Finance
Managing costs is one of the best ways of ensuring that a firm can charge a competitive price on its products without compromising on its profitability. At The Shetland Wool Company, the managing director has to take into consideration the conflicting interests of the sales director and the finance director when making the final decision. The firm has to meet all the basic costs to ensure that it maintains sustainable operations. In this section, the focus is to address financial issues that will enable the managing director to make sound financial decisions.
Marginal Costing as an Appropriate Way to Control Costs and Set a Selling Price
The managing director’s friend has suggested that marginal costing is an appropriate way to control costs and set a selling price. Before stating whether the argument of the friend is right, it is necessary to assess the current pricing strategy of the firm based on the cost of production. Table 1 shows the unit cost of a product at this company based on the current costs of wool, labor, transport, advertising, directors’ fee, and head office expenses. The total cost for a unit product is £368. It means that if the company uses its current pricing policy of charging 200% of the total cost of production, the product price will be £736. The problem is that the price range in the market is currently at £200-400. It means that it would be unrealistic to charge more than double the average market price even if the market is not price-sensitive, as the marketing department suggests. As such, the only realistic price will be £400, which is the premium price in the market. This price, which is not based on the firm’s current pricing policy, will allow the company to make a profit before tax of £32.
Table 1: Product Pricing Based on Cost
It is important to understand the concept of marginal costing before determining if the suggestion of the director’s friend is true. Normann-Tschampel (2020, p. 41) explains that “Marginal costing is a method where the variable costs are considered as the product cost, and the fixed costs are considered as the costs of the period.” The advice is true because marginal costing is a common strategy that firms use to set their prices. However, in the case of The Shetland Wool Company, marginal costing can only apply if the production capacity is increased. As shown in the above calculations, the fixed cost of production (head office, directors’ salaries, and advertising) is (50+62.5+57.5) = £170 while the variable cost is £ 198. Ignoring the fixed cost means that the company can charge a price of £250 and still make a profit. However, this can only hold when the items sold increase significantly to ensure that the gross profit covers the fixed costs. The advice to the managing director is that this strategy should only be employed when the firm intended to double or triple the current production to benefit from the economies of scale. If the managing director considers investing more in marketing and an increase in the volume of production, as had been suggested by the sales director, a costing strategy may be considered. Under the current circumstances, only value-based pricing makes sense to ensure that the company remains sustainable.
Appropriate Alternative Methods of Costing
The Shetland Wool Company can use various methods of costing such as standard costing, activity-based costing, or lean costing to achieve specific market goals both in the short and long term. The managing director, working closely with the finance director, will need to determine the appropriate method of costing that should be used to help in controlling costs and setting the right price for the company’s products (Turner, Weickgenannt, & Copeland, 2020). The selected method should be based on the principles defined in the supply and demand theory.
This model of microeconomics defines how a firm should price its products in a competitive market. As Malagatti (2020, p. 78) observes, the theory holds that “the unit price for a product may vary until it settles at a point of economic equilibrium, or when the quantity at which consumers demand a product equals the quantity at which a consumer supplies it.” When the demand exceeds the supply, then the price will increase, and vice versa holds. The management of this company should take into consideration this principle when choosing the appropriate costing method. It should avoid the assumption that increasing the quantity supplied will not have any effect on the price. Chances are that when the supply is significantly increased, the basic principle of supply and demand theory states that the price will fall.
Standard costing is one of the most commonly used methods of costing in the modern business environment. It is the one that this company should consider using. In this method, a company is required to assign standard costs instead of actual costs when calculating the cost of goods sold and its inventory (Weygandt, Kieso, & Kimmel, 2018). The standard cost is set based on the efficient use of materials and labor when producing goods under a standard operating condition (Bhimani, Datar, Horngren, & Rajan, 2019). When using this method, the management must understand that although standard costs are used with the assumption that conditions of operations are standard, the actual cost is always different. Environmental forces may be so favorable that the actual cost is way below the standard cost that was expected by the firm. In other cases, a firm may face undesirable market forces that inflate the cost beyond the standard cost. Taschner and Charifzadeh (2020) define the assessment of the difference between the actual cost incurred to produce goods and the standard cost as variance analysis.
The management will need to conduct a variance analysis to determine if it is favorable. As Drury (2018) observes, when the actual cost that The Shetland Wool Company pays to produce goods is higher than the standard cost, it is considered an unfavorable variance. It is a sign that the firm is spending more to make a unit product than the market average. Factors such as high cost of raw materials, high cost of labor, and the efficiency in production are some of the factors that can cause unfavorable variance. However, when the actual cost is lower than the standard cost, then the variance analysis will be considered favorable (Popkova, 2018). Factors such as improved production methods, use of emerging technologies, and reduced cost of inputs can help a firm to achieve a favorable variance.
Selling Price for both the Current Year and Next Year
The Shetland Wool Company will need to determine an appropriate price for its products that will enable it to not only attract and retain loyal customers but also maintain the sustainability of the firm’s operations. Costing and pricing theory is the most effective method because it ensures that the set price meets the cost of production. Based on the facts and figures provided, table 2 below highlights the total cost per unit product from year 1 to year 5. The assumption is that from year 5, the company will be producing 5000 units, but the cost of advertising will not change based on the advice given by both the finance director and the friend to the managing director.
Table 2: Unit Cost of Products
The cost of production is relatively high in the first year. It drops significantly in the second year because the fixed costs remain the same while the quantity produced increases. There is a gradual increase from year 2-5 because of the increase in directors’ salaries. The proposed price, based on the cost of goods produced is £350, and it will not change for the first 5 years. As shown in figure 1 below, the company will make a loss in the first year. However, it will break even in the first quarter of the second year. The highest profit will be made by the end of the second year. The profit margin will continue to reduce slightly unless the management of the company finds other ways of lowering marginal costs of operation to match the increasing costs.
Marketing
The management of The Shetland Wool Company is facing a unique challenge in the market as it increases sales for its very high-end hand-knitted wool sweaters. Although the company has successfully carved a niche in the market, managing costs as a way of enhancing profitability has been a major issue. The top managers have also failed to agree on the best strategy that they should use to increase sales without inflating the cost of delivering a unit product in the market. In this section, the focus is to explore the market opportunities and trends in the United Kingdom, identify potential customers for the firm, and make recommendations on suitable market segments and implementation plans. The section will assess both the macro-environmental factors and micro-environment actors that directly affect the firm’s operations in the market.
Macro-Environmental Factors
The ability of The Shetland Wool Company to achieve success in the market depends on its ability to understand and effectively respond to market forces in the country. The United Kingdom is one of the developed nations in the world, and external market forces are significantly different from those in other parts of the world. When assessing the macro-environmental factors in this country, the PESTEL model, illustrated in figure 2 below, can be effective.
The first macro-environmental factor that the management of The Shetland Wool Company has to consider is the political climate. As shown in the figure above, of interest should be political stability, labor laws, and corruption index. The United Kingdom has enjoyed decades of political stability, which means that this company will enjoy a secure environment that makes it possible to grow. The labor laws were drafted to help protect both the employer and employees (Marshall & Johnston, 2019). It means that there are no unfair practices in favor of either the company or its employees. In the short term, the company can plan its human resource knowing that it is protected from undesirable activities such as industrial actions as long as it obeys the labor laws.
The issue of corruption remains one of the biggest challenges that firms face in their operations. Kotabe and Helsen (2020) observe that in some countries, firms are forced to bribe government officials to ensure that they remain protected. The United Kingdom is one of the least corrupt countries in the world (Dimitriadis, Dimitriadis, & Ney, 2019). It means that this company will only need to follow the law in its operations without having to offer bribes. Such an environment is beneficial both in the short and in the long term.
The economic environment is another major macro factor that influences the ability of a firm to achieve success. One of the major factors is the country’s growth domestic product (GDP), especially in terms of the purchasing power of employees. The United Kingdom has one of the highest GDPs in Europe, with a relatively high purchasing power among its citizens (Nishimura, 2019). It means that a significant number of people can afford the high-end products of the company both in the long and short term. Inflation is another major factor that cannot be ignored when assessing the market forces. Although it is not easy to predict when inflation may strike, because it is often influenced by numerous national and global forces, the government of the United Kingdom has been keen on putting measures that can help manage inflation (Peter & Donnelly, 2018). As such, The Shetland Wool Company is assured of some form of government protection in case of inflation. Similarly, the government has strict regulations about interests charged on loans. They have been maintained at low rates to encourage businesses to take loans as a means of spurring growth.
The social environment of a given country has a direct impact on the ability of a given firm to achieve success. Culturally, the United Kingdom is one of the most diverse countries in Europe. Many years of immigration and integration have resulted in a culturally diverse nation. However, Chernev and Kotler (2018) admit that racism and religious intolerance remain major social concerns in the country. Lack of social integration may be a major problem in the workplace environment. This company can easily overcome this social challenge because its employees work from home. It means that the intolerance will not be significantly felt in the workplace environment. The lifestyle of the targeted market defines their purchasing pattern. In the United Kingdom, there is a growing preference for high-quality products because of the increasing purchasing power of its citizens. If the trend continues, the firm will achieve long-term growth as the size of the market continue to expand. A high-quality sweater is essential for those who are keen on protecting their health, especially during winters.
Technology has emerged as one of the critical macro-environmental factors that define the operations of a firm. In the clothing industry, automation has become the ultimate trend that helps companies to improve the quality of their products, lower operational costs, and lower the time it takes to produce a unit product. With the increasing growth of artificial intelligence (AI) in the United Kingdom and around the world, the use of machines has become unavoidable in modern society (Seligman, 2018). The Shetland Wool Company may face serious challenges as it over relies on human labor.
It may realize that it is spending more per unit product than its rivals in the market. Its current production strategy also limits innovation and research. Armstrong et al. (2021) explain that innovation thrives in an environment where people work as a team. They can come up with ideas for making their work easy and have the capacity to test these ideas to determine if they can work. The company can also sponsor research to help inform best practices that it embraces in its operations. In the long term, the strategy that this firm uses may become unstainable as technology continues to improve.
The ecological factors can no longer be ignored when assessing the external forces of a firm. Issues about climate change and environmental pollution have attracted massive attention from scientists, the political class, business executives, and the general public (Pencarelli & Forlani, 2018). Customers want to be assured that the process of producing items they purchase does not pose a serious negative effect on the environment. Political leaders in the country have drafted laws and regulations meant to limit the level of greenhouse gases emitted into the air. The management of The Shetland Wool Company has a responsibility of ensuring that its activities do not pose any threat to the environment. It means that it will have to monitor the production strategies of its customers to ensure that they are within the set regulations. Investing in corporate social responsibilities (CSR) activities such as planting trees or eradication of plastic wastes in the environment may help in strengthening its brand in the market.
The legal environment is identified as the last factor in this model of external assessment of macro forces. As Pettinga et al. (2019) observe, a firm cannot survive in an environment that lacks a clear legal environment. The legal and regulatory environment is meant to protect firms, customers, the government, suppliers, and the general public from unscrupulous business practices. Antitrust laws, copyright laws, and customer protection laws are often enforced efficiently in the United Kingdom (Rajagopal, 2020). The firm must make an effort to ensure that its practices strictly abide by these laws and regulations. Another legal issue that the management of The Shetland Wool Company has to take into consideration is labor laws. The government has defined rules that have to be observed when defining the minimum salary that workers have to be paid. It has also defined the standard working hours for employees. To avoid any litigation and industrial actions, the management should ensure that employees are fairly remunerated. The working environment should meet standards set by the government and other relevant local authorities.
Micro Environment Actor
The management of The Shetland Wool Company will need to understand the microenvironment actors that may have a direct influence on their operations in the market. As shown in figure 3 below, these actors include the company itself, the suppliers, marketing intermediaries, customers, competitors, and the public. Each of these players has unique interests, which may sometimes be conflicting. Knowing how to balance each of their interests to ensure that everyone is satisfied is critical in enhancing the success of the firm.
When assessing micro actors, the analysis should start by assessing the internal environment at The Shetland Wool Company. SWOT Analysis, shown in table 1 below, is an effective tool that can help in assessing the internal environment. As shown in the table, one of the main strengths of the firm is its flexibility. It can easily change from one strategy to the other as new practices emerge. It is also evident that its team of skilled and dedicated employees makes it easy for the management to meet its targets without having to supervise workers regularly. The ability of the employees to work from home also means that the company cuts on costs of rent and related services in its production.
The company has challenges that may hurt its operations in the market. One of the main weaknesses is its slow pace of embracing emerging technologies because its employees work from home. They are also unable to share new ideas with ease to help improve their efficiency. The management is also unable to closely monitor the activities of workers. The firm should find a way of overcoming these challenges.
The market presents opportunities that the company should find a way of fully exploiting. The growing purchasing power of customers in the United Kingdom is one of the main opportunities that this firm should exploit. The higher the number of potential buyers, the bigger the market for this firm (Brege, 2020). The emerging marketing platforms also make it easy for the firm to reach out to its customers. Social media platforms (Facebook, YouTube, Instagram, Twitter, and Tik Tok) have become effective methods of communicating with customers. New trends and preferences in the market, if the firm can adjust its products accordingly, also presents a growth opportunity.
The market has challenges that the management will need to find a way of managing. One of the main market threats is stiff competition from firms offering the same or alternative products. This factor is discussed in detail in the next paragraph. Disruptive technologies may render the current strategies used by the firm obsolete (Fillis & Telford, 2020). It is also essential for the firm to monitor and effectively respond to the emerging labor laws to avoid a dispute with employees.
Table 3: SWOT Analysis
Competition in the market is essential in compelling a firm to embrace best practices in the market. Suppliers, marketing intermediaries, customers, and the public are critical micro actors, but the main interest in this analysis is competitors. According to a report by (Fillis & Telford, 2020), the United Kingdom is the third-largest market for knitwear in Europe. The report indicates that in 2019, the market size was estimated to be worth over €2.6 billion, which corresponds to about 300 million units of clothing that year (Fillis & Telford, 2020). The market size has been growing considerably. The level of competition is equally getting stiffer. Some of the top competitors in this market include Mars Knitwear, Paul James Knitwear, The Cotton London, Britannical, and Blackshore Coastal Clothing. Each of them targets various segments of the market in the country. The success of The Shetland Wool Company will depend on its ability to select an appropriate market segment and to provide quality products that meet their specific needs.
Potential Target Customers Segments
Segmenting the market to identify the most attractive potential target customers is essential for a company that seeks to offer quality products to a specific niche. According to Seligman (2018), a market can be segmented based on demographic, behavioral, psychographic, or geographic factors. A firm must understand its capacity before defining the appropriate strategy of segmenting the market. Demographic segmentation focuses on factors such as the age of targeted customers, their education level, sex, income levels, marital status, family size, nationality, religion, and occupation (Buchbinder, 2019). It enables a firm to understand the pattern of thought one is likely to make when they intend to purchase a given product. Behavioral segmentation focuses on the loyalty of customers, benefits that they seek, actions that they take on a website, and online shopping habits (Pérez, Salcedo-Perez, & Ocampo-Guzma, 2017). Psychographic segmentation focuses on customer traits that are emotional and mental. Some customers would purchase a given product primarily because of the sentimental value.
Geographic segmentation, as the name suggests, focuses on the location of clients as the basis of classifying them into a specific group. For Shetland Wool Company, the most appropriate segmentation strategy is on the geographic location of the company. The firm is relatively small in size and financial might, and as such, it is advisable to select a specific geographic location with a high concentration of the targeted customers. Using such a strategy will help the firm to cut the cost of transportation, warehousing, and marketing. Selecting a location such as the city of London is essential as the firm seeks to gain dominance in that specific area before spreading to other parts of the country. The firm will be producing high-quality hand-knit sweaters for different demographics in the region. It will have to meet diverse customer preferences as it will be operating in different sector types such as adults, teenagers, male, and female clients. It will also seek to target customers of different religious groups.
Recommendations
After defining the right segmentation method, the management of this firm should develop an implementation plan of reaching out to the targeted customers. It should start by strengthening its brand name and image in the market. Using both mass and social media platforms, the marketing unit should promote The Shetland Wool Company brand and its products in the market. It may need to develop different commercials for different demographical segments. Teenagers, youth adults, and the elderly of both genders need a commercial that strictly relates to their preferences and market trends. The product, which is the hand-knit sweater, should be designed to meet the expectations of a specific market segment.
Given the small geographic location for the firm, the management should consider directly delivering its products to specifically selected specialty shops within London using its vans. The company should ensure that these products are arranged in stores based on the different demographic segments of customers. There should be a section for children, teenagers, youth adults, adults, and the elderly. The focus should be to ensure that products in each segment meet the needs of the targeted customers. The pricing strategy should be based on market trends and the cost of production for the company.
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