholesale cost
of a product is £10 per unit, the retailer
will look to sell it for 2.4x £10 = £24.
This is equal to a total mark-up of £14
(i.e. the selling price of £24 less the
bought cost of £10).
The main advantage of cost-based
pricing is that selling prices are
relatively easy to calculate. If the
mark-up percentage is applied
consistently across product ranges,
then the business can also predict
more reliably what the overall profit
margin will be.
The main disadvantage is that cost-
plus pricing may lead to products that
are priced un-competitively. Another
potential issue is that firms may
experience changes in their production
costs which are not then reflected in
the selling prices offered, leading to
lower profit margins.
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Mark-up pricing. This is where the
business adds a profit mark-up to the
direct cost for each unit in order to
arrive at the selling price. This profit
mark-up will need to cover the fixed
overheads and then contribute towards
profit.
Predatory (or destroyer) pricing. This
method of pricing involves a business
setting its prices at such a low level
that other (often smaller) competitors
cannot compete profitably, and as a
result they are forced out of the
industry. This leaves the larger
business in a dominant position, and it
can then raise its prices to a much
higher level in order to recoup any
losses that they incurred when their
prices were low.
Skimming pricing. This is a pricing
strategy for a new product, designed to
create an up-market, expensive image
by setting the price at a very high level.
It is a strategy often used for new,
innovative or high-tech. products, or
those which have high production
costs which need recouping quickly.
Penetration pricing. This is a pricing
strategy for a new product, designed to
undercut existing competitors and
discourage potential new rivals from
entering the market. The price of the
product is set at a low level in order to
build up a large market share and a
high degree of brand loyalty. The price
may be raised over time, as the
product builds up a strong brand-
loyalty.
Prestige pricing. This strategy is used
where the business has a prestigious,
up-market image, and it wishes to
reflect this
through high
prices for its
products (e.g.
Rolls Royce).
Demand-orientated pricing. This
method of pricing involves setting the
price of the product at a level based
upon customers' perceptions of the
quality and value of the product.
Competition-orientated pricing. This
method of pricing ignores both the
costs of production and the level of
customer demand. Instead it bases the
price level on the prices charged by
the competitors in the industry -either
undercutting the competitors, charging
a higher price, or charging the same
price. 'Going rate' pricing is the term
used to describe a business charging
a similar price to competitors for a
similar product.
Psychological pricing is a pricing
tactic that is designed to appeal to
customers who use emotional rather
than rational responses to pricing
messages.
Sometimes prices are set at what
seem to be unusual price points. For
example, why are DVD’s priced at
£12.99 or £14.99? The answer is the
perceived price barriers that customers
may have. They will buy something for
£9.99, but think that £10 is a little too
much. So a price that is one pence
lower can make the difference
between closing the sale, or not!
The aim of psychological pricing is to
make the customer believe the product
is cheaper than it really is. Pricing in
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this way is intended to attract
customers who are looking for “value”.
For example, a new car might be
priced at £12,995 rather than at
£13,000. A rational customer would
know that the price difference of £5 is
tiny for such a high value item as a
new car. However, customers don’t
necessarily behave rationally. Some
may look at that price and “round it
down” to £12,000, making the
perceived difference more significant!
The main advantage of psychological
pricing is that it allows a business to
influence the way that customers view
a product without the need to actually
change the product.
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Costs
Variable and Total Costs
Generally speaking, a business will
incur two types of cost when it
produces goods and provides services
to consumers:
Fixed costs & Variable costs.
A fixed cost is one which is totally
independent of the level of output,
and it would be incurred even when
output was zero. Examples include
rent, mortgage payments, managers'
salaries, and loan repayments. They
are often referred to as overheads.
Total fixed costs (TFC)
Variable costs are those which vary
directly with output (i.e. as the level
of output increases, then variable
costs increase). Examples include raw
materials, production wages, other
direct production costs, and utility bills.
Total variable costs (TVC)
When fixed costs are added to variable
costs, then the total costs (TC) of the
business can be calculated.
In other words, TFC + TVC = TC.
This helps the business to calculate its
total costs at any given level of output.
Total costs
Note that TC starts at the same point
as TFC.
Average costs (AC) are calculated by
dividing total costs by the level of
output.
In other words:
Average costs
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It is clear to see that average costs will
also start to decline over time. When
this occurs in the long-run, then the
business is said to have achieved
economies of scale.
However, the business is likely to
reach a level of output where average
costs (the cost per unit) will start to rise
again. In these circumstances, the
business is said to be experiencing
diseconomies of scale.
When average fixed costs are added
to average variable costs, then the
average total costs (AC) of the
business can be calculated.
In other words:
AFC + AVC = AC
This helps the business to calculate its
average cost at any given level of
output.
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Contribution Analysis
Contribution is the term given to the
amount of money that remains after all
direct and variable costs have been
deducted from the sales revenue of
the business.
It is called 'contribution' because it
represents the amount of money which
is available to contribute towards
covering the fixed costs of the
business and, once these are covered,
it represents the amount of money
which will contribute towards the profit
of the business. In other words,
contribution - fixed costs = profit.
Contribution can be analysed in two
ways:
Contribution per unit sold
Contribution per unit sold = Sales price
per unit - Variable costs per unit.
For example, if a product has a selling
price of £ 10, and its variable costs
(labour, raw materials, etc) is £ 3 per
unit, then it has a contribution of £ 7
per unit.
If a product is loss-making, but it
nevertheless makes a contribution
towards covering the fixed costs of a
business, then it would be unwise to
delete the product from the product
portfolio. This is because the total
profit of the business will actually
decrease if the contribution from the
loss-making product is no longer
received. Therefore it is vital that a
loss-making product is not deleted
simply because it fails to produce a
profit - if it produces a contribution
towards fixed costs, then it is still
worthwhile to produce it.
Total contribution
Total contribution = Total sales
revenue - Total direct and variable
costs.
For example, if a business has total
sales revenue of £ 4 million, and its
total variable and direct costs are £ 2.5
million, then the total contribution for
the business is £ 1.5 million. This
contribution will hopefully cover the
fixed costs and then contribute
towards profit.
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Break-Even Charts
This is a graph showing the total
revenue and the total costs of a
business at various levels of output. It
is a form of Management Accounting
and it enables a manager to see the
expected profit or loss that a product
will face at different levels of output.
The break-even point is the point on
a break-even chart where the total
revenue (T.R) of a business (or
product) is equal to its total cost
(T.C).
It can also be calculated
mathematically by using the following
formula:
For example:
A business produces just one product,
which it sells for £ 9 per unit. The
variable cost of each unit is £ 4 and
the business faces fixed costs per year
of £ 1 million.
The business currently produces and
sells 500,000 units.
What is the break-even level of
output and what profit will the
business make if it sells all of its
output?
In order to assist the drawing of the
break-even chart, we can calculate the
break-even level of output and the
amount of profit using simple formulae:
In other words, the business will need
to produce 200,000 units before it
breaks-even.
Any level of output below 200,000 will
yield a loss.
Any level of output above 200,000 will
yield a profit.
The profit is equal to total revenue
minus total cost (or profit = TR -
TC).
Total revenue (TR) is calculated by
multiplying the selling price by the
number of units sold.
In this example, the selling price is £ 9
and the number of units sold is
500,000.
Therefore the total revenue (TR) is £ 9
x 500,000 = £ 4.5 million.
The total cost (TC) is calculated by
adding together the total fixed costs
(TFC) to the total variable costs
(TVC).
In this example, the fixed costs are £ 1
million and the total variable costs are
£ 4 x 500,000 units = £ 2 million.
Therefore the total cost (TC) is £ 3
million.
The profit is, therefore, TR - TC,
which gives us: £ 4.5 million - £
3million = £ 1.5million.
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We can now draw a break-even chart
and check the figures on the chart with
the answers above.
In order to have an accurate break-
even chart, three lines must be
plotted:
Total Fixed Costs (TFC),
Total Costs (TC)
Total Revenue (TR).
The x-axis is labelled as 'Output' (in
units). In this example, the axis will go
up to 500,000 units.
The y-axis is labelled as 'Costs,
Revenue and Profit' (in £ ). In this
example, the axis will go up to £ 4.5
million.
As you can see, the answers on the
chart correlate with the answers
calculated using the two formulae
above. The break-even point (shown
as a red dot) is the point where the TC
and the TR lines cross. This is then
measured by dropping a vertical red
line down to the x-axis, to give 200,000
units.
The profit at 500,000 units is then
calculated by taking a red vertical line
up from the 500,000 unit mark to
where it hits the TC line. This is then
measured across to the y-axis (again
using a red line) to give us total costs
of £ 3 million.
The vertical red- line from the 500,000
unit mark is then extended to where it
hits the TR line. Again, this is then
measured across to the y-axis to give
us a total revenue of £ 4.5 million.
Therefore, the profit is the
difference between TR and TC (i.e. £
1.5 million).
Although break-even analysis is a very
useful tool, it does have several
drawbacks:
It assumes that the TFC, the TC and
the TR functions are linear. In reality,
this is very unlikely.
It assumes that the selling price is
constant, in reality the selling price is
likely to vary from customer to
customer and region to region.
It assumes that the business only
produces one product.
It assumes that the business can sell
all of its output. In reality, very few
businesses will be able to do this and
some will remain as unsold stock.
The data used to construct the break-
even chart may well be out-of-date and
therefore inaccurate.
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Profit and Loss Account
The profit and loss account is a
financial statement which represents
the revenue that the business has
received over a given period of time,
and the corresponding expenses
which have been paid.
It also shows the profit that the
business has made over a period of
time (usually 12 months) and the uses
to which the profits have been put.
Revenue
Revenue is the inflow of money to the
business in the course of the ordinary
activities of the enterprise.
There are a number of different
sources of revenue;
cash sales
credit sales (i.e. where the business
has sold goods to customers, but has
not yet received the cash)
interest
royalties
dividends that the business receives
on its investments or
fees for hiring-out the resources of the
business to a third party.
Revenue is recognised at either the
receipt of the cash OR at the point of
sale (if the goods are sold on credit).
Expenses
Expenses are expired costs (i.e. costs
from which all benefits have been
extracted during an accounting
period). Examples include wages, raw
materials, and utility bills -often known
as revenue expenditure.
It must be remembered that expenses
are not necessarily the same as
costs.
For example, if a business purchases
a new fixed asset (such as a machine)
then it will clearly incur the monetary
cost of purchasing the machine (say
£50,000).
However, this £50,000 will not be
written-off as an expense, since the
benefits from the machine will last for
more than a single accounting period
(i.e. for more than 12 months). Instead
of writing-off the total cost of the
machine, a portion of the £50,000 will
be written-off as an expense each year
over the useful life of the machine -this
is known as a 'depreciation charge'.
Format of the Profit and Loss
account
The usual layout for a profit and loss account
is as below:
£000 £000
Sales Revenue
1,000
Cost of Sales:
Materials 300
Direct labour 200
Production overheads 100
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(600)
Gross profit
400
Less selling expenses 100
Less administrative expenses 120
(220)
Trading [Operating] Profit
180
Add non-operating income
(10)
Profit before interest and tax
190
Less interest expense
(30)
Profit before tax [Net Profit]
160
Less taxation
(60)
Profit after tax
100
Less dividends
(20)
Retained Profit
80
The first line gives the Sales
Revenue for the business from selling
its goods and services.
From this, we deduct the "Cost of
goods sold" (costs directly associated
with the production of the goods and
services - such as the cost of the raw
materials, the labour charges
associated with the production, and
the production overheads. These are
sometimes referred to as direct
materials, direct labour and direct
overheads).
Sales revenue less C.o.G.S. is
known as Gross profit.
However, we have not yet accounted
for selling and administrative expenses
(such as advertising costs, distribution
costs, salaries, utility bills, etc.).
When these are deducted from the
Gross Profit, the result is known
as trading or operating profit. These
refer to the profit made from normal
trading activities.
The next adjustment is to add on any
income from other activities, known as
non-operating income (e.g. renting out
premises). The resulting figure is
known as profit before interest and
tax.
We then deduct a figure for interest
charges. The resulting figure is known
as profit before tax or net profit.
The final part of the account is known
as the appropriation account. It
provides information on the way in
which the profit is dispersed.
Some is taken in corporation tax and
goes to the Inland Revenue, some is
drawn from the business as
dividends to be distributed to the
shareholders and the remainder
is retained within the business for re-
investment.
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Ratio Analysis - Introduction
Ratio analysis is an accounting tool,
which can be used to measure the
solvency, the profitability, and the
overall financial strength of a business,
by analysing its financial accounts
(specifically the balance sheet and the
profit and loss account).
Accounting ratios are very easy to
calculate and they enable a business
to highlight which areas of its finances
are weak and therefore require
immediate attention.
There are two main ratios that can be used to measure the profitability of a business:
1. The gross profit margin. 2. The net/operating profit margin.
The gross profit margin
This measures the gross profit of the
business as a proportion of the sales
revenue. It is calculated using the
following formula:
For example, if a business has gross
profit of £4 million and sales revenue
of £6 million, then the gross profit
margin would be:
This means that for every £1 of sales
revenue, £0.67 remains after all direct
expenses have been deducted. This
money then contributes towards
covering the other expenses of the
business.
The business would want this margin
to be as high as possible, since a high
margin will leave more profit for
covering the remaining expenses and,
if the business is a 'company', for
covering the dividend payments to
shareholders.
The net/operating profit margin
This measures the net profit of the
business as a proportion of the sales
revenue. It is calculated using the
following formula:
For example, if a business has gross
profit of £1 million and sales revenue
of £6 million, then the net profit margin
would be:
This means that for every £1 of sales
revenue, 16.7 pence remains after all
direct and indirect expenses have
been deducted. This money then
contributes towards covering the
corporation tax that must be paid on
profits to the Inland Revenue and, if
the business is a 'company', covering
the dividend payments to
shareholders.
Any profit which remains is kept in the
business for re-investment and is
called 'retained profit'. Again, the
business would want this margin to be
as high as possible, allowing both
large dividend payments to
shareholders and a significant amount
of profit to be retained for growth.
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Improving profit margins
Mars bars shrink in size
The size of Mars and Snickers
chocolate bars has been shrunk by
more than 7 per cent as the company
tries to cut costs.
A Mars bar
While the best-selling treats have been
reduced from 62.5g to 58g, their prices
have remained the same.
The change happened in the second
half of last year and the downsized
versions are now on sale in the shops,
where a Mars bar still costs 37p and a
Snickers is 41p.
Mars UK claimed the switch to smaller
sizes was designed to help tackle the
nation's obesity crisis.
However, the move was not advertised
despite claims it was for a public
health initiative.
The reduced Mars contains just 19
fewer calories at 261, while the
Snickers has 23 fewer at 296.
Mars UK has now confirmed that the
change was triggered by rising costs,
according to the Daily Mail.
"Like all food manufacturers, we have
seen continued cost increases over
the last few years," it said in a
statement.
"We look to absorb the vast majority of
these costs by being more efficient,
but on occasion we have to consider
increasing prices.
"By slightly reducing portion sizes on
Mars and Snickers we were able to
continue to responsibly meet
consumer demands for healthier
lifestyles whilst not increasing our
prices."
Consumer Focus, the customer body
set up by the Government, is
concerned that firms are attempting to
fool consumers.
"Shrinking the size of chocolate bars
should be part of a drive to combat
obesity. However, shrinking size but
not price could damage consumers'
trust in the brands they love," said its
policy expert Lucy Yates.
Mars UK's sister operator in Australia
is shrinking the size of 90 products
while keeping prices the same.
The change there has been handled
very differently by being presented in a
major advertising campaign as a public
health measure.
The tactic of cutting product sizes,
known as the Grocery Shrink Ray in
America, is a tactic being used by
many British companies.
74 | P a g e
There are a number of ways a firm can
improve its profit margins:
1. Reduce the number of special
offers.
2. Buy cheaper raw materials
3. Stock a wider range of products
4. Increase prices
5. Reduce wastage
6. Stock more seasonal items.
What are the effects of each of these
on the profit and loss account?
What could be the consequences?
1.6.1
Sales volume & revenue: Goods/services Sales volume Total revenue Pricing: demand-based cost-based competition-based psychological.
72-73 184-188
may 2009 q9 May 2010 q12
1.6.2
Business Costs: Fixed costs Variable costs Total costs
73-75
1.6.3
Profit & contribution Calculating profit Contribution: selling price – variable costs
82
Sample paper q5
1.6.4 Break-even revenue level. Break-even analysis Break-even point Actions Chart/formula Margin of safety Limitations of break-even
82-87
Sample paper q4 Jan 2009 q9c May 2010 q8
1.6.5 Profit & Loss account Calculating profit & loss Gross Profit Cost of Sales Expenses Net/Operating Profit
377-382
May 2009 q10
1.6.6 Measurement of profit Use of P & L account Ratio analysis: Gross Profit Margin Net Profit Margin Improving Profit Margins Limitations of ratio analysis
394-404
May 2009 q4 Sample paper q2
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Past paper questions
76
Section 7: Putting a business idea into practice
Once an entrepreneur has recognised
an opportunity, he/she must draw up a
business plan. This is a document
which outlines the marketing,
production and financial plans for the
proposed business. It is used to try
and persuade investors (banks, etc.) to
lend money to the entrepreneur to fund
his/her new business.
The main sections of a business
plan include:
- the aims and objectives of the
business
- details of the new product or service
being offered
- an outline of the existing market
details (i.e. size of the market, number
of existing competitors)
- how and where the product will be
produced
- the proposed number of employees
- a cashflow forecast, a projected
profit and loss account and balance
sheet for the end of the first year's
trading
- details of the finance required and
the forecasted rate of return on this.
Most small businesses have very
limited resources. Research is costly
and can seem like a poor use of time.
Some entrepreneurs ignore planning
and analysis and instead rely on their
gut instinct. They launch products they
believe customers want and
competitors cannot match. Poor
planning
is a
major
cause of
busines
s failure.
Busines
ses are
more likely to succeed if their strategy
is carefully planned
There is an alternative. A business
plan is a report by a new or existing
business that contains all of its
research findings and explains why the
firm hopes to succeed. A business
plan includes the results of market
research and competitor analysis.
Analysis is when a business
interprets information.
Drawing up a business plan forces
owners to think about their aims, the
competition they will face, their
financial needs and their likely profits.
Business plans help to reduce risk and
reassure stakeholders, such as banks.
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Cash Flow Forecast
Cash Flows
Cash is the most liquid of all the assets
of a business -it represents the bank
balance and the cash that the
business has available on the
premises (otherwise known as 'petty
cash').
Cash flow refers to the difference
between the cash flowing into the
business (e.g. through sales revenue)
and the cash flowing out of the
business (e.g. bills and wages).
Cash flow problems
Having a positive cash flow is vital for
the survival of a business, since
without the ability to pay workers and
suppliers then the business will soon
have to cease trading.
This potential problem is compounded
by the fact that businesses often have
to pay many expenses several weeks
or even months before any cash
actually flows into the business.
For example, wages and salaries will
have to be paid to employees,
suppliers will have to be paid for any
raw materials, and the rent or
mortgage payments will have to be
paid before the products can be
manufactured and sold to customers.
Further to this point, if the products are
sold on credit to customers, then the
time delay between the cash outflows
and the cash inflows will be even
longer.
The major causes of cash flow
crises for a business are:
1. Overtrading -where the
business attempts to expand
too rapidly, without a sufficient
financial base.
2. Having too much money
invested in stocks.
3. Allowing too much credit to
their customers.
4. Unexpected changes in
demand for their products.
5. Overborrowing -therefore
having large monthly loan
repayments, which have to be
met.
There are many actions that a
business can take when it is
experiencing a liquidity crisis:
1. Offering price discounts to
boost sales and sales
revenue.
2. Selling off fixed assets.
3. A 'sale and lease back'
arrangement.
4. Chasing debtors for the
monies owed to the business.
5. Selling off stocks.
Whatever action is decided upon, the
business must ensure that it is
implemented quickly and that a careful
eye is kept on the liquidity (cash flow)
position in the future.
Cashflow statement
A cash flow statement is a Financial
Accounting document, which shows
the cash inflows and the cash outflows
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for a business over the past 12
months.
It indicates those months in which the
business suffered a cash flow crisis
(where cash outflows were greater
than cash inflows) and it will also
highlight those months in which the
business was cash-rich (i.e. more cash
inflows than cash outflows).
It allows a business to prepare a cash
flow forecast for the forthcoming year,
by basing the estimated cash inflows
and outflows on the results from the
previous year.
Cashflow forecast
A cash flow forecast is a
Management Accounting document,
which outlines the forecasted future
cash inflows (from sales) and the
outflows (raw materials, wages, etc)
per month for a business over an
accounting period.
Example:
Total
£ Jan Feb Mar Apr
Sales
revenue 2850 900 850 750 350
Other
revenue 650 200 200 100 150
Total cash
inflows 3500 1100 1050 850 500
Total cash
outflows 3400 700 950 1200 550
Net
monthly
cash flow
100 400 100 (350) (50)
Bank
balance 300 600 700 350 300
The business forecasts that in January
it will experience cash inflows of
£1,100 and cash outflows of £700,
leaving a positive net monthly cash
flow of £400.
This is added to the £200 bank
balance which existed at the end of
December, to give a forecasted bank
balance at the end of January of £600.
In February, the forecasted cash
inflows are only £100 more than the
forecasted outflows, leaving a bank
balance of £700.
However, in the months of March and
April, the business is forecast to
experience negative net monthly cash
flows (i.e. its cash outflows are
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forecast to be greater than its cash
inflows).
This gradually reduces the bank
balance to just £300 by the end of
April.
It is important for a business to
produce a cash flow forecast, so that it
can prepare for those months in which
it is forecast to experience a cash flow
crisis (i.e. the business needs to
arrange extra borrowing or overdraft
facilities to provide extra cash).
Alternatively, in the months where the
business is forecast to be cash-rich, it
can use this money profitably
elsewhere within the business (e.g.
new product development).
1.7.1
Creation of a business plan What is a business plan? Contents
Cash flow management
21-25
79-86
may 2009 q 7 may 2010 q 5
may 2011 q12
80
Past Paper questions
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Revision
http://www.wordle.net/create
Create a word cloud that identifies the keywords from Unit 1!
The clouds give greater prominence to words that appear more
frequently in the source text. You can tweak your clouds with different
fonts, layouts, and color schemes. The images you create with Wordle
are yours to use however you like. You can print them out, or save
them to the Wordle gallery to share with your friends.
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Revision
Create a power-point presentation that answers one of the following tasks:
Entrepreneur
a) Identify an entrepreneur, what does he/she do, why, and how?
Examples: Steve Jobs, Mark Zuckerberg, Anita Roddick, Giorgio Armani. What
were their motives?
Supply and Demand
b) Draw and label a supply and demand curve showing their interaction. Explain
what happened if one of the main factors (determinants) changes. Eg price of
substitutes.
Market research
c) Identify 3 other methods of market research. What are the advantages and
disadvantages of these methods? Find suitable examples of poor market
research eg Coca-Cola Dasani
Market Niche
d) Identify 2 companies that have a Market Niche. What does this mean and
what are the specific segments they have identified?
Product Positioning
e) Think of a small café/restaurant you have visited in Valencia. How have they
positioned themselves? Who are the competition? Why are they different
(competitive advantage) and which methods to they use toa dd value? Eg
How to they persuade us to pay 1,50 for a coca cola that costs 50c in the
supermarket?
Product Trial
f) Identify a product Trial that has taken place that you are familiar with. How did
they test market? What were the advantages and disadvantages? Was it/Is it
successful?
Stakeholders
g) Identify a small business you are familiar with. Who are the stakeholder
groups involved. How are they involved? How could they be affected by the
current economic recession?