Managing Financial Resources - Management Assessment Answers

Introduction

Clicks group is the company that deals in the retail business of healthcare. The company opened its first store in the year 1968 in Cape Town. The company deals in the various divisions of the healthcare. The company operates through various brands like Clicks, GNC, The Body Shop, Claire’s, Musica and UPD. Clicks deals in pharmacy, health and is a beauty retailer in South Africa. GNC is involved in global nutritional supplement sector. The Body Shop brand deals in high-end natural beauty products. Claire’s is involved in the industry of fashion jewellery and accessories while Musica is the largest retailer of music and the related merchandise. UPD is involved in the supply of the pharmaceuticals to retail pharmacies and hospitals. The company deals in various industries through different brands like pharmacies – where it deals on both retail and wholesale basis, nutritional supplements, natural beauty products, fashion accessories and music. The performance of the company therefore is dependent upon the individual performances of all these brands.

Part A - Cost Analysis

The cost can be described as the value that would be foregone for the production of goods or rendering of services. It is important that the costs that are associated with the products and services are identified correctly as it helps in the preparation of the budgets, the pricing of the products and adoption of the measures for controlling the cost that are avoidable. The cost is analysed from various perspectives for the products to understand the components of the cost and the manner in which the cost can be optimized for the units sold or service rendered.

Horizon of Time

If the cost in analysed on the basis of the time horizon, it can be divided into two parts: -

Short-Run Cost

The cost that is incurred in the short run by an enterprise would be considered as the short run cost. The short run is the time period in which at least one input is fixed while the others are variable. In the short run the firm can employ higher units of the variable resources for increasing the production but the production quantity would be limited to the maximum capacity of the fixed input component. This time horizon is known as the operating period of the firm. In the short-run the increase in the production quantity is fixed.

The short run cost follows the law of diminishing returns. The total output increases up to a certain extent by the application of additional units of variable input. It results in the decrease of the average cost as the fixed cost is divided among higher number of units. But after a certain stage, the further application pf the input units start producing diminishing returns. It results in increased marginal costs for the products. However, the average cost of the product would keep on falling till the time the marginal cost is lower than the average total cost. When the marginal cost exceeds the average total cost, the average total cost would start falling.

Long-Run Cost

In the long-run the firm has ample time to invest in the resources or invest in additional resources to increase the units of inputs that were fixed in the short-run. The long-run is also known as planning horizon because in the long-run the firm can implement any decision after proper planning and analysis as it does not face the time constraint as in the short-run. Therefore, in this time horizon more than one or rather all of the inputs can be varied because the firm has the time for altering the units.

The short-run or long-run for a firm have not been defined in economics as in accounting. Therefore, they have to be interpreted according to the nature of operations of the entity and the duration of time that would be taken by the entity to vary its inputs. Therefore, the planning period might differ from one entity to another depending upon the business operations.

Cost on the Basis of Nature

If the cost is classified into the basis of the nature – it would be classified as the variable cost, the fixed cost and the total cost.

Fixed Cost

The cost that are fixed in nature and are committed cost are included in the fixed cost. It is the cost that firm will have to incur even at zero level of production of the output. These costs are fixed and would not vary with a change in the output. The inputs that are included in the costs are known as the fixed factors of production and they once incurred would generally remain same irrespective of the level of output. The average fixed cost keeps on diminishing with an increase in the level of output because with an increase in the level of output, the cost is apportioned with between higher number of inputs. With an increase in the units of the output the average fixed cost of the firm would move towards x-axis but would never touch x-axis as it would not become zero.

Variable Cost

The variable cost are the costs that are directly proportional to the units of output that are produced. They would not be incurred at zero level of production. They would increase with an increase in the level of output. Therefore, it implies that for increasing the production more units of the variable inputs have to be applied. The average variable cost increases after a certain output due to the diminishing returns.

Total Cost

It is the summation of the total fixed cost and total variable cost. Therefore, this cost is incurred even when there is no production and it increases with an increase in the number of units that are produced. The average cost is computed by dividing the total fixed and variable cost by the units of production. The average total cost curve would decline initially but after a certain level of output it would rise. With an increase in the units of output, the average total cost curve comes nearer to average variable cost but it never meets due to the presence of the average fixed cost.

The concept of these costs can be explained hereunder with the following graph: -

In the above total cost curve, we can observe that the fixed cost is a line parallel to x-axis (quantity of output) as the fixed cost remains same irrespective of the level of output. The total cost and the total variable cost lines are parallel lines as the distance between them consists of the fixed cost that remains constant.

Cost and Profit Maximization Output

With an increase in the units that are sold, the price of the product decreases. Therefore, marginal revenue is a line that falls constantly with an increase in the output. The marginal cost initially falls but after certain level of output it rises. Therefore, the profit maximization output would be the units at which the marginal revenue is equal to marginal cost.

Application of the Theory to the Case

In the given case, we can observe that the company deals in a variety of products. Therefore, the keeping in mind the diversity of the products in which the company deals it can be stated that the short-run and long-run concept might differ across these various businesses. For instance, the time horizon required for investment in pharmacy would be different from the time horizon that would be required for investment in music and entertainment merchandise.

If the annual report of the year 2016 is studied of the company we can observe that the company has incurred both short run and long run costs. Therefore, the expenses that have been incurred during the year comprise of both operating horizon and planning horizon. The investment in the operating horizon would have been made in the company. The revenue change by 9.5% on an overall basis in the year 2016 as compared to the year 2015.

If we analyse the revenue of the retail sector we can assess that revenue increased by 12.8% in the year 2016. The operating expenses increased by 11.2% only (Appendix 1). The expense growth reflects the investment in new stores by the company, the increase in the number of pharmacies and the expenditure incurred to improve the value that is delivered to the customer. The addition of new stores and pharmacies can be considered as long-run costs while the investment to improve the value delivered to the customer would be considered as short run cost. The entity has incurred both short run and long-run cost in this situation. It implies that the segment might have witnessed economies of scale while would have resulted in lower production cost which resultantly reduced the operating expenses.

Part B - Ratio Analysis

It is one of the method of analysis of the financial statements of the entity where the ratios are computed on the basis of the financial statements figures. These figures are assessed to understand the returns that have been generated by the operations of the company, its financial performance and financial performance. The ratios of the company are compared with another companies to ascertain the strengths and weaknesses of these companies. The ratio analysis of the company has been presented hereunder: -

Liquidity

The liquidity ratios help in the assessment of the ability of an entity to meet its debts. The liquidity of an entity is ascertained by the current ratio and the quick ratio.

If the current ratio of the company is observed over the past five years we can assess that the ratio has remained almost constant in the past five years with slight fluctuations. It implies that the liquidity position of the company has remained almost same over these years. The current ratio is 1.06 in the year 2016 which implies that for meeting the current liabilities, the company would have to sell all its current assets. All the current assets are not readily marketable like the inventory and prepaid expenses therefore, it can be evaluated that the liquidity position of the company is weak as per this ratio. The quick ratio is less than 1 in all the years. It is 0.43 in the year 2016 which implies that the liquid assets would be insufficient to repay the short-term debt obligations of the company and it might face working capital management challenges as well.

Financial Health

This ratio measures the proportion of debt and equity in the capital mix of the company.

In the given case it can be observed that the assets of the company have been majorly financed by debt. The debt capital comprises for about 70% of the investment in the assets of the company. Since the debt component is very high it is important that the entity maintains profitability and liquidity at all times. The debt capital is coupled with fixed interest obligations that have to be incurred irrespective of the income of the company. Therefore, it is important to ensure that the company has ample funds to meet the short-term obligations and adequate profit to pay the interest on the long-term debt. The debt component is more than twice of the equity. It is 2.42 times in the year 2016. Therefore, the company must consider before it further increases the debt component of the company.

Profitability

The profitability ratios measure the income that has been generated by the company from various perspectives like the revenue, the equity investment, the capital investment and the investment of the assets. The returns are assessed from various perspectives to assess the feasibility of the returns that have been generated for different stakeholders.

The gross margin states the profit that has been earned on the goods that have been sold only after considering the cost of the goods sold. The gross margin ratio has been consistently declining though the decline is very slight except for the last year. It implies that either the cost of goods that have been sold has increased or the company has reduced the pricing of the goods to sustain demand and increase revenue. The net margin also improved in the year 2016 if compared to the net margin of the year 2015. The increase in the gross margin resulted in an increase in the net margin.

The return on assets has been very low as compared to the return in equity or return in invested capital. It implies that current liabilities have a major proportion in the statement of financial position. The current liabilities comprise for almost 60% of the total assets while the current assets form about 65% of the total assets. It implies that the business requires higher amount of investment in current assets as compared to the fixed assets. The return on equity has declined in the past five years but still the return is very strong at 49% in the year 2016. The company must assess the reasons that led to the fall in the return on equity and must adopt measures for addressing those factors.

Efficiency

The efficiency ratio states the ability of the company to generate sales from the assets and liabilities. The higher the ratio, the better it is for the company. A higher ratio implies that the entity has used the resources very efficiently for the generation of the sales.

The receivables turnover ratio and the inventory turnover ratio both are at satisfactory levels currently. They have deteriorated for the past five years but are still at an acceptable level therefore the company must consider adopting measures to prevent the further deterioration of the ratio. The fixed turnover ratio has improved over time. The proportion of increase in the turnover has been higher as compared to the proportion of increase in the fixed assets which has resulted in the stronger ratios over the past five years. There is a vast difference between the fixed asset turnover and the asset turnover ratio because the current assets form major part of the total assets of the company.

Part B - Decision Making Techniques – Short Term

The decision-making techniques in the short-term require identification of the costs and the relevant factors that would impact the profitability of the entity in the near future are considered under the short-term decision making.

In the short-term the output can be increased only up to a certain extent by varying the variable costs. The fixed costs would remain constant. Therefore, irrespective of the level of production within the relevant range, the fixed cost would be constant. The firm will only be required to incur variable cost. Therefore, the decision would be made in the short-term with an objective of maximizing the total contribution margin. Since the fixed cost is fixed, an increase in the contribution would result in an increase in the profit for the firm in the short-term.

Break-Even Analysis

The break even point refers to the point or the number of units at which the firm neither earns any profit nor suffer any losses. Since in the short run the fixed cost is constant the amount of contribution must be increased to attain the break-even point. For computing the break-even fixed cost must be related to the product or service must be distinctly identifiable.

One of the major challenges faced in the short-term is the allocation of the fixed costs to the relevant product. The contribution amount which increases with an increase in the number of outputs initially contributes towards the recovery of the fixed cost and after that towards the profit.

The main objective in the short term is to maximize profit by increasing the variable inputs. Therefore, fixed cost and the contribution helps in the ascertainment of the break-even point or the point at which the company would earn no loss and would not even suffer any losses.

Outsourcing

In the current business environment mots of the entities are considering outsourcing the non-core activities so that they can concentrate more on the core business activities. The outsourcing of an activity would only be feasible if the product or service can be procured at a cheaper rate from the outside market rather than the in-house production of the goods or the rendering of the service. It would also be feasible if outsourcing would result in the additional income generation from the spare capacity that would increase the overall contribution of the firm.

Exchanging of Fixed Costs with Variable Cost

The outsourcing results in the exchange of the fixed cost with variable costs. In case the product is made in the company, the fixed cost would be high while the variable cost would be low. However, if the product or service is outsourced fixed cost would be low and variable cost would be high which would reduce the break-even point for the company.

However, if the company requires high volume of the relevant product or service it can even consider procuring the assets on hire in place of buying it. It would change the fixed cost with variable costs.

Making the Best Use of the Available Resources

One of the most crucial decision of the short-term is to ensure the optimum usage of the available resources like the human resource and the physical resource. If the production is lower tan the expected it would result in under-recovery of the overheads which would result in loss for the firm.

In the short-term decisions it is important to ensure that the staff time is utilized in the most efficient manner where the staff time can be used in more than one manner. Similarly, the cost that has to be incurred on the fixed assets is certain and constant therefore it must be utilized in such a manner that the firm is able to generate highest possible value from these resources.

Competitive Tendering

In competitive bidding the present personnel of the firm are required to bid on the work that the company intends to outsource. The bid is also sought from the contractors and the bids are compared in such instances to ascertain the lowest bid that would increase the contribution.

Pricing of the Products

The product must be priced in such a manner that it is able to sustain the demand and increase the amount of contribution. Various of the factors have to be considered while pricing the product. The factors have been discussed hereunder:

Full Cost versus the Marginal Cost Pricing

After the break-even point is achieved by the company, it can consider pricing the additional products in such a manner that they are able to generate at least some portion of contribution for sustaining demand. The fixed costs are constant therefore, in the short-run the firm would might consider selling the products on marginal cost rather than the full cost to sustain demand after a certain level.

Business Benefit Pricing

In the business benefit pricing the product is priced at the price which the customer is willing to pay. In this type of pricing, the firm is aware of the value that has been added for the customer by the product or service and charges accordingly.

Others

The others include pricing the product on the basis of profit and the cash flow, pricing on the basis of the standard costs and pricing the product in such a manner that the firm is able to win the contract in bidding.

Opportunity Cost

The opportunity cost is the value that has to be forgone because it is used in one way. It is important to ensure that the benefits that are generated are in excess of the opportunity cost of the resources.

Part C – Benefits and Limitation of Budgeting

The budget provides the guidelines for the functions of all the managers. It states the target which the firm expects to achieve in a certain interval of time. Therefore, the budgets provide the benchmark upon which the day to day activities of the firm are based.

Benefits of Budgeting

The benefits of the budgeting have been discussed hereunder: -

1. It helps in the forecasting of the costs that might be incurred and the manner in which it will occur like the frequency of its occurrence.
2. The budget helps in the analysis of the costs that would be incurred by the company in the production and other operation cost thus, providing assistance in the setting of the price.
3. The budget helps in estimating the working capital requirements of the company by estimating the revenue and the costs of the company.
4. It helps is assessing the current performance of the entity and if they are in confirmation with the budgeted goals. The budgetary goals can be modified according to the operations and performance of the entity.

Clicks Groups deals in a variety of products and has numerous stores across various locations. The budgeting would help in the determination of the revenue that is expected from various locations and various products. It would help the company in determining the costs that are attributable to these units. In case the cost to be incurred is lower than the expectations it would help the company in investing such sum at places which would boost the brand image and the overall revenue of the company.

Limitations of Budgeting

The limitations of budgeting have been discussed hereunder: -

1. The forecasting of the sales is the starting point of budgeting as all the factors are somehow dependent upon the sales which the company is expected to generate. The forecast of sales is very difficult as it is dependent upon the actions of the customers. Therefore, if it is not forecasted adequately the purpose of framing the budget would fail.
2. The budget is dependent upon the prior years factors to a great extent. Therefore, if certain revenue or expense has been affected by some temporary factors in a certain year, the budget prepared on the basis of those figures would be meaningless.
3. The budget is based on the forecasts and the information that is available. Therefore, if the information that is available is incorrect there is a possibility of the framing of incorrect budget.
4. Some of the budgetary limitations that are attributable to human behaviour are: framing of budgets with underestimated cost and over estimated revenue to exercise pressure on the employees, Unnecessary usage of the excessive resources present in the budget thus preventing the best possible use of the resources, the communication gap between the management and the employees who implement the budget.

The budget is based on information and forecasts and it is probable that increase of these factors would increase the uncertainty of the budgets. Clicks Group deals in various products at various location which requires integration of many inputs in the framing of the budget which makes it uncertain. The budgets are based on forecast and it is difficult to accurately forecast higher number of inputs.

Recommendations

Keeping in mind the nature of business operations of the company Click Group it is recommended that the group budget that is initially framed must be revised at frequent intervals so that it is aligned to the current operations of the company. The necessary information and inputs must be taken from the managers of various products at various locations while framing the budget to ensure that the preparation of a meaningful budget.

Conclusion

The report has helped in understanding the cost in a better manner. It helps in assessing the significance of the cost in the organization and the measures that can be adopted by the organization to ensure that the cost is managed effectively. The project helped in better understanding of the factors that have to be considered while making the short-term decisions, the nature of the cost. It helped me in understanding the difference in the manner of assessment of the cost when it is assessed for long-run and short-run. There are various factors like fixed cost, contribution that have to be considered and are equally important so, decisions made on the basis of a single factor might be ineffective. The project has provided me a detailed knowledge of the financial statement analysis of the organization with the key ratios and their interpretation. The project helps in understanding the various factors that would be considered for costing by understanding the nature of operations of the entity and interpreting its financial performance and financial position with the key ratios.