A business is not set up overnight. It takes a lot of effort, struggles, sleepless nights, sacrificed dinners, and teamwork. After putting a lot of effort into product research, idea generation, execution, and finally launching in the market, the most critical question is pricing strategy.
Pricing strategy is the most critical card of the marketing mix puzzle. However, it doesn’t only relate to the marketing department. The pricing strategy of a company has a direct impact on its accounting, finances, and profitability.
Different pricing strategies bear different fruits. And any business cannot go for a random pricing strategy. The selection of your product’s pricing strategy is highly dependent on your cost accounting, financial management, and budget allocation.
In this article, we will walk through the pricing strategies and, most specifically, economy pricing. This writing piece aims to understand economy pricing, its execution, and what type of businesses can leverage the economy pricing.
Different Pricing Strategies
A price is not the result of the ‘Cost + Certain Percentage’ equation. The pricing strategies are a cumulative product of market positioning, market demand, cost structure, nature of the product, and competition.
A firm use different pricing strategies for choosing the appropriate pricing model for their product.
The pricing strategy mix is an important term of marketing.
There are different types of pricing strategies as a part of this strategy mix. Let’s go through each of them.
The price skimming strategy is artificially setting the price of a product higher to maximize the profit. The skimming strategy is most commonly used in niche positioning when a certain group of people is willing to buy the product at any price.
Most businesses employ price skimming when they have a unique selling point, and they know that soon market will become saturated as new entrants will invade. Therefore, the company offsets its future price drops by charging a high price at present.
Most luxury product selling businesses apply premium pricing. As the name implies, premium pricing is charged for the products having higher value or luxury utility. Most common services and products that employ premium pricing include Five-star and Seven-star Restaurants, Premium Airlines, or any product that make the user feel privileged. Some of the real-life examples of businesses employing premium pricing include Apple, Gucci, Tesla, BMW, etc.
The third pricing strategy used by businesses is penetration pricing. As the name implies, this pricing strategy is mostly used by the newly launched products. The firms set a lower than value price to make a sound entry into the market.
This pricing strategy is applied to appeal to the customers to try the product. Once the customers are convinced by the product, and it becomes their favorite, prices are raised.
I can remember a pizza shop that was opened in my hometown a year ago. The price of a regular pizza was half the price of Pizza Hut or Dominos Pizza. But the taste was not less than those brands. However, the prices have been raised by double in one year because the brand has proven itself and become the choice of customers.
What Is Economy Pricing?
Now let’s understand economy pricing.
The literal definition of economy pricing is,
It is the pricing strategy where the price of products is kept low by decreasing production costs.
In the economy pricing, most marketing and advertising costs are cut to offer a lower price than the competitors. A firm willingly lowers down its price and earns a very minimal margin per product. But the overall profit is not decreased due to high sales volume.
Due to this, economy pricing is often referred to as volume-based pricing.
The most common types of businesses employing this pricing modeling are dealing in generic products like grocery, medications, economic and budget airlines, etc.
How Does It Work?
Let’s go for deeper insights into economy pricing execution and working. The firms and businesses employing this strategy are well aware that they won’t make high profits per unit.
A business that is selling the economy-products keeps the selling volume at the top of anything else. Therefore, they make an effort to bring the product in front of customers at a lower price than competitors.
If we look at the cost accounting perspective of economy pricing, it is a Cost-plus pricing strategy. The products chosen for this model are of lower value and lower production cost. The business launches the products at a small profit per unit.
The formula for the Economy pricing is,
Production Cost + Profit Margin = Price
In the case of this pricing model, only the volume of sales pay. To further understand the working of economy pricing, imagine buying spaghetti instead of Barilla’s spaghetti.
Think of buying the tissue wipes instead of Kleenex or Puffs UltraSoft.
In both these examples, the product is the same, but the price difference will be just due to the brand name attached with Barilla, Kleenex, and Puffs.
Common Business Types That Employ Economy Pricing
Which businesses mostly use the economy pricing strategy to gain a competitive advantage of high sales volume?
Let’s look into common business types employing the economy pricing model.
Grocery Stores And Super Markets
Grocery stores and supermarkets are the best illustrations of the economy pricing model. Every grocery store features different brands, and they have their own catalog of famous brands. However, the grocery stores can leverage economic pricing by cutting the promotion, overhead, and marketing costs to offer a lower price than the competitors.
Generic Drugs and Pharmaceuticals
The drugs and pharmaceuticals industry work similar to the grocery store. Several generic drugs and medications are perfect substitutes for the branded medications with the same chemical composition.
The airplane has to incur the same costs as a single flight, whether it’s filled or empty. Therefore, budget airlines use economy pricing to fill the seats and lower the cost per unit.
Big Box Stores
Big box stores are the retail stores that occupy a large physical space and offer a wide range of products in multiple niches. The most renowned big box stores are Walmart, Costco, Home Depot, IKEA, etc.
Advantages Of Economy Pricing
Every pricing strategy has certain advantages that make it stand out from others. Here are some of the key advantages economy pricing offers.
Best Technique During Economic Recessions
Economy pricing is the most successful pricing strategy for any business during economic downturns and recessions. When there is an economic recession, people are less conscious about the brand name and more concerned about saving money on every purchase. If a business put this strategy in place, they can increase their sales exponentially.
A Strategy To Increase Market Share
Most businesses applying an economy pricing strategy win the competitive edge of providing the same product at a lower price. Therefore, the volume sales and revenues help a business to increase its market share in the relevant industry.
Fixed Costs Are Well Covered
It is a good strategy to cover the fixed costs for large business units. If a company facing operational losses shut down its operations, it is a total failure. However, if they do some cost cuts and provide the same product at a lower price than market competitors, they can fairly cover the fixed costs.
Disadvantages Of Economy Pricing
There are some downsides of this strategy, which a business must be aware of before putting the strategy into practice.
Customer Loyalty Is A Dream
Most customers looking for the best deals and best prices go for the products with economy pricing. The top priority of such customers is the maximum saving. They won’t bother to switch any brand if they are getting the best price somewhere else. This is one major downside of the economy pricing. Despite large volume sales, the customer loyalty of such businesses is low. To succeed in the long run, you need to have a steady stream of new customers.
Large business units can adopt the economy pricing strategy despite lower profit margins. The reason is that they are well versed in attaining economies of scale and make profits. However, this pricing strategy is a big no for the small businesses trying to leverage this policy. Small businesses looking for scaling opportunities cannot make enough profits by using this policy. All they can earn is restricted profits.
When the businesses see that a large unit is earning a lot of profit and market share by applying economy pricing, they find it easy to replicate the model. As a result, there are a lot of players in the market.
Low Product Quality
When the companies cut their overhead costs, the result is sometimes an inferior product with low value. In the short run, a company might make a lot of profit, but the quality problems might increase in the long run.
High Exposure To Risk
The businesses using economy pricing are operating on very narrow profit margins. A major economic or social event triggering the change in demand, consumer behavior, purchasing patterns, or economic slowdown can lead to a big disaster for the business. Therefore, the economy pricing strategy exposes the business to high risk.
Economy pricing is a great strategy for the necessities and in times of economic downturn. A business should have a very good understanding of the industry-specific operational costs to be able to apply economy pricing. With very thin profit margins, there is less room for making mistakes. Therefore, you must put all the cards in the right spot to complete the profit by economy pricing puzzle.
Budgeting is a very critical activity of any business. It is a multi-dimensional activity that provides a plan of action as well as direction to the management. The scope of budgeting is not limited to resource allocation and a roadmap provision.
Another very important aspect of budgeting is ‘control.’ If budgeting helps you create an action plan for strategizing a business’s spendings, control helps to follow and stick to the plan.
Budgetary control is a method or technique that facilitates the senior management of a firm or company that the budgetary limits are followed, and compliance is ensured.
According to the definition in CIMA Official Terminology(2005),
In management accounting, control means ensuring that activities planned and undertaken lead to the desire outcomes. So, the scope of control is effective and efficient operations, internal financial control, and compliance with laws and regulations.
Feed Forward Control is a type of budgetary control that is an important driver of financial management decision-making. This article will walk through the types of controls, Feedforward control, how managers use it, its pros and cons.
Let’s get into the article.
Types Of Control Systems
Generically, there are two types of control systems.
Open Loop Systems are those which do not encompasses the corrective actions. Such systems are often referred to as non-feedback systems. These control systems are continuous and the result has no influence on the outcome or output of the business operations. These control systems lack a feedback loop.
Closed-loop systems are those which fully take into account the corrective actions necessary for aligning expected performance with the actual performance. Such control systems are often named feedback systems. The closed-loop budgetary control system is further subdivided into feedback control and feedforward control.
Feedforward is an important tool in the budgetary control systems.
It has been described very elaboratively in CIMA Official Terminology (2005) as,
The Feedforward control encompasses the forecasting of the differences between the actual and planned outcomes. It also includes the implementation of corrective actions to avoid the differences before the event actually happens.
To completely understand the concept of feedforward control, you must understand feedback control.
In the feedback control, the simple phenomenon of comparing the actual outcomes with the budgeted results. The actions are taken for the future budgets and financial period.
Therefore, the main difference between the two is that,
Feedforward control is a proactive approach that encompasses the corrective actions before the negative outcomes are actually shown up. The scope of feedforward control implies taking action before it’s too late.
Breaking Down Feedforward Control
Let’s break down the concept of feedforward control to completely understand it.
Unlike feedback control, feedforward control is a technique that is employed to prevent any deviation from the planned outcomes. The inputs are monitored, and a response action is generated accordingly.
If the feedforward control is broken down into different steps, it would be:
A careful and comprehensive analysis of the planning and control system
Regular review of the system for input variables and the inter-relationships for a consolidated output
To collect the data about input variables and synchronizing it with the developed system
Regular analysis of actual input data variations from planned inputs and assessing its effect on the expected result
Based on the analysis, taking the corrective actions to align the planned and actual paths.
It is a future-oriented control that is mostly undertaken in between the financial period. Feedforward control has been implemented in the budgetary control procedures because time-lag decisions do not contribute positively. Feedback control is obsolete from a budgeting perspective because it is like a post-mortem.
Therefore, with the forecasts of feedforward control, managers are better able to take corrective actions. The feedforward control helps devise different techniques for different purposes.
The most common use of this future-directed control is planning cash availability, sales targets, and PERT(Programme Evaluation and Review Technique).
Let’s understand the practical implication of Feedforward control to better understand this control system in business management.
A sales manager of company XYZ reviews the monthly control reports about the revenues values. According to the budget, the sales for the year ending Dec 31, 2020, are $800,000 in total. The said product line has a total of 3 products.
The feedback control report for May looks like something in the table below:
Sales Report For May
The feedforward control report of the same month will look different. It will be something like the table given below.
Sales Report For May
Latest Forecast for the year
Example no 2:
Here is another example to enhance your understanding of the concept.
A firm, Layman Co., has prepared its budget for the financial year 2020. According to the budget, the firm will generate sales of around $ 2 million during 12 months, starting from January to December.
At the end of April 2020, the firm can generate sales of around $600K. By December, they should be generating sales of around $1800K. This amount is still $200K below the budgeted sales.
Now, these forecasts are based on the feedforward control system. The firm is better able to address the expected variations and take corrective measures. In this way, the firm will not be deprived of a sales generating opportunity.
How Can Manager Use The FeedForward Control Systems?
The control systems are a combination of integrated controls that collectively contribute to the internal control and organizational goals. There are different controls, including management control, financial control, performance management, and managing information systems.
No control can be fully implemented in isolation. The managers use different integrated tools to make decisions. For instance, the organizational goals are achieved by integration of management, finance, HR, marketing, information systems, and project management.
Similarly, let’s go deep down in financial control. Financial control is a series of activities starting from planning, budgeting, management, accounting, and auditing. By feedforward control, the managers can decide their course of action for the expected variations.
The benefit of feedforward control is that business managers do not have to wait for the year-end: regular analysis and interpretation help in aligning the budget and actual performance.
Here are some advantages of feedforward control to the managers of any business and the business itself.
The most promising benefit of the feedforward control system is that it is a proactive approach instead of a reactive one. The advanced forecasting of any unexpected event or fluctuations helps the business managers take corrective measures and find a solution to the problem before even if the problem occurs.
Time-Saving For Year-End
Feedforward control requires more cost and effort. But the final result is worth it. The forecasting and forecasting approach of the software on a monthly and recurring basis can be a time-saving activity. The feedforward control can help a lot in completing quarterly and annual budgets due to already collected data.
Besides, the monthly analysis and corrective measures save a lot of time for the year-end accounting.
The management Is Prepared For Unknown
Since the scope of the approach is to forecast the problems and be prepared for them. If the feedforward control is always in line, the management will be prepared for the unknown and unexpected.
With many good points, there are some downsides of this control system too.
Technology has blessed every field with new advancements, discoveries, and facilitation. Generally, a budget is prepared by following the budget templates. However, the integration of feedforward control with the accounting software requires additional costs. Therefore, it might not be a feasible solution for most small businesses.
Main Focus Is Budget
In the feedforward control system, the whole focus of activities is toward forecasting and budgeted values. The day-to-day operations and their activity become irrelevant, and managers are spending most of their time ensuring compliance.
As a result, product quality assurance, customer dealing, manufacturing, and other critical business functions might get ignored.
Time Consuming Activity
Another downside of feedforward control is its continuous nature. As a result, most of the managers’ time is eaten up in preparing monthly budgets and comparing the results with the expected amounts.
The scope of the article was to discuss the feedforward control system as a budgetary control system. It must be clarified here that the feedforward control is not a dedicated control system for business management or financial management. The application of this control system is extended in different fields, from project management to genetic engineering.
However, our focus was to discuss the application of the control system for better budgetary estimates and the overall financial performance of the firms.
By application of feedforward controls, companies are better able to forecast the contingencies and variations in the set targets. The corrective actions can be taken well within time to save the business from a major setback.
In any business, production costs are the foundation of the pricing strategy, profit margins, and market positioning. The most important costs incurred in any manufacturing operation are material, labor, and factory overhead.
Material is often existing as a cushion between production and consumption of the goods. In any inventory, you will find material in various shapes and sizes. The materials are waiting for processing, semi-processed material, finished goods at the site, in transit, at the warehouse, in retail outlets. In all these forms, there must be a legit economic justification for the inventories or material.
Each unit carried is costing something to the business, and all costs have to be incurred in the financial statements. Therefore, material planning is used to determine material levels and procurement.
The most critical factors managed by material planning are:
The quantity of material
Time to purchase material
To answer these two questions of how much and when is dealt by two conflicting costs that are:
Cost of carrying inventory
Cost of inadequate carrying
The cost of carrying the variable costs that vary with the change in the amount ordered is included. The most common costs are interest, tax, warehousing, or storage. The cost of inadequate carrying, on the other hand, is also an important consideration for the calculation of order quantity.
One most popular and common method of calculating the quantity to be ordered is Economic Order Quantity (EOQ). In this article, EOQ, its formula, calculation, importance, and limitations will be discussed.
What is EOQ?
Economic Order Quantity is defined as,
It is the ideal or optimal quantity of inventory that can be ordered at a time to minimize the annual costs of inventory.
This quantity and production-scheduling model was developed by Ford W. Harris in 1913. Over the time of one century, there have been further developments and refinements in the model to make it more relevant
Suppose a business firm purchases materials once or twice a year, but the order sizes are big. In that case, they are incurring too much cost for carrying the inventory. It increases the annual inventory cost.
Conversely, if the business firm buys smaller quantities in too many orders during a year, the ordering cost goes up. Ultimately, it will also increase annual inventory costs.
Therefore, an optimal quantity of inventory to be ordered at a time requires balancing two factors of the equation.
Cost of carrying or possessing material
Cost of ordering or acquiring material
Assumption Of EOQ
The Economic Order Quantity model works on certain assumptions.
In EOQ, it is assumed that the demand for the material is always the same. The constant demand implies that the seasonal fluctuations and consumer behavior will not affect the demand over the year.
The second assumption is related to constant holding and ordering costs. According to the assumption, ordering costs and carrying cost is always same. The change in transportation costs, interest rates, warehouse rent do not impact the ordering and holding costs of the material.
The final assumption is the absence of any discounts. The EOQ model doesn’t encompass the rebates or trade discounts offered to the business.
Now let’s jump to the formula of EOQ.
The differential calculus has been employed to devise a formula for the calculation of EOQ. The formula is as follow:
Following costs are components of the Economic Order Quantity.
Ordering cost represents the cost of one order. It is calculated by dividing the annual demand by the number of orders annually.
Number Of Orders = D/ Q
The annual ordering costs are found by multiplying the number of orders by the fixed cost of each order.
Annual Ordering Cost = (D/Q) x S
Holding costs of inventory if often expressed as cost per unit multiplied by interest rate. The holding costs can be direct costs of financing the inventory purchase or the opportunity cost of not investing the money somewhere else.
The formula of Holding cost is expressed as,
Holding cost = H = iC
Since the inventory demand is assumed to be constant in EOQ, the annual holding cost is calculated using the formula.
Annual Holding Cost = (Q/2) X H
Total Cost And Economic Order Quantity
By adding the holding cost and ordering cost gives the annual total cost of the inventory. For calculation of the EOQ, that is, optimal quantity, the first derivative of the total cost with respect to Q is taken.
Annual Total Cost = [(D/Q) X S] + [(Q/2) X H]
How To Calculate EOQ?
Let’s calculate the EOQ by example.
Suppose a company has an annual demand of 2500 units. The total cost to place one order is $1200. The per-unit cost is $250. According to the calculations, the carrying costs of the company are 12% of the per-unit cost.
It is required to find the Economic Order Quantity.
If we arrange the data, it will look like this,
EOQ = 408 units per order.
Why Is Economic Order Quantity Model Important?
The economic order quantity model is an important consideration because it helps to find the optimal number of units per order. The firms can minimize their material acquisition costs by applying the EOQ model.
There can be modifications in the EOQ formula to find other production levels or order intervals. According to the economies of scale, the larger quantities of order result in decreased per-unit cost of ordering.
The EOQ is also used by companies as a cash flow tool. By the calculations, a business firm can control the amount of cash tied up to acquire the inventory. Besides, the companies are in a better position to manage their inventories more efficiently. In the absence of this technique, the companies might end up sticking too much cash into large amounts of inventories. Otherwise, the smaller orders will result in an unwanted surge in the annual ordering costs.
The investors can also calculate the EOQ for assessment of a firm’s efficiency in managing its inventory.
Advantages Of EOQ
There are certain benefits the firms can reap by using the EOQ as a cost-scheduling and production-scheduling model. Some of them are mentioned here.
Inventory Costs Are Minimized
Using the EOQ model, the companies are saving them from the unnecessary warehousing costs resulting in the case of extra stocks of inventory. Other factors can be the reason behind the surge in inventory costs.
For instance, damaged products, unsold inventory, the pattern of ordering affects costs. But suppose you’re business deals in low-velocity products. In that case, EOQ can be a beneficial tool to help you find an optimal level of order quantity.
Optimized Inventory Means Minimum Stockouts
EOQ is the most efficient model that tells you how to minimize inventory stockouts without holding unnecessary inventory for longer periods. The essence of the EOQ model is the quantity a firm needs re-ordering and how often to re-order.
Every business is different. Different industries have different requirements. For some businesses ordering smaller amounts more often can be a cost-effective solution. For others, the case might be the complete opposite. You can optimize your inventory management by EOQ.
Overall Efficiency of Handling Inventory Is Improved
The carrying costs and ordering costs are the two most important considerations in EOQ. When a company is using EOQ, its overall efficiency of handling the inventory is increased. You can smartly calculate the EOQ by taking into consideration of all important cost variables.
Limitations Of EOQ
The limitations of the EOQ model are based on the assumptions made in the formula derivation. The EOQ assumes consumer demand, ordering costs, and holding costs to be constant. These assumptions affect the efficiency of the model.
The unpredictable and uncertain events that every business might face are totally ignored. The change in transportation fares, consumer demands, economic recession or boom, or seasonal fluctuations is some events that affect the demand and costs of ordering as well as holding inventory. Any purchase discounts are also not taken into account for the calculation of EOQ.
EOQ might not be a 100% accurate tool to calculate the optimal order quantity, but it helps the business improve its inventory management. Despite its limitations, EOQ is a powerful production-scheduling technique to make inventory-related decision-making more smooth.
However, one thing should be understood that EOQ is just one of the many inventory management techniques used by businesses. The EOQ will be higher if the business’s set-up costs increase or there is a demand surge. However, the EOQ will be lower when the cost of holding inventory is high.
The high-low method in accounting is used to separate the elements of variable cost and fixed cost from the total cost. It makes use of certain techniques to deduct an element of fixed cost from the total cost. The method makes use of two different levels of activities and related costs.
One of the activities is expected to be higher with higher cost and another activity is expected to be lower with lower cost. That’s why the method is called the high low method.
How it works
The cost of a lower activity is deducted from the cost of higher activity and the resultant is written in the numerator. Similarly, a low level of production is deducted from a higher level of production and placed in the denominator. In other words, a difference in the cost is divided by the difference in the level of production.
The given formula provides the variable cost per unit of production. The logic behind the concept is that when the total cost of lower activity is deducted from the total cost of higher activity, the fixed cost included in the total cost of lower activity is deducted from the fixed cost of the higher level of activity along with variable cost (to the extent of equality in both production levels).
Hence, the numerator is left with the variable cost of the differential units, when the variable cost of differential units is divided with differential units it results in variable cost per unit. Let’s understand this procedural format of the concept with the following example.
Consider the total production cost of February was USD 45,000 and the number of units produced was 10,000. Similarly, the cost of production was USD, 55,000 and the number of units produced was 14,000. There is no fluctuation of fixed costs in February and March.
Hence, the difference in total costs in both months is due to the difference in the level of product. We shall put the figures in the formula given above.
Both figures given in the numerator contain the same fixed cost. Hence, when we deduct USD 45,000 in USD 55,000 the fixed cost is net and the variable cost to the extent of equality in the level of production is eliminated. In other words, as fixed cost is the same in both months the fixed cost has been eliminated by deduction.
Similarly, the variable cost of producing 10,000 units has been deducted from the total cost of USD 55,000 at the higher level of activity. Hence, the remaining balance of the numerator is the variable cost of differential 4,000 units.
The division of differential cost with the differential level of activity results in the variable cost per unit. So, differential cost of USD 10,000 divided by differential units of 4,000 results in USD 2.5 per unit (10,000/4,000).
We have found per unit of variable cost and can use it to find variable cost at any level of production. We simply need to multiply per unit cost by the level of production. For instance, the level of production in February was 10,000 units. So, USD 25,000 (10,000*USD 2.5/per) is the variable cost for the month of February.
Since we know the total cost for the month of February was USD 45,000 and the variable cost for the month calculated is USD 25,000. Since we know total cost is a sum of variable cost and fixed cost and we have total cost and fixed cost.
So, if we deduct the variable cost from the total cost we get a fixed cost for the month. Like, USD 45,000 – USD 25,000 = USD, 20,000 which is fixed cost. Hence, the total cost is USD 45,000, of which variable cost is USD 25,000 and fixed cost is USD 20,000.
Limited data is required to finalize the calculations in the high-low method.
It’s easy to separate the variable and fixed costs with some basic procedural calculations.
Only two levels of activities and respective costs are required irrespective of other details.
An accountant can obtain all the required data from the internal books of the business and does not have to collect data from any external source. It really makes the process fast.
The figures calculated with the high low method are estimates and not exact numbers. If exact information is required external vendor needs to be contacted or their documents can be analyzed.
The high-low method ignores small details like variation in cost, economies of scale, and fluctuation in the cost of manufacturing. Further, it assumes there is no change in the fixed cost even in different periods.
The results produced by the high low method can easily be obtained by analysis of accounting records like cost cared etc. which is more reliable. So, there seems to less importance on the high low method.
Step fixed cost
Sometimes, the change of activity level increases the fixed cost. For instance, the factory got a monthly production capacity of 10,000 units and pays a monthly rent of USD 10,000 per month. However, the company needs to produce 15,000 units in some particular month.
So, to produce additional 5,000 units the company has to extend their production facility which is expected to incur the cost same as the previous facility of 10,000 units. Hence, once the limit of normal production capacity is reached the company has to incur another fixed cost irrespective of additional units to be produced.
It is important to note that if a higher level of activity is above a threshold of normal production. One has to consider step fixed cost/additional fixed cost to come up with the full fixed cost.
However, if both levels of activities remain under the threshold of normally fixed cost there is no need to consider step fixed cost in the calculation of the high low method.
Budgetary control is a concept of financial accounting that helps to oversee the payments and receipts within an organization. It provides a greater tool to plan, monitor, and control financial activities within an organization.
The concept of budgetary control can be linked with liquidity and management of the cash flow. However, the concept of budgetary control is not limited to cash flow management, it extends to include profitability, capital management, financial management, and all other aspects of business management.
The concept of budgetary control is based on a comparison between budgeted amounts and actual amounts. The budgeted amounts are forecasted based on the current market and business conditions. That’s the planning stage of the operations that need to be set in line with the market research and expectation.
Although, the budget needs to be challenging it must be realistic and designed to increase the efficiency of the managers. A good budget needs to be comprehensive, easy to understand, in line with the motives of the organization, and free from unrealistic assumptions.
The preparation of the budget can be top to bottom or bottom to top. The top to bottom does not include input from the lower employees in the hierarchy and the bottom to up approach of setting a budget involves operational staff in the process of setting a budget.
At the end of the period, an actual amount is compared with the estimated or budgeted figures to come up with the variance. The obtained variance needs to be analyzed if that’s controllable or no. The variance might be favourable or adverse depending on the situation that helps to decide the performance of the managers.
The objective of budgetary control is to measure the performance, control the financial and operational activities, the establishment of responsibilities, and close monitoring of the different managerial aspects. Further. If budgets are prepared and monitored effectively, it helps to improve the profitability and liquidity structure of the business. Let’s understand how budgetary controls help the business in the achievement of the organizational objectives.
1) Performance measurement
The comparison of budgeted and actual financial figures generates variance. The variances can be negative or positive, if the variance is positive it’s good news for the managers as their performance exceeds an expectation. On the contrary, if a variance is negative the reasons need to be investigated for the lower performance of the manager. Further, the business needs to consider if performance was severely affected by the external market conditions or it was negligence on the side of the manager.
The volume of variance indicates the intensity of the variation. If an adverse variation is not material the cost of action might be more than the benefits obtained from it.
2) Control of financial and operational activities
The system of budget pre-actively sets the direction for managers responsible to make decisions. They have targets in the mind from the start of the period and the capability to direct their energy towards the achievement of periodic targets/goals.
The mechanism of budget further allows the managers to decide the risk exposure of the company. For instance, if the target is set to increase sales exponentially, it’s logical to look for acquisitions and mergers. In addition to this, managers with expense budgets in mind are expected to have more skepticism before approval.
3) Establishment of responsibilities
In the world of accounting, there is a concept of responsibility centers. These responsibility centers have their own revenue and expenses. The process of setting a budget helps to set the target of revenue and expenses for the specific responsibility center.
The setting of budget for responsibility center helps to easily identify its performance and contribution in the overall profit/loss for the company. The combination of budgetary controls and responsibility accounting increases the transparency and culture of enhanced efficiency throughout an organization.
4) Close monitoring of managerial aspects
The budget is of prime importance in the management of the company. It brings collaboration between different departments that sit at the table and decide what needs to be done with how much resources. Effective implementation of the budget process makes managers think about activities that will take place throughout the organization.
The budget helps to think about all the managerial aspects including the purchase of inventory, cost of inventory holding, cost of production, production losses, forecasted sales, forecasted expenses, required threshold of inventory, expected sales, cost of sales, related administrative and operational expenses, etc. It makes managers think about different managerial aspects that help them to improve their efficiency and organizational profits.
Types of budget
Various budget types have been developed to cover different areas of financial statements and managerial information. These types of the budget include production budgets, sales budgets, capital budgets, expense budgets, labor budgets, and cash budgets, etc.
These different types of the budget help in identification of areas that need to be improved. For instance, if there is adverse variance in the sales it suggests the company enhance marketing efforts. If all the negative areas with massive adverse variance are considered and improved, it definitely helps to improve the financial performance of the company.
Planning and monitoring of the budget require consumption of energy. However, there are massive advantages of applying principles of the budget. These advantages include but not limited to ease in goal setting, setting targets, improved departmental coordination, enhanced responsibility accounting, enhanced centralized control, and identification of financial areas that need to be improved. If the business gets success in improving specific areas, it gets to improved performance of the business.
The concept of budgeting is based on estimates that might not be always accurate. There may be a gap in expectation or goal, this might lead to demotivation if targets are not achieved. Another side of the budgeting is difficulty in coordination and collaboration between different departments of the company. Hence, the activity of budgetary control may be costly and time-consuming.
Sometimes, there may be significant changes in the external environment of the business that have severe impacts on performance. If changes in the external environment are not considered the use of budget may be full of problems instead of enhancement in the business efficiency.
Capital is the lifeblood of any business. Capital is a combination of equity and debt. So, any company needs debt and equity to balance its capital. When you heard the word ‘bad debt,’ you might wonder if there is any good debt too? Because all of us have a general perception that debt is a bad thing. For any business, debt has many benefits that include a low-cost capital fund and tax deductions.
Debt, receivables, and dues are a normal affair of the business. You might allow your debtors to clear the payments for services acquired in 15 days, 30 days, or sometimes 60 days too.
Let’s say the allowed period has passed, but no payments have been cleared yet. The debtor is also not responding to your calls; it is the danger alarm. At this stage, the money owed becomes doubtful debt. However, once the owed money becomes uncollectible, it is called bad debt.
Recording bad debts or doubtful debts is necessary to depict a business’s true and fair financial position. The event of bad debts must be recorded in the accrual accounting system. The condition is not true for cash-based accounting.
Although bad debts exist in cash-based accounting too. But, no entry for credit sales was made in the first place. Therefore, a reversal entry for bad debts is also not passed.
This article will explain what exactly bad debts are and how to do accounting for bad debts.
What Are Bad Debts?
We can define bad debts as,
‘Bad debt is an expense for any business entity. When the part of the company’s account receivables becomes uncollectible, bad debt expense must be recognized.’
In other words, bad debts are unfortunate costs of any business due to
There might be different reasons why a bad debt expense occurs. Here are few reasons for bad debts.
When the debtor fails to pay the debt within the specified time, it becomes bad debt
The entity or creditor is unable to collect the debt due to technical reasons
When the debtor shows an unwillingness to pay the debt amount or is incapable of paying the debt. i.e., bankruptcy
Any debt becomes bad debt if there is some dispute over price, quality, or delivery of products
Bad debts Vs. Doubtful Debts
Bad debts and doubtful debts are often confused terms. Both terms are closely related, but there is a difference between the two. Let’s explain what factor distinguishes bad debts from doubtful debts.
Bad debts are the account receivables that have been clearly identified as uncollectible in the present or future time. The account receivables are credited by the amount of bad debt. The debtors who have become bad debts are removed from the accounts by passing an entry for bad debt expenses.
Doubtful debts cannot be specified with a surety. They are account receivables having a probability of becoming uncollectible in the future. You cannot ascertain a specific invoice or specific debtor to be doubtful debt.
It is done based on probability by creating a provision or allowance for doubtful debts. Provision for doubtful debt is a reserve calculated by different methods. We will discuss those methods in the coming sections of the article.
Criteria To Record Bad debts
Any business entity cannot record anything as a bad debt based on personal assumptions or gut. There are certain criteria set to guide the deduction of bad debts.
Bad debt is only deductible if:
It is genuine. Genuine means that the amount due has become uncollectible with complete recognition.
The account receivables have become uncollectible within the current tax year. The uncollectible amount can be whole or part of the total account receivable.
The U.S. Code 166 guides the deduction of bad debts. Under the provision, business debt can be deducted as bad debt in part or whole, depending on the amount that has become uncollectible. However, for the deduction of non-business debt, the whole amount of debt must become irrecoverable.
Example Of Bad Debt
We have explained the reasons and criteria for the deduction of bad debts. However, examples can explain the concept more elaboratively.
Company Alpha is in the business of manufacturing spare parts for cars in the local market. It sells the goods to a retailer on term credit for 90 days. As the transaction occurs, the Retailer account receivable is debited to the balance sheet, and sales are credited in the income statement.
80 days pass, and the company comes to know that retailer has filed for bankruptcy and his assets have been liquidated. At this point, the debt has become uncollectible and become an expense for the company Alpha.
After the realization, the company will record the amount due in the bad debt expense. The account receivable will be credited and closed.
Methods Of Recording Bad Debts
There are two methods for recording bad debts. One is the direct write-off method, and the other one is the allowance method. Each method has a different use and relevancy in books of accounts. We will discuss each technique and scenarios when they are used.
Direct Write Off Method
The direct write-off method directly deducts the bad debts from account receivables. As the name implies, once bad debts have been realized, they are recorded as an expense against the revenues. Under this method, no allowance is created, and the amount directly affects the net income.
For instance, in the one-year company had made a lot of credit sales hence increasing the net income. However, many debtors might become bad debt in the following year, putting pressure on the income statement.
The direct write-off method is extensively used in the United States for Income tax purposes. The direct method has the precision and accuracy of the actual amount going to bad debts. However, the technique has a very big downside.
The matching principle of GAAP is violated in the direct write-off method. The matching principle implies that the expenses related to certain revenues must be recorded against the same revenues. In the scenario discussed above, the matching principle is exploited. The direct write-off method is suitable for immaterial amounts that do not largely affect the income.
The second method is the allowance method. It is a more realistic and practical approach for recording bad debts. The allowance method or provision method is based on the contingency planning principles of accounting. The bad debts for a specific financial year are anticipated before they occur.
The reserve account for doubtful debts is created and maintained every year. The exact amount of the bad debts is deducted from the reserve account. Every year an anticipated amount based on historical data is credited to the reserve account.
The allowance method is mostly used by business entities to cater the large material amounts. The contra-account of ‘Provisions for doubtful debt’ is created in this method.
How to Calculate Bad Debts Provisions
In the allowance method for bad debts, the anticipation of bad debts is made. This anticipation cannot be made by assumptions. It requires some set rules and standards. There are two most commonly used methods for the estimation of bad debt provisions or doubtful debts.
Percentage Of Sales Method
In the estimation of bad debt provision under both techniques, historic figures are very critical. Another factor that contributes to the percentage of sales method is credit policy.
In this technique, an estimate is made about how much credit sales might become defaulter in the coming months or days. The percentage is calculated by closely analyzing the past years. Once the percentage is derived, it is multiplied by the current credit sales. This estimation shows the anticipated amount that will go to provision for doubtful debts.
Percentage Of Receivables Method
The percentage of the receivable method also encompasses the historical value of bad debts in the past years. The aging schedule is made in this method for accurate estimation. The percentage is also calculated in this method by the historic values.
The amount calculated by the aging schedule tells the minimum amount of bad debt reserve that the business entity must maintain. Let’s understand this by the illustration.
In the aging schedule, $437 is the most important figure. It is the total estimate of expected bad debts. Therefore, this amount shows the minimum reserve to be kept. For instance, if the reserve account already has $137, only $300 additional is required.
The following entry will be passed for recording the provision.
Bad debt Expense
Allowance For Doubtful debt
(provision For Bad debts created)
When there is a debit balance of ‘allowance for doubtful debt’ account, what will be the solution?
Let’s say the account has a debit balance of $163. The minimum provision required is $437. Now we will add $437 and $163. A total amount of $600 will be credited against the bad debt expense. The following entry will be passed:
Bad Debt Expense
Provision For doubtful debt
(provision For Bad debts created)
Accounting For Bad Debts
Let’s have a look at the accounting treatment for bad debts.
We will take the example of Company Alpha. Let’s suppose the company had recognized the bad debts of $450 for the year 2020.
For the direct write-off method, the following entries will be passed in the books of accounts.
Bad Debt Expense
(To write down the account receivable for bad debt)
If the same event occurs for the allowance method, the accounting treatment will be different. Let’s say the company had $600 in the allowance for doubtful debts. The actual value is $450. What will be the entry under the allowance method?
Bad debt Expense
Allowance For Bad debts
(provision For Bad debts created)
An additional journal entry will be recorded to balance off the contra account of allowance and write-off receivables.
Allowance For Doubtful Debt
(To write off account receivables)
In this article, we have tried to comprehend the accounting for doubtful and bad debts. Recording and recognition of bad debts and doubtful debts is very critical to the company’s financial position. It is a requirement under the IFRS rules of contingencies. The matching principle of GAAP also implies recording related expenses and revenues within the same financial period.
By recognition of bad debts, the company’s assets or net income is not overstated or understated. Therefore, the true financial position of the company helps investors to decide about their investment decisions and stakes in the entity.