Chapter 10

Question 1

1 Explain the difference between how a service firm and a trading business operates or functions.

Answer 1

A trading firm aims to generate a profit by selling a good rather than a service; that is, by selling a physical item of stock rather than their time, labour or expertise (which is what is required for a service firm)

Question 2

2 State the different form of revenue that a service firm would earn compared to that of a trading business.

Answer 2

A service firm will generate fees as their revenue whereas a trading business will generate sales as their revenue.

Question 3

1 Explain why prices must not be set too high.

Answer 3

If prices are set too high, customers may be driven into the arms of the firm’s competitors, and insufficient sales will be made..

Question 4

2 Explain why prices must not be set too low.

Answer 4

If prices are set too low, the business may generate plenty of sales, but those sales will not provide sufficient revenue to meet expenses, and the firm will not be able to earn a profit.

Question 5

3 State two reasons why a business owner must set a desired minimum profit.

Answer 5

i that the business earns a profit comparable with their previous income (usually from paid employment)
ii a return similar to what they would have earned had they invested their funds elsewhere.

Question 6

4 Show how the desired minimum profit is calculated.

Answer 6

Wage equivalent plus Desired return on investment =

Minimum desired profit

Question 7

1 List the various techniques which can be used by a small business to set selling prices.

Answer 7

• Recommended retail price
• Competitors’ prices
• Market reaction
• Percentage mark-up
• Cost-volume-profit analysis.

Question 8

2 State two reasons in favour of using recommended retail price.

Answer 8

• It is the selling price suggested by the manufacturer or wholesaler of goods. Thus, the owner does not need to work out a selling price
• Using recommended retail price may create some pressure to follow suit to ensure that prices remain competitive.

Question 9

3 State one reason why recommended retail price cannot be used to set all prices.

Answer 9

Not all products can use recommended retail price because only the manufacturer or wholesaler on goods (such as books, magazine and cards) will suggest a recommended retail price.

Question 10

4 Explain why it is important to account for the prices charged by competitors.

Answer 10

It is important so that they are comparable with those prices set by their competitors. If prices are set too high, then sales will be lost to cheaper competitors and profit will suffer.

Question 11

5 Explain how the reaction of the market can lead to:

• decreased selling price
• increased selling prices

Answer 11

• increased selling prices – if demand is particularly high for a product, customers will be so keen to get their hands on the product that they will be willing to pay a higher price.
• decreased selling prices – if there is no demand at a particular price, the business will have no choice but to discount its prices to generate sales.

Question 12

6 Explain one limitation of relying on recommended retail price, competitors’ prices and the market reaction to set prices.

Answer 12

These three techniques for setting selling prices are based more on observation than calculation, and require the owner to be aware of the market in which the business is operating. However, while they may ensure that the firm’s prices are competitive and reasonable to the market, setting prices in this way does not ensure that the most basic goal of all – that of earning a profit – will be achieved.

Question 13

1 Define the term ‘mark-up’.

Answer 13

A mark-up is a predetermined profit margin (expressed as a set amount, or a percentage of the cost price) that is added to the cost price of a product to determine its selling price.

Question 14

2 Explain the circumstances in which it would be appropriate to use a percentage mark-up to set selling prices.

Answer 14

In businesses such as those that sell electronic or white goods, knowing the mark-up on particular products allows sales staff to discount selling prices to generate sales, while still maintaining a minimum profit margin.
 

Question 15

3 Show the formula for calculating selling prices using a percentage mark-up.

Answer 15

Selling price (mark-up price) = Cost price x (1 + mark-up/100)

Question 16

4 State what must be added to the mark-up price to determine the final selling price for customers.

Answer 16

GST of 10% must be added to the mark-up price to determine the final selling price.

Question 17

1	Define the following terms:
•	break-even point 
•	variable cost 
•	fixed cost 
•	contribution margin

Answer 17

• break-even point – the level of sales where total revenue equals total expenses and the business makes neither a profit nor a loss
• variable cost – costs that vary directly with the level of activity
• fixed cost – costs that do not vary with the level of activity
• contribution margin – the Gross Profit from each sale that goes towards covering fixed costs and contributing to Net Profit; calculated by deducting variable costs from the selling price.

Question 18

2 State two reasons why a fixed cost is not always fixed.

Answer 18

• A cost is usually only fixed for a specified period of time, and when this period expires, the cost may change
• A cost is usually fixed for a specified range of activity, and if the volume of sales exceeds that range, the cost may change.

Question 19

3 Show the formula used to conduct a cost-volume-profit analysis.

Answer 19

Quantity to be sold = Total fixed costs + Profit/ Selling price per unit – Variable cost per unit

Question 20

4 Explain what will occur if sales are:
• above the break-even point
• below the break-even point

Answer 20

• above the break-even point – the business will earn a profit
• below the break-even point – the business will suffer a loss.

Question 21

5 List the three assumptions underlying the cost-volume-profit formula.

Answer 21

• Assumes that costs can be clearly identified as variable and fixed
• Assumes that selling prices and all costs will remain constant
• Assumes that all goods produced will be sold

Question 22

6 Show the formula used to calculate sales revenue.

Answer 22

Sales revenue = Selling price x Quantity to be sold

Question 23

7 Explain why sales revenue and profit are not the same.

Answer 23

The fact that a business will earn revenue does not mean it will make a profit. Any revenue a business earns must be used to meet the total fixed costs and total variable costs the business will incur.

Question 24

1 Explain what is reported in an Income Statement.

Answer 24

The Income Statement details the sales revenue the business has earned, and the costs or expenses it has incurred in the process (detailing variable costs and fixed costs separately).

Question 25

2 Show how each of the following figures in the Income Statement is calculated:
• sales revenue
• total variable costs
• variable profit

Answer 25

• sales revenue – Selling price per unit x Quantity sold
• total variable costs – Variable cost per unit x Quantity sold
• variable profit – Contribution margin per unit (Selling price per unit – Variable cost per unit) x Quantity sold.

Question 26

3 Using at least two examples, explain why it is usual to use more than one pricing method.

Answer 26

No one price-setting method can guarantee success, so each owner has to take into account a variety of pricing options when determining selling prices. A business may use a specific mark-up or a cost-volume-profit analysis as a starting point for certain products; however, they would then have to consider what competitors are charging, or look at the conditions in the marketplace and adjust their prices accordingly.

Question 27

4 Explain why GST is not included in the cost-volume-profit calculation and Income Statement.

Answer 27

The cost-volume-profit calculation attempts to calculate the number of products a business must sell in order to break-even or make a certain level of profit. Given that GST is not a revenue or an expense for the business and will not be included in the Income Statement, it must be excluded from the calculation.