1

Unit 1

Developing new

business ideas

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Section 1: Characteristics of successful entrepreneurs

Characteristics of entrepreneurs

What motivates entrepreneurs?

Leadership styles

Section 2: Identifying a business opportunity

What makes a market?

What should firms supply?

Identifying what consumers want or need

Section 3: Evaluating a business opportunity

Researching demand for the business idea

Is there a market for the business idea?

Positioning the business idea

Product trial

Opportunity costs (developing one business idea as opposed to another)

Section 4: Economic considerations

Current economic climate

Section 5: Financing the new business idea

Sources of finance

Section 6: Measuring the potential success of a business idea

Estimation of sales levels, costs and profits

Break-even revenue level

Measurement of profit

Section 7: Putting a business idea into practice

Creation of a business plan

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Resources

http://www.s-cool.co.uk/

http://www.businessstudiesonline.co.uk/

http://www.tutor2u.net/

http://www.thetimes100.co.uk/

http:// www.bized.co.uk

6

Section 1

Characteristics of entrepreneurs

Identifying an Opportunity

It is vital for the success of a business

that it manages to identify an

unsatisfied consumer need in a market

and then produce a product, or provide

a service, which meets the consumers'

needs. The new product / service can

be protected against competition by

the use of copyrights and patents.

These protect the owner / inventor

from having their products, ideas, etc.

copied and reproduced by other

people without their permission.

Some of the most common reasons for

starting up a new business include the

need for independence; to achieve

your personal ambitions; being bored

with your current job; links with your

hobbies and interests; redundancy

from your previous job.

Many businesses which have started

in the UK over the past 25 years have

failed within the first 3 years of trading.

To reduce the probability of failure, it is

vital that businesses carry out market

research in order to establish if a

profitable gap exists in a market and to

see if their business is in a strong

enough position to fill this gap.

In order to make a success of the new

business venture, the entrepreneur

must be hardworking, ambitious, firm,

decisive, organised, a good negotiator

and must be able to recognise an

opportunity when it arises.

Keywords: Initiative, creative,

resilient, risk-taker, hard-worker, self-

confident.

Find out what these

words mean.

Watch the dragon´s

den videos.

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Motives for being an entrepreneur

Keywords: Profit motives: survive,

sales maximization, profit

maximisation

Non-profit motives: being your own

boss, working from home, helping

others (ethical)

What are the benefits of being ethical?

– good publicity, additional sales,

helping others.

Why start a business? (Motives)

The skill involved in wanting to start

and run a business is called

enterprise. The individual who sets up

their own business is called an

entrepreneur.

There are several reasons why

entrepreneurs are willing to take a

calculated risk and set up a business.

Possible motives include:

Making a profit. A business does

this by selling items at a price that

more than covers the costs of

production. Owners keep the profit

as a reward for risk-taking and

enterprise.

The satisfaction that comes from

setting up a successful business

and being independent.

Bei

ng able to

make a

difference

by offering

a service

to the

community such as a charity shop

or hospice.

A new business needs its own

name and a product. The

challenge is to make goods and

services that satisfy customers, are

competitive and sell at a price that

more than covers costs.

(Risk)

Problems of Start-ups

Most new businesses will face a

number of problems when they are

starting up and if these problems are

not tackled immediately, then they may

lead to the insolvency and failure of

the new venture. Below are listed

some of the major problems faced by a

new company:

Raising finance and meeting the repayments

Raising finance and meeting the

repayments is often cited as the major

reason for the failure of many new

business ventures. It can often be

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difficult for a budding entrepreneur to

persuade banks and other financial

institutions to lend money to a new

business, and often they will only lend

the money at a high rate of interest.

These repayments can cripple the

business and eventually lead to its

insolvency.

As well as the repayments, the bank

will insist that some security (or

collateral) is provided by the business,

so that if the business defaults on the

loan repayments, then the bank will

take ownership of an asset of the

business which will cover the amount

of the outstanding loan.

Having a positive cash flow

Leading on from this previous point,

having a positive cash flow is vital for

the survival of the business. Liquidity is

the financial term given to express the

ability of a business to raise cash at

short notice. Any new business must

have sufficient cash available to meet

its short-term needs (such as paying

employees, paying suppliers, rent,

utility bills, etc.).

Many businesses have a lot of cash

tied up in stocks, which are often

difficult to sell and therefore the

business may find it difficult to raise

cash quickly. Further to this, if the

business gives its customers credit

(i.e. buy now, but pay us at a later

date) then this will simply add to any

cash flow problems

that the business is

facing.

Paperwork and legal requirements

All businesses face a variety of

paperwork and legal requirements,

and if any of these are overlooked or

completed inaccurately, then this could

lead to the failure of a new business.

Taxation and insurance payments are

vital for the smooth running and

survival of new businesses. Any

oversight on these payments could

land the entrepreneur with a large tax

bill or, perhaps worse, property and

stock which will not be insured against

fire, theft, etc.

Enticing consumers to try the new product

Enticing consumers to try the new

product / service can also be a major

problem for any new business,

especially if there are already a

handful of established businesses

which dominate the market. Ensuring

that consumers try your product and

then buy it again at a later date

(consumer loyalty) can often only be

done through extensive (and costly)

advertising and promotional

campaigns.

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Leadership

Leadership is the process of

influencing people so that they will

perform a variety of tasks in an

effective manner. It is, therefore,

crucial to have a strong leader who

can inspire and motivate the

employees.

A leader is different to a manager,

since a manager is often appointed to

a position of power, whereas a leader

may often emerge as the best to cope

in a given situation (i.e. an employee

who is very competent at computing

may well be viewed as a leader, even

though he may be towards the bottom

of the organisational hierarchy).

There are a number of styles of leadership:

Autocratic

This is often referred to

as an authoritarian

leadership style, and it

basically means that the

people at the top of an

organisation make all the

decisions and delegate very little

responsibility down to their

subordinates.

Communication is top-down, with no

opportunity for feedback to the leader.

It can cause much resentment and

frustration amongst the workforce and

it is not very common in today's

business world.

Democratic

This involves managers

and leaders taking into

account the views of the workforce

before implementing any new system.

This can lead to increased levels of

morale and motivation amongst the

workforce, but it can also result in far

more time being taken to achieve the

results since many people are involved

in discussing the decision.

Laissez-faire

This is where

employees are set

objectives, and then

they have to decide how

best to achieve them using the

available resources. This method of

leadership can result in high levels of

enthusiasm for the task in-hand, but it

can at times rely too much on the skills

of the workforce.

Paternalistic

This is fairly autocratic in its approach

to dealing with employees, although

their social and welfare needs are

taken into account when a decision is

made that will affect them. The leader

is likely to consult the workforce before

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implementing any decision, but he is

unlikely to listen to much of the

feedback.

What makes a good leader or manager?

For many it is someone who

can inspire and get the most

from their staff.

Be able to think creatively to

provide a vision for the

company and solve problems

Be calm under pressure and

make clear decisions

Possess excellent two-way

communication skills

Have the desire to achieve

great things

Be well informed and

knowledgeable about matters

relating to the business

Possess an air of authority

Managers deal with their employees in

different ways. Some are strict with

their staff and like to be in complete

control, whilst others are more relaxed

and allow workers the freedom to run

their own working lives (just like the

different approaches you may see in

teachers!). Whatever approach is

predominately used it will be vital to

the success of the business. “An

organisation is only as good as the

person running it”.

Summary of management styles

Description Advantages Disadvantages

Autocratic Senior managers

take all the important

decisions with no

involvement from

workers

Quick decision making

Effective when

employing many low

skilled workers

No two-way

communication so can be

de-motivating

Creates “them and us”

attitude between

managers and workers

Paternalistic Managers make

decisions in best

interests of workers

after consultation

More two-way

communication so

motivating

Workers feel their social

needs are being met

Slows down decision

making

Still quite a dictatorial or

autocratic style of

management

Democratic Workers allowed to

make own decisions.

Some businesses

run on the basis of

majority decisions

Authority is delegated to

workers which is

motivating

Useful when complex

decisions are required

that need specialist skills

Mistakes or errors can be

made if workers are not

skilled or experienced

enough

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McGregor

Examined how managers´ attitudes affect how workers behave. He

identified 2 extreme types of managers.

TASK: Find out about McGregor´s theory

1.1.1

Characteristics of Entrepreneurs: Self-confident, creative, resilient, risk-taker, initiative hard-worker.

Text 1-5

pp questions may 2009 q1 may 2010 q1

1.1.2

What motivates Entrepreneurs? Profit & non-profit motives

1-5

Jan 2009 q2 Sample paper q9

May 2010 q9

1.1.3

Leadership Styles: Effective leader, styles, factors affecting, theory x and y

244-247

Jan 2009 q8 May 2010 q2

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Past paper questions

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14

Section 2: Identifying a business opportunity

What is a market?

A shop is an example of a market

Businesses sell to customers in

markets. A market is any place where

buyers and sellers meet to trade

products - it could be a high street

shop or a web site. Any business in a

marketplace is likely to be in

competition with other firms offering

similar products. Successful products

are the ones which meet customer

needs better than rival offerings.

Markets are dynamic. This means that

they are always changing. A business

must be aware of market trends and

evolving customer requirements

caused by new fashions or changing

economic conditions.

The theory of demand

At higher prices, a lower quantity

will be demanded than at lower

prices, ceteris paribus. At lower

prices, a higher quantity will be

demanded than

at higher prices,

ceteris paribus.

Basically, when

the price is high demand is low and

vice versa. Ceteris paribus means 'all

other things being equal'. It is very

important that you state this condition

when using demand curves. I will

explain why under "determinants of

demand". First, let's have a look at the

normal downward-sloping demand

curve:

In the diagram above, the demand for CDs is fairly low at the relatively high price of fifteen pounds, but at the bargain price of five pounds demand is much higher.

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The determinants (factors) of demand

It is fairly obvious so far

that the price of a good

is a pretty strong

determinant of its

demand, but there are

many other things that will affect

demand too.

Real income. If one's real income rose

(real means 'allowing for inflation'), one

should be able to afford more CDs.

The price of other goods. If the price

of CD players rose then one would

expect demand for CD players to fall,

and so would the demand for CDs.

These goods are complements. If the

prices of rock concerts rose then one

would expect the demand for these

concerts to fall. Perhaps those who

decided against the concert might buy

a CD instead. These goods

are substitutes.

Tastes and preferences. A slightly

obscure but very important

determinant. As you get older, you

may lose interest in the repetitive

music currently in the charts and try

some original sounds from the 60s,

70s or 80s. Changing preferences will

affect your demand for a product

regardless of its price.

Expectations of future prices. If you

think that the price for CDs is likely to

fall in the near future, perhaps

because of reduced production costs

or competition from the US, you may

delay some purchases which will

reduce demand in the current time

period. Alternatively, you may feel that

CD prices are likely to rise in the near

future, perhaps due to the lack of

competition in the retail market, so you

may increase your demand in the

current time period.

Advertising. Although many of you

probably doubt the effectiveness of

some of the appalling adverts on the

TV, one assumes that these

companies would not spend fortunes

on these adverts if they did not expect

to see a significant rise in demand for

the product in question (Virgin and Our

Price are always trying to sell you CDs

via the TV.)

Population. Quite obviously, a

significant rise in the number of people

in a given area or country will affect

the demand for a whole host of goods

and services. Note that a change in

the structure of the population (we

have an ageing population) will

increase the demand for some goods

but reduce the demand for others.

Interest rates and credit

conditions. If interest rates are

relatively low then it is cheaper to

borrow money that can then be spent.

This is not so applicable to CDs, but

will certainly affect the demand for 'big

ticket' items such as cars and major

electrical goods. In boom time (like the

late 80s) it is often easier to obtain

credit regardless of the rate of interest.

The normal downward-sloping demand

curve shows the relationship between

the price of the good and its

demand, all other things being

equal. Those 'all other things' are the

list above: incomes, prices of other

goods, etc. If you do not make this

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assumption, then you could have a

situation when the price of CDs falls,

but at the same time one's income falls

by such a large amount that one

actually demands fewer CDs. In other

words, one does not want to

confuse shifts in the demand

curve and movements along a

demand curve.

The theory of supply

Just like with demand, where it only

became effective if it was backed up

with the ability to pay, supply is

defined as the willingness and ability of

producers to supply goods and

services on to a market at a given

price in a given period of time. With

demand, the downward-sloping curve

reflected an inverse relationship

between price and quantity demanded.

The opposite is true of supply. In

theory, at higher prices a larger

quantity will generally be supplied

than at lower prices, ceteris

paribus, and at lower prices a

smaller quantity will generally be

supplied than at higher prices,

ceteris paribus. So this time we have

higher supply at higher prices and vice

versa. Again, in is important to assume

that 'all other things remain constant'.

Any change in one of the other

determinants of supply will cause the

curve to shift

While it is fairly obvious why the

demand curve is downward sloping, it

is not so clear why the supply curve

should be upward sloping. Basically,

the producer will make higher profits

as the price per unit sold increases.

Imagine that a brewer produced a

lager and a bitter. Assume, not

unreasonably, that the costs of

production are the same per pint

produced, whether it is a pint of lager

or a pint of bitter. If the price of lager

then rose relative to the price of bitter,

it would seem sensible for the brewer

to transfer resources from making

bitter towards the production of lager,

thereby increasing the supply of lager

as its price rises.

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The determinants (factors) of

supply

As with the demand curve, there are

many things that affect supply as well

as the price of the good in question.

Notice how similar many of these

factors are in comparison to the factors

that affect demand. Notice also that

nearly all of these factors affect the

firms' costs. Given that the firms'

supply curve is its marginal cost curve

(see the 'costs and revenues' topic)

then it is of no surprise that a cost

changing measure will shift the supply

curve.

Prices of other factors of

production. An increase in the price

of, say, hops, will increase the costs of

a brewing firm and so for any given

price the firm will not be able to brew

as much beer. Hence, the firm's supply

curve will shift to the left. The same

would be true for changes in wage

costs or fuel costs.

Technology.

The supply curve

drawn above

assumes a

'constant' state of technology. But as

we know, there can be improvements

in technology that tend to reduce firms'

unit costs. These reduced costs mean

that more can be produced at a given

price, so the supply curve would shift

to the right.

Indirect taxes and subsidies.

When the chancellor

announces an

increase in petrol

tax, it is the firm who

actually pays the tax. Granted, we end

up paying the tax indirectly when the

price of petrol goes up, but the actual

tax bill goes to the firm. This again,

therefore, represents an increase in

the cost to the firm and the supply

curve will shift to the left. The opposite

is true for subsidies as they are

handouts by the government to firms.

Now the firm can make more units of

output at any given price, so the

supply curve shifts to the right.

Labour productivity.

This is defined as the output per

worker (or per man-hour). If labour

productivity rises, then output per

worker rises. If you assume that the

workers have not been given a pay

rise then the firm's unit costs must

have fallen. Again, this will lead to a

shift to the right of the supply curve.

Price expectations.

Just as consumers delay purchases if

they think the price will fall in the

future, firms will delay supply in they

think prices will rise in the future. It's

the same point but the other way

round.

Entry and exit of firms to and from

an industry.

If new entrants are attracted into an

industry, perhaps because of high

profit levels (much more on this in the

topic 'Market structure'), then the

supply in that industry will rise at all

price levels and the supply curve will

shift to the right. If firms leave the

industry then the supply curve will shift

to the left.

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Case Study

US alcohol retailers find law changes

hard to swallow

Jon Genderson is gearing up for a big increase in internet sales

The US consumes more bottles of wine than any other nation in the world. But almost 80 years after the end of Prohibition, buying a drink can still be tricky.

It's illegal, for instance, to buy vodka in Delaware to take to a party in Pennsylvania. And retailers in Maryland are not allowed to ship alcohol to anybody living in another state.

That's because of the 4,000 or so different laws that govern the alcohol industry and give individual states unprecedented rights to regulate sales and consumption within their borders.

The protections have often favoured small businesses, but many now fear they're under threat from cross-border wine sales on the internet, and the end of state monopolies that could lead to deregulation.

'Scary' "The worst-case scenario is that you have a reduction of competition, removal of small businesses from the marketplace or potentially not having small businesses in the marketplace at all," says John Bodnovich, executive

director of the American Beverage Licensees, which represents 20,000 small retailers across 34 states.

Prices of alcohol are below sale cost all over England, sometimes less than a bottle of water. And there's terrible binge drinking. We look at that and say: 'What's different about our system?'”

Craig WolfWine and Spirits Wholesalers of America

He's particularly concerned about new laws in the state of Washington which take effect in June. State controlled off-licences are closing, and grocery stores and supermarkets will be allowed to sell alcohol instead.

But the biggest threat to small businesses comes from a measure which says an alcohol retailer must operate from stores no smaller than 10,000 sq feet.

"What's happened in Washington state is scary," says Chuck Ferrar, owner of Bay Ridge Wine and Spirits in Annapolis, Maryland.

"[The alcohol industry] is the last bastion of small businesses, 50% of our businesses are owned by Asian minorities because it's one of the few remaining industries where somebody can start a small business and see it grow and thrive.

"But Washington will drive the small business under. And I think it will eventually happen here, that alcohol

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will be sold in groceries and supermarkets."

Public demand

Another big change affecting the industry is the internet. In 2005 the Supreme Court ruled that wineries could ship direct to their customers anywhere in the country, regardless of individual state legislation. That left many states scrambling to change their laws.

Chuck Ferrar says small retailers will be driven out of alcohol sales in Washington

"It's coming because the consumer wants it," says Joe Conti, chief executive of the Pennsylvania Liquor Control Board. "Consumers will be able to buy from a winery in California and have it sent to their home in Pennsylvania - that will be happening within months. That's a good thing for the consumer and we embrace that type of competition."

But the Supreme Court ruling did not include small retailers, and the Wine and Spirits Wholesalers of America (WSWA) remains opposed to direct shipping.

"It's a black market because you don't have the regulatory power to find out who is ordering from where," says WSWA president Craig Wolf.

"Once you open the door to direct shipping and you don't go through a licensed wholesaler, you don't know whether taxes are being paid, whether minors are getting alcohol, and you don't know if it's an illegal source," he says.

But Jon Genderson, managing director of Schneider's of Capitol Hill, a wine and liquor store in Washington DC, believes wholesalers are opposed because they're worried about increased competition in their tier of the market.

"The wholesalers are worried about these things, but it's change that benefits the consumer and that's why I think it's going to happen," he says.

"It's the natural evolution of the business. It just makes sense and when things make sense and the current laws don't make sense I think that eventually they'll be changed. I think we're smart enough to make those changes," he says.

He says the internet still represents a small percentage of sales, but his business is gearing up for the anticipated change.

"We're in the process of revamping our website for a third time, modernising and making it more interactive. I'm hoping it will be easier and easier, and that there will be more and more states we'll be allowed to ship to," he says.

'Checks and balances' Moves to deregulate alcohol in the US go to the heart of debates about its role in society and the concerns that led to prohibition. Mr Wolf says many

Americans have grandparents who

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remember what the country was like before controls were established.

Californian wineries will soon be able to ship direct to homes in Pennsylvania

"There is a fear that if you tinker and mess with it, you don't know what you're going to end up with - and it could be very bad," he says.

"We don't want to cast aspersions on England - but if you look very carefully at what happened, there was deregulation. There are now 24/7 sales there, there's vertical integration there with big box stores controlling the retail operation - or

big retailers controlling the suppliers.

"Prices of alcohol are below sale cost all over England, sometimes less than a bottle of water. And there's terrible binge drinking. We look at that and say what's different about our system?

"Our's is a much more regulated system. There are many more checks and balances, not only between market players but also from government on the market players."

1.2.1 What makes a market?

Buyers & sellers

13

may 2009 q1

1.2.2

What should firms supply?

Supply, factors of supply

14-15

Jan 2009 q1

1.2.3

Identifying what consumers want or need:

Demand, factors of demand,

market-orientation.

13-17

May 2009 q3/q4

Jan 2009 9d

Sample paper q8

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Past paper questions

22

Section 3: Evaluating a business opportunity

Market Research

Market research involves gathering

and analysing data from the

marketplace in order to provide goods

and services that meet their needs.

A wide variety of information used to support marketing decisions can be obtained from market research. A selection of such

uses are summarised below:

Information about the size and competitive structure of the market

• Analysis of the market potential for existing products (e.g. market size, growth, changing sales trends) • Forecasting future demand for existing products • Assessing the potential for new products • Study of market trends • Analysis of competitor behaviour and performance • Analysis of market shares

Information about Products

• Likely customer acceptance (or rejection) of new products • Comparison of existing products in the market (e.g. price, features, costs, distribution) • Forecasting new uses for existing products

• Technologies that may threaten existing products • New product development

Information about Pricing in the Market

• Estimates and testing of price elasticity • Trends in pricing over recent years • Analysis of revenues, margins and profits • Customer perceptions of “just or fair” pricing • Competitor pricing strategies

Information about Promotion in the Market

• Effectiveness of advertising • Effectiveness of sales force (personal selling) • Extent and effectiveness of sales promotional activities • Competitor promotional strategies

Information about Distribution

in the Market

• Use and effectiveness of distribution

channels

• Opportunities to sell direct

• Cost of transporting and

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warehousing products

• Level and quality of after-sales

service

Primary research

This is research designed to gather

primary data, that is, information which

is obtained specifically for the study in

question. It can be gathered in three

main ways - observation,

questionnaires and experimentation.

Observation involves watching people

and monitoring and recording their

behaviour (e.g. television viewing

patterns, cameras which monitor traffic

flows, retail audits which measure

which brands of product consumers

are purchasing).

Questionnaires are a means of direct

contact with consumers and can take a

variety of forms. Personal

questionnaires (such as door-to-door

interviewing), postal questionnaires,

telephone questionnaires and group

questionnaires (such as asking for the

attitudes of a group of consumers

towards a new product).

Questionnaires can be a very

expensive and time-consuming

process and it can be very difficult to

eliminate the element of bias in the

way that they are carried out. It is

important that every respondent must

be asked the same questions in the

same order, with no help or emphasis

being placed on certain questions /

responses.

Experimentation involves the

introduction of a variety of marketing

activities into the marketplace and then

measuring the effect of each of these

on consumers. For example, test

marketing, where a new product is

launched in a small, geographical area

and then the response of consumers

towards it will dictate whether or not

the product is launched nationally.

Secondary research

This is the collection of

secondary data, which

has previously been

collected by others and

is not designed

specifically for the study

in question, but is

nevertheless relevant. Secondary data

is far cheaper and quicker to gather

than primary data, but it can be out-of-

date by the time that it is researched.

The main sources of secondary data

are reference books, government

publications and company reports.

The primary and the secondary

research will provide the business with

much data relating to its markets and

its consumers. This data can then be

used to describe the current situation

in the marketplace, to try to predict

what will happen in the future in the

marketplace, and to explain the trends

that have occurred.

The business may also use the market

research data to segment the market.

This involves breaking the market

down into distinct groups of consumers

who have similar characteristics, so as

to offer each group a product which

best meets their needs.

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The main ways of segmenting a

market are:

By consumer characteristics:

this involves investigating their

attitudes, hobbies, interests,

and lifestyles.

By demographics: their age,

sex, income, type of house, and

socio-economic group.

By location: the region of the

country, urban -v- rural, etc.

Effective segmentation of the market

can lead to new opportunities being

identified (i.e. gaps in the market for a

product), sales potential for products

being realised and increased market

share, revenue and profitability.

Quantitative vs Qualitative research

Quantitative research

Quantitative research is

about measuring features of a market

and quantifying that measurement with

data. Most often the data required

relates to market size, market share,

penetration, installed base and market

growth rates. However, quantitative

research can also be used to measure

customer attitudes, satisfaction,

commitment and a range of other

useful market data that can tracked

over time.

Quantitative research can also be

used to measure customer awareness

and attitudes to different

manufacturers and to understand

overall customer behaviour in a market

by taking a statistical sample of

customers to understand the market

as a whole. Such techniques are

extremely powerful when combined

with techniques such segmentation

analysis and mean that key audiences

can be targeted and monitored over

time to ensure the optimal use of the

marketing budget.

At the heart of all quantitative research

is the statistical sample. Great care

has to be taken in selecting the sample

and also in the design of the sample

questionnaire and the quality of the

analysis of data collected.

Market research involves the collection

of data to obtain insight and

knowledge into the needs and wants of

customers and the structure and

dynamics of a market. In nearly all

cases, it would be very costly and

time-consuming to collect data from

the entire population of a market.

Accordingly, in market research,

extensive use is made of sampling

from which, through careful design and

analysis, marketers can draw

information about the market.

There are several types of sample

that can be used to gather

quantitative data:

Market research involves the collection

of data to obtain insight and

knowledge into the needs and wants of

customers and the structure and

25 | P a g e

dynamics of a market. In nearly all

cases, it would be very costly and

time-consuming to collect data from

the entire population of a market.

Accordingly, in market research,

extensive use is made of sampling

from which, through careful design and

analysis, marketers can draw

information about the market.

Designing the sample

Sample design covers the method of

selection, the sample structure and

plans for analysing and interpreting the

results. Sample designs can vary from

simple to complex and depend on the

type of information required and the

way the sample is selected.

Sample design affects the size of the

sample and the way in which analysis

is carried out. In simple terms the more

precision the market researcher

requires, the more complex will be the

design and the larger the sample size.

The sample design may make use of

the characteristics of the overall

market population, but it does not have

to be proportionally representative. It

may be necessary to draw a larger

sample than would be expected from

some parts of the population; for

example, to select more from a

minority grouping to ensure that

sufficient data is obtained for analysis

on such groups.

Many sample designs are built around

the concept of random selection. This

permits justifiable inference from the

sample to the population, at quantified

levels of precision. Random selection

also helps guard against sample bias

in a way that selecting by judgement or

convenience cannot.

Defining the Population

The first step in good sample design is

to ensure that the specification of

the target population is as clear and

complete as possible to ensure that all

elements within the population are

represented. The target population is

sampled using a sampling frame.

Often the units in the population can

be identified by existing information;

for example, payrolls, company lists,

government registers etc. A sampling

frame could also be geographical; for

example postcodes have become a

well-used means of selecting a

sample.

What size should the sample be?

For any sample design deciding upon

the appropriate sample size will

depend on several key factors

(1) No estimate taken from a sample is

expected to be exact: Any

assumptions about the overall

population based on the results of a

sample will have an attached margin of

error.

26 | P a g e

(2) To lower the margin of error usually

requires a larger sample size. The

amount of variability in the population

(i.e. the range of values or opinions)

will also affect accuracy and therefore

the size of sample.

(3) The confidence level is the

likelihood that the results obtained

from the sample lie within a required

precision. The higher the confidence

level, that is the more certain you wish

to be that the results are not atypical.

Statisticians often use a 95 per cent

confidence level to provide strong

conclusions.

(4) Population size does not normally

affect sample size. In fact the larger

the population size the lower the

proportion of that population that

needs to be sampled to be

representative. It is only when the

proposed sample size is more than 5

per cent of the population that the

population size becomes part of the

formulae to calculate the sample size.

Random sampling - this gives each

member of the public an equal chance

of being used in the sample. The

respondents are often chosen by

computer from a telephone directory of

from the Electoral Register.

Quota sampling - this method

involves the consumers being grouped

into segments which share certain

characteristics (e.g. age or gender).

The interviewers are then told to

choose a certain number of

respondents from each segment.

However, the numbers of people

interviewed in each segment are not

usually representative of the

population as a whole.

Cluster sampling - this normally

involves the consumers being grouped

into geographical groups (or 'clusters')

and then a random sample being

carried out within each location.

Stratified sampling - the consumers

are grouped into segments again (or

'strata') based upon some previous

knowledge of how the population is

divided up. The number of people

chosen to be interviewed from each

'strata' is proportional to the population

as a whole.

Qualitative research

Qualitative market research is about

investigating the features of a market

through in-depth research that

explores the background and context

for decision making. There are two

main qualitative methods - depth

interviews and focus groups. However

qualitative research can also include

techniques such as usability testing,

brainstorming sessions and “vox pop”

surveys.

Depth Interviewing

Depth interviews are the main form of

qualitative research in most business

markets. Here an interviewer spends

time in a one-on-one interview finding

out about the customer’s particular

circumstances and their individual

opinions.

The majority of business depth

interviews take place in person, which

has the added benefit that the

27 | P a g e

researcher visits the respondent’s

place of work and gains a sense of the

culture of the business. However, for

multi-national studies, telephone depth

interviews, or even on-line depth

interviews may be more appropriate.

Feedback is through a presentation

that draws together findings across a

number of depth interviews. In some

circumstances, such as segmentation

studies, identifying differences

between respondents may be as

important as the views that customers

share.

The main alternative to depth

interviews - focus group discussions -

are typically too difficult or expensive

to arrange with busy executives.

However, on-line techniques

increasing get over this problem.

Focus Group Discussions

Focus groups

are the

mainstay of

consumer

research. Here

several

customers are

brought

together to take

part in a discussion led by a

researcher (or “moderator”). These

groups are a good way of exploring a

topic in some depth or to encourage

creative ideas from participants.

Group discussions are rare in business

markets, unless the customers are

small businesses. In technology

markets where the end user may be a

consumer, or part of a team evaluating

technology, group discussions can be

an effective way of understanding what

customers are looking for, particularly

at more creative stages of research.

Niche Marketing

This involves a business selling its

product(s)

in small,

often

lucrative,

segments

of a

market. It

is the

opposite strategy to mass marketing.

Many small businesses can identify

unsatisfied consumer needs in a

particular segment within a large

industry, and they can develop

products to meet these needs.

This allows the small businesses to

exist in industries that are dominated

by large businesses (e.g. Classic FM

in the radio broadcasting industry,

SAGA in the holiday industry).

However, if larger rivals appear within

the niche market, the smaller

businesses will often find it difficult to

compete effectively with these well-

resourced businesses.

It is also dangerous for a business to

offer just one product within the

market, since any larger rivals are

likely to be more diversified and have a

wider product portfolio. Theses larger

businesses could, therefore, reduce

their prices to such a low level that the

small business cannot compete

profitably.

28 | P a g e

Nevertheless, during periods of

economic growth and higher consumer

spending, then niche markets can offer

a very lucrative opportunity to many

small businesses to offer a

personalised, high value-added

service/product.

What is the difference between

niche and mass marketing?

In most markets there is one dominant

(mass) segment and several smaller

(niche) segments…

For example, in the confectionery

market, a dominant segment would be

the plain chocolate bar. Over 90% of

the sales in this segment are made by

three dominant producers – Cadbury’s,

Nestle and Mars. However, there are

many small, specialist niche segments

(e.g. luxury, organic or

fair-trade chocolate).

Niche marketing can

be defined as:

Where a business

targets a smaller

segment of a larger

market, where customers have

specific needs and wants

Targeting a product or service at a

niche segment has several

advantages for a business (particularly

a small business):

• Less competition – the firm is a “big

fish in a small pond”

• Clear focus - target particular

customers (often easier to find and

reach too)

• Builds up specialist skill and

knowledge = market expertise

• Can often charge a higher price –

customers are prepared to pay for

expertise

• Profit margins often higher

• Customers tend to be more loyal

The main disadvantages of marketing

to a niche include:

• Lack of “economies of scale” (these

are lower unit costs that arise from

operating at high production volumes)

• Risk of over dependence on a single

product or market

• Likely to attract competition if

successful

• Vulnerable to market changes – all

“eggs in one basket”

By contrast, mass marketing can be

defined as:

Where a business sells into the

largest part of the market, where

there are many similar products on

offer

The key features of a mass market are

as follows:

• Customers form the majority in the

market

• Customer needs and wants are more

“general” & less “specific”

• Associated with higher production

output and capacity (economies of

scale)

• Success usually associated with low-

cost operation, heavy promotion,

widespread distribution or market

leading brands

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Competitive Advantage

Definition: A competitive advantage is

an advantage over competitors gained

by offering consumers greater value,

either by means of lower prices or by

providing greater benefits and service

that justifies higher prices.

How: Location, Value for money,

Brand name, Facilities, Image ,Taste,

Customer service .

Competitive Advantage

Choose one of the methods of how a

company could gain a competitive

advantage over its competitors. Select

a well-known product or brand.

Create a poster identifying how the

product (Mercedes Class M) or

brand (Gilette) has gained this

competitive advantage.

Eg Apple Ipod and image

30 | P a g e

Adding Value

The increase in the

benefits of a good or

service which are

created at each stage

of production.

Methods – changing

raw materials,

packaging, branding (using

personalities or famous logos)

For example, businesses can add

value by:

Building a brand – a reputation for

quality, value etc that customers are

prepared to pay for. Nike trainers sell

for much more than Hi-tec, even

though the production costs per pair

are probably pretty similar!

Delivering excellent service – high

quality, attentive personal service can

make the difference between

achieving a high price or a medium

one

Product features and benefits for

example, additional functionality in

different versions of software can

enable a software seller to charge

higher prices; different models of

motor vehicles are designed to

achieve the same effect.

Offering convenience – customers

will often pay a little more for a product

that they can have straightaway, or

which saves them time.

A business that successfully adds

value should find that it is able to

operate profitably. Why? Remember

the definition of adding value: where

the selling price is greater than the

costs of making the product.

By definition, a business that is adding

substantial value must also be

operating profitably.

Quite simply, it can make the

difference between survival and

failure; between profit and loss.

The key benefits to a business of

adding value include:

- Charging a higher price

- Creating a point of difference from

the competition.

- Protecting from competitors trying to

steal customers by charging lower

prices

- Focusing a business more closely on

its target market segment

31

Positioning the Business Idea

This is the process of creating an image for the product in the minds of customers.

Identify the competition.

Identify their strengths and

weaknesses.

Identify how to differentiate your

product.

Identify Gaps in the market –

market mapping.

Try to gain a competitive

advantage.

Add value

Market mapping consists of identifying key variables about a product, plotting where existing brands or suppliers are in terms of combining the variables, then identifying any gaps in the market”.

P o s i t i o n i n g a n d M a r k e t m a p p i n g

Once an entrepreneur has identified an appropriate segment of the market to target, the challenge is to position the product so that it meets the needs and wants of the target customers.

One way to do this is to use a “market map” (you might also see this called by its proper name – the “perceptual map”).

The market map illustrates the range of “positions” that a product can take in a market based on two dimensions that are important to customers.

Examples of those dimensions might be:

High price v low price Basic quality v High quality Low volume v high volume Necessity v luxury Light v heavy Simple v complex Lo-tech v high-tech Young v Old

Let’s look at an illustrated example of a market map. The map below shows one possible way in which the chocolate bar market could be mapped against two dimensions – quality and price:

32

How might a market map be used?

One way is to identify where there are “gaps in the market” – where there are customer needs that are not being met.

For example, in the chocolate bar market, Divine Chocolate (a social enterprise) successfully spotted that some consumers were prepared to pay a premium price for very high quality chocolate made from Fairtrade cocoa. Green & Black’s exploited the opportunity to sell premium chocolate made from organic ingredients. Both these brands successfully moved into the high quality / high price quadrant (see above) before too many competitors beat them to it.

The trick with a market map is to ensure that market research confirms whether or not there is actually any demand for a possible “gap in the market”. There may be very good reasons why consumers do not want to buy a product that might, potentially, fill a gap.

33 | P a g e

Complete a Market Map for a local shop or restaurant in Valencia.

34

Product trial

The first

step for a

new

business or

product is to

attract trial

purchases.

A new

magazine may run special offers to get

customers to try the first issue, hoping

that repeat sales are generated. The

magazine will soon close if customers

fail to buy future issues. The aim of a

special offer scheme is to convert trial

purchases into repeat sales.

Repeat business is all about

encouraging customers who buy for

the first time to buy again and again!

A business invests a lot of effort and

cash in trying to get a customer to

purchase a product for the first time.

This is known as product trial. Much

advertising is aimed at encouraging

customers to try a new product, or

switch from an existing competitor.

After a new product has been tried

once, its success can be measured in

how quickly, how often, and in what

quantity it is repurchased. Repeat

purchase refers to the number or

percent of customers who purchase a

second time, or to how often they buy

again.

The problem with advertising is that it

is very expensive. A business is

unlikely to be successful and profitable

if it has to keep advertising heavily in

order to generate demand from new

customers. It is much better if

customers can be encouraged to

become loyal to the product – even

better, to recommend the product to

their friends and family!

Achieving a high level of repeat

purchase is good news for a business.

So what is required?

Firstly, the product should be of the

right quality. A sub-standard or low

quality product is sure to disappoint

first-time customers. They are unlikely

to buy again or recommend the

product to others.

Secondly, a business should do all it

can to develop an effect relationship

with existing customers. This includes

activities such as:

- Regular communication (e.g. email

newsletters)

- Incentives for loyalty (e.g.

promotional discounts)

- Research into customer needs and

wants (e.g. through customer surveys)

35 | P a g e

Stakeholders

There are many groups of people

who have an interest, financial or

otherwise, in the performance of

a business - these different

groups are known as

stakeholders. The main

stakeholders are considered to

be:

Shareholders

These people have a clear financial

interest in the performance of the

business. They have invested money

into the company through purchasing

shares and they expect the company

to grow and prosper so that they

receive a healthy return on their

investment. The return that they

receive can come in two forms. Firstly,

by a rise in the share price, so that

they can sell their shares at a higher

price than the purchase price (this is

known as making a capital gain).

Secondly, based on the level of profits

for the year, the company issues a

portion of this to each shareholder for

every share that they hold (this is

known as a dividend). The

shareholders are also entitled to vote

each year at the A.G.M. to elect the

Board of Directors, who will run the

company on their behalf.

Employees

This group also has an obvious

financial interest in the company, since

their pay levels and their job security

will depend on the performance and

the profitability of the business. It is

employees who perform the basic

functions and tasks of the business

(producing output, meeting deadlines

and delivery dates, etc.) and over

recent years their traditional role has

started to change. They are often now

encouraged to become involved in

multi-skilled team-working, problem

solving and decision making - thus

having a significant input to the

workings of the business.

Customers

Customers are vital to the survival of

any business, since they purchase the

goods and services which provides the

business with the majority of its

revenue. It is therefore vital for a

business to find out exactly what the

needs of the consumers are, and to

produce their output to directly satisfy

these needs - this is done through

market research. The goods and

services must then be promoted in

such a way as to appeal to the target

market and to inform them of the

availability, price, etc. Once the goods

and services have been purchased by

the customer, it is essential that after-

sales service is offered and that the

customer is happy with his/her

purchase. The business must try to

keep the customer loyal so that they

36 | P a g e

return in the future and become a

repeat-purchaser.

Suppliers

Without flexible and reliable suppliers,

the business could not guarantee that

it will always have sufficient high

quality raw materials which they

require to produce their output. It is

important for a business to maintain

good relationships with their suppliers,

so that raw materials and components

can be ordered and delivered at short

notice, and also so that the business

can negotiate good credit terms from

the suppliers (i.e. buy now, pay at a

later date).

The Government

The government affects the

workings of businesses in many

ways:

1. Businesses have to pay a variety of

taxes to central and local government,

including Corporation tax on their

profits, Value-Added Tax (V.A.T) on

their sales, and Business Rates to the

local council for the provision of local

services.

2. Businesses also have to adhere to a

wide-ranging amount of legislation,

which is aimed at protecting the

consumers, the employees and the

local environment from business

activity.

3. Businesses will be affected by

different economic policies, (for

example, if interest rates are

increased, then this will discourage

businesses from borrowing money

since the repayments will now be

significantly higher). However,

businesses can also benefit from

government incentives and initiatives,

such as new infrastructure, job

creation schemes and business

relocation packages, offering cheap

rent, rates and low-interest loans.

The Local Community

Businesses are likely to provide

significant amounts of employment for

the local community and often will

produce and sell much of their output

to the local residents. The sponsorship

of local events and good causes (such

as local charity work) can also help the

business to establish itself in the

community as a caring, socially

responsible organisation. Many

businesses develop links with local

schools and colleges, offering

sponsorships and resources to these

under-funded institutions. However,

businesses can also cause many

problems in local communities, such

as congestion, pollution and noise, and

these negative externalities may often

outweigh the benefits that the

businesses bring to the community.

Disagreements between stake holders

Due to the demands placed on

businesses by so many different

stakeholders, it is no surprise that

there are often disagreements and

conflict between the different groups.

Some of the more common areas of

conflict are:

Shareholders and management

37 | P a g e

Profit maximisation is often the over-

riding objective of shareholders -

resulting in large dividend payments

for them. However, it is far more likely

that the managers of the business will

aim to profit satisfy rather than profit

maximise (that is, they will aim to earn

a satisfactory level of profits, and then

use the remaining resources to pursue

other objectives such as diversification

and growth). This conflict between

these two groups is often referred to

as divorce of ownership (the

shareholders) and control (the

management).

Customers and the business

Customers are unlikely to remain

loyal and repeat purchase from the

business if the product that the have

purchased is of poor quality and/or is

poor value for money. More customers

are prepared to complain about the

quality of products and after-sales

service than ever before, and the

business must ensure that it has in

place a number of strategies designed

to satisfy the disgruntled customer,

reimburse any financial loss that they

may have incurred and persuade them

to remain loyal to the business.

Suppliers and the business

Suppliers are often quoted as

complaining about the lack of prompt

payments from businesses for

deliveries of raw materials, and if this

became a regular problem then the

suppliers may well refuse credit to the

businesses or may even cease all

dealings with them. On the other hand,

many businesses have been known to

complain about the late deliveries of

raw materials and components from

suppliers, and the dubious quality of

the parts once they have been

inspected.

The community and the business

As outlined previously, the local

community can often suffer at the

hands of a large company through the

negative externalities of pollution,

noise, congestion and the building of

new factories in areas of outstanding

beauty. However, if the business faces

strong protests from residents and

from pressure groups concerned about

its actions, then it may decide to

relocate to another area, causing

much unemployment and a fall in

investment in the community it leaves

behind.

38 | P a g e

Market segmentation - targeting strategies

Once a firm has successfully identified

the segments within a market, the next

step is to target these segments with

products that closely match the needs

of the customers within that segment.

There are a number of targeting

strategies, including:

Niche/concentration marketing –

this is concerned with targeting one

particular, well-defined group of

customers (a niche) within the overall

market.

Jordan’s, the cereal company, adopted

this approach by targeting groups of

customers interested in organic

products at a time when this group of

consumers represented a relatively

small proportion of the overall market.

Niche markets can be targeted

profitably by small firms who have

relatively small overheads and,

therefore, do not need to achieve the

volume of sales required by larger

competitors.

The main disadvantages of niche

markets are that the potential for sales

growth and economies of scale may

be limited, and the survival of the firm

may be seriously affected if sales

begin to decline.

Mass marketing – this is concerned

with selling a single product to the

whole market. This strategy is based

on the assumption that, in respect to

the product in question, customers’

needs are very similar if not identical.

The main benefit for the firm is that it

can produce on a large scale,

benefiting from low unit production

costs via economies of scale. These

lower costs can be passed on to the

consumer in the form of lower prices

because, although profit margins on

each item sold may be lower, high

sales volume should generate large

profits overall.

The main disadvantage of mass

marketing is that, increasingly in

today’s markets, consumers are less

interested in standardised products

and often prepared to pay premium

prices for products that cater for their

specific needs.

market segmentation - bases of segmentation

Geographic

• Region of the country

• Urban or rural

Demographic

• Age, sex, family size

• Income, occupation, education

• Religion, race, nationality

Psychographic

39 | P a g e

• Social class

• Lifestyle type

• Personality type

Behavioural

• Product usage - e.g. light, medium

,heavy users

• Brand loyalty: none, medium, high

• Type of user (e.g. with meals, special

occasions)

why segment markets?

There are several important reasons

why businesses should attempt to

segment their markets carefully. These

are summarised below

Better matching of customer needs

Customer needs differ. Creating

separate offers for each segment

makes sense and provides customers

with a better solution

Enhanced profits for business

Customers have different disposable

income. They are, therefore, different

in how sensitive they are to price. By

segmenting markets, businesses can

raise average prices and subsequently

enhance profits

Better opportunities for growth

Market segmentation can build sales.

For example, customers can be

encouraged to "trade-up" after being

introduced to a particular product with

an introductory, lower-priced product

Retain more customers

Customer circumstances change, for

example they grow older, form

families, change jobs or get promoted,

change their buying patterns. By

marketing products that appeal to

customers at different stages of their

life ("life-cycle"), a business can retain

customers who might otherwise switch

to competing products and brands

Target marketing communications

Businesses need to deliver their

marketing message to a relevant

customer audience. If the target

market is too broad, there is a strong

risk that (1) the key customers are

missed and (2) the cost of

communicating to customers becomes

too high / unprofitable. By segmenting

markets, the target customer can be

reached more often and at lower cost

Gain share of the market segment

Unless a business has a strong or

leading share of a market, it is unlikely

to be maximising its profitability. Minor

brands suffer from lack of scale

economies in production and

marketing, pressures from distributors

and limited space on the shelves.

Through careful segmentation and

targeting, businesses can often

achieve competitive production and

marketing costs and become the

preferred choice of customers and

distributors. In other words,

segmentation offers the opportunity for

smaller firms to compete with bigger

ones.

40

Opportunity cost

Opportunity cost is one of the most important and fundamental

concepts in the whole of economics. Given that we have said

that economics could be described as a science of choice, we

have to look at what sacrifices we make when we have to make a choice. That is

what opportunity cost is all about.

The definition of opportunity cost is: The cost expressed in terms of the next

best alternative foregone or sacrificed

Take the following example:

I recently bought a new pair of shoes which cost me

£40.

The cost here is being expressed in terms of the amount

of money you had to give up to acquire those shoes.

Because we all have a common understanding of

'money' as being notes and coins that we use to

exchange for the things we want, we can pretty much understand this sentence.

We have to remember that money is merely bits of paper or

metal that we use as a convenient and accepted method of

facilitating exchange - getting what we want. Expressing 'cost' in

terms of the amount of money we have to give up to get what

we want is always helpful in giving us the true 'cost' of

something. For that, we need to use 'opportunity cost'.

What statements like this fail to convey, however, is the true picture of what you are

sacrificing by choosing to buy the shoes. It is more accurate to say something like

'the price I paid for these shoes was £40.' To get an idea of the true 'cost', we would

really need to know something of the sacrifice made in giving up that £40.

£40 can buy a number of things - let us assume that it can also buy the following:

When thinking about how to dispose of your money, you have to make choices and

these represent the choices at this moment in time. These choices represent

different aspects of value. Each of the items might represent some value to you but

they may be different. It is important to remember that you might, in an ideal world

where there were no scarce resources, want all these things.

41 | P a g e

TRADE OFFS

In business there are many occasions when one factor has to be traded off against another.

An entrepreneur might get huge help at the start from friends, yet realise that these same friends lack the professionalism to help the business grow.

The needs of the business may have to be traded off against the friendships. Other trade-offs may include – giving up a good job and prospects to be your own boss, giving up the most enjoyable things for profit etc.

1.3.1

Researching demand for the business idea: Market research: Methods-primary/secondary Quantitative/qualitative problems.

143-149

may 2009 q5 jan 2009 q6

sample paper q7

1.3.2

Is there a market for the business idea? Market size & share, growth, mass marketing niche, segmentation.

152-155

Sample paper q3 May 2010 q 3

May 2010 q 10

1.3.3

Positioning the business idea. Competition, market mapping, competitive advantage, adding value. differentiation

7-10 May 2009 q8 May 2009 q11

Jan 2009 q3 Sample paper q9b

May 2010 q6

1.3.4 Product Trial Testing, expense, methods, benefits, disadvantages.

166

Jan 2009 q9a Sample paper q1

May 2010 q7

1.3.5 Opportunity Costs Trade-Offs Choice – factors, stakeholders.

48-50

Jan 2009 9e Sample paper 9e

42 | P a g e

Past paper questions

43 | P a g e

44

Soft drink project

Design a “new” soft drink to be

readily available from December

2012.

Your Project should include

An advert

Marketing Mix:

Identify price, product, place and

promotional aspects

Questionnaire/Interviews/Surveys –

to determine through market

research, the current fashion/tastes

of the soft drinks markets.

Segmentation – whose is your

market/customers? Which groups

would buy your product?

Market Mapping – who are the

competitors and what are the

strengths and weaknesses.

Product trial – How are people

going to try it?

Additional information – market

size, recent trends etc

Added value – how do you

convince people to pay a price for it

when they know it only costs x

amount to produce.

When complete you will have

completed a business plan!

45 | P a g e

Section 4:

Economic considerations

The Economic Environment

Economics is concerned with the

process of satisfying the needs and

wants of the population, by using the

limited resources of the economy

(land, labour, capital and enterprise,

otherwise known as the 'factors of

production') in the most efficient way.

There are generally considered to be

four main objectives of an economy:

1. A low level of unemployment

2. A low level of inflation

3. A high level of economic

growth

4. A good foreign trading

position

Unemployment is defined as the

number of people in the workforce in a

country who are looking for a job, but

cannot find one.

The two major measures of

unemployment are the 'claimant

count' (where people must declare

that they are out of work, capable of

working, available to work and actively

seeking work) and the 'International

Labour Force' count (where people

must be out of work, have been

looking for work in the past 4 weeks

and must be available to start work in

the next 2 weeks).

Unemployment can be very damaging

to an economy because it can lead to

falling output, high government

spending, and falling aggregate

demand.

There are several methods that a

government can use to reduce the

amount of unemployment in an

economy:

Policies to increase demand: such

as reducing taxation or reducing

interest rates.

Retraining incentives offered to the

unemployed.

Helping new businesses to set-up,

and offering incentives to existing

businesses to relocate to areas of high

unemployment.

Inflation is defined as a general and

sustained rise in the average prices of

goods and services within an economy

over a period of time. It is calculated

by reference to the Retail Price Index

(R.P.I), which is a weighted index,

designed to indicate any changes in

the average price level in the UK.

Inflation can be very damaging to an

economy because it leads to the

reduced purchasing power of the

pound, uncertainty about the future, a

fall in investment and savings, and

increasing costs for businesses.

46 | P a g e

There are several methods that a

government can use to reduce the

rate of inflation in an economy:

Increasing interest rates to discourage

high levels of customer spending.

Reducing the amount of credit

(borrowing) that is available to

customers.

Incomes policies, where pay increases

are limited, so to deter high levels of

costs and expenditure.

Economic growth. This term refers to

a real growth (i.e. accounting for the

effects of inflation) in the income per

capita (or income per head) of the

population over a given period of time.

It is normally measured by reference to

Gross Domestic Product (G.D.P)

and Gross National Product (G.N.P).

Gross Domestic Product is the total

value of a country's output over a

period of time (usually 12 months).

Gross National Product is calculated

by adding G.D.P. to the net income

from abroad (i.e. the income earned on

overseas investments by UK citizens

and businesses, minus the income

earned by foreigners investing in the

UK).

Economic growth is likely to lead to an

increase in the amount of investment

in the economy, as well as an increase

in the number of new businesses

starting up, leading to increases in

output, expenditure and income.

In order to improve the G.D.P. or the

G.N.P. per capita (i.e. in order to

achieve a faster rate of economic

growth), then the government must

ensure that the workforce is

adequately educated and trained to

perform their jobs effectively,

significant amounts of investment in

new machinery and production

techniques are undertaken, and

natural resources must be used to

their optimum efficiency.

Balance of payments. This is a

record of a country's financial

transactions with the rest of the world

over a given period of time (normally

12 months).

The current account of the balance of

payments measures both 'visible' trade

(that is, the imports and exports of

tangible goods such as furniture and

cars) and 'invisible' trade (that is, the

imports and exports of intangible

services, such as banking, shipping,

and insurance). The capital account of

the balance of payments measures

any flows of capital between the UK

and other countries (purchase of

shares and other forms of investment).

The exchange rate is the external

price of a country's currency,

47 | P a g e

expressed in terms of another

currency.

For example, £1 = 1.5 euros

A free-floating exchange rate system

involves the value of the currency

being allowed to float (fluctuate)

according to the supply and demand

for the currency.

A demand for sterling is created when

the UK exports goods and services

(foreigners must pay for these goods

and services using sterling, which they

purchase in exchange for their own

currencies).

A supply of sterling is generated when

the UK imports goods and services

(i.e. the UK must pay for these imports

using the foreign currency of the

country concerned). These foreign

currencies are purchased in exchange

for sterling on the world currency

market.

An increase in the value of the pound

is known as an appreciation, and a

fall in the value of the pound is known

as depreciation.. A strong pound

makes goods and services produced

in the UK more expensive for

foreigners to purchase, but makes

foreign goods and services cheaper to

import.

A fixed exchange rate system

involves the value of the currency

being fixed against other currencies

and not being allowed to fluctuate in

response to the demand and supply

for it. This involves government

intervention on a regular basis, buying

the currency when its value is

threatening to fall, and selling the

currency when its value is threatening

to rise.

Under this system, the government

can devalue the currency if it feels that

its value is too high against foreign

currencies, making their goods and

services uncompetitive. This

devaluation of the currency boosts the

international competitiveness of the

country's exports, by making them

cheaper for other countries to

purchase.

Alternatively, the government can

revalue the currency if it feels that its

value is too low against foreign

currencies, making the level of

demand too high for their goods and

services and leading to inflation.

48 | P a g e

Exchange Rates

The exchange rate is the price of a

currency. That’s often a very difficult

concept to get your head around,

particularly as ‘common sense’ is

misinformed by “exchanging” or

“swapping” currencies when you go

abroad on holiday. But if you get

some Euros before heading off for

France, you aren’t swapping your £s

for €s. You’re buying them.

So the £ is quite literally on sale in the

foreign exchange market. The graph

above points out the basic history you

need to understand. The £ broadly fell

in value (it ‘depreciated’) from the

1980s until the early 90s. Our

currency then sharply appreciated in

the mid 90s, where it stayed (with

some fluctuations) before plunging

again in 2008.

What does this mean for UK

businesses?

- In general, a lower value £ means

that imports are more expensive.

That’s part of the reason why there’s

been upward pressure on inflation

recently. Anything that comes from

abroad is now more expensive: parts,

components, finished goods, stocks,

oil, food. Almost all firms import

something, and are therefore likely to

face higher costs. UK customers may

move away from imports and foreign

holidays as they are relatively more

expensive.

- That leads to a wider benefit: the UK

is now relatively cheaper to foreigners,

providing UK firms with better export

opportunities, as well as more

domestic demand.

Evaluation points

- The impact of changing exchange

rates will be different on different

businesses. Firms with big import bills

will be hit hard. Other businesses that

are seeking to expand exports may

find demand increasing for their

products or services. Firms that were

planning to ‘offshore’ some of their

production might reconsider (check out

the links below).

- The uncertainty of exchange rate

change is a big headache for firms,

and tends to undermine overseas

investments and makes UK firms think

twice before embarking on any

overseas project.

- Exchange rates might not make such

a big difference if firms or their

customers are not price sensitive, of

course.

49 | P a g e

1.4.1

Current Economic Climate: Economic Growth, Exchange Rates, Inflation unemployment

text 46-50

may 2009 q6 may 2009 q12

jan 2009 q7 may 2010 q 13

50 | P a g e

Section 5: Financing the new business idea

Legal Structure

Sole Trader

A sole trader is a

one-person

business, commonly

found in trades

where only small

amounts of finance

are required to set

up and where there

are very few advantages to the

existence of larger organisations (e.g.

hairdressing, newsagents, market

traders).

Sole traders often employ waged

employees, but they alone have to

provide all the finance (often savings

and bank loans) and bear all the risks

of the business venture. In return, they

have full control of the business and

enjoy all the profits.

A sole trader faces unlimited liability

for his/her debts and it is referred to as

an unincorporated business - this

means that there is no legal difference

between the business and the owner.

Examples of Sole Traders

Partnership

To overcome

many of the

problems of a

sole trader, a partnership may be

formed. A partnership is an association

of individuals and generally there will

be between 2 and 20 partners.

Each partner is responsible for the

debts of the partnership and therefore

you would need to choose your

partners carefully and draw up an

agreement on the responsibilities and

rights of each partner (known as a

Deed of Partnership or The Articles

of Partnership). The most common

examples of a partnership are doctor's

surgeries, veterinarians, accountants,

solicitors and dentists.

As stated earlier, most partners in a

partnership face unlimited liability for

their debts. The only exception is in a

Limited Partnership. This is where a

partnership may wish to raise

additional finance, but does not wish to

take on any new active partners.

To overcome this problem, the

partnership may take on as many

Sleeping (or Silent) Partners as they

wish - these people will provide

finance for the business to use, but will

not have any input into how the

business is run. In other words, they

have purely put the money into the

business as an investment. These

Sleeping Partners face limited liability

for the debts of the partnership. A

partnership, just like a sole trader, is

an unincorporated business.

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Private Limited Company

This is a type of

joint-stock

company (that is, it

is an incorporated

business - where

the business has a

separate legal

identity from the owners). Often

private limited companies are small,

family run businesses which are

owned by shareholders.

Each shareholder in a private limited

company MUST be a part of the

business and under no circumstances

can any shares be sold to members of

the general public. Each share entitles

the owner to 1 vote at the company's

Annual General Meeting (A.G.M.) and

also to a share of the company's profit

at the end of the financial year (a

dividend).

Each shareholder has

limited liability for the

company's debts and can,

therefore, only lose the

value of their investment

in the company. A

company is run by a

Board of Directors (who are elected

by the shareholders) and this is

headed by a Chairman.

Before a company can be formed, a

number of legal documents must be

completed - most important are the

Memorandum of association and the

Articles of Association. These cover

details such as :

the objectives of the business

its headquarters and registered office

the amount of capital to be raised from

the sale of shares

details concerning meetings within

the business

the arrangements for auditing the

accounts of the business.

When these are completed, they

are sent to the Registrar of

Companies, who will then issue the

business with a Certificate of

Incorporation which allows the

business to trade as a Private Limited

Company. The company's name must

finish with the word Limited and it

must raise less than £50,000 of share

capital.

It can be very difficult for a shareholder

in a private limited company to sell

their shares, since a buyer must be

found within the framework of the

company.

Public Limited Company (P.L.C.)

This is the

other, much

larger, type of

joint-stock

company and,

just like a

private limited

company, a PLC is an incorporated

business, is run by the Board of

Directors on behalf of the

shareholders and has an A.G.M. at

which shareholders vote on certain key

issues relating to the company.

The main difference between a PLC

and a private limited company is that a

PLC can sell its shares on the Stock

Exchange to members of the general

52 | P a g e

public and can, therefore, raise

significantly more finance than a

private limited company.

If a private limited company wishes to

become a PLC, then it must change its

Memorandum and Articles of

Association and re-submit them to the

Registrar of

Companies.

If the

company is

considered to

have acted

legally and for

the best interests of its shareholders,

then it will be issued with a new

Certificate of Incorporation and also

with a Certificate of Trading, which will

allow it to sell its shares on the Stock

Exchange. The price of the shares will

then fluctuate according to investors'

perceptions of the PLC.

It is often the case with a PLC that the

owners of the company (shareholders)

will wish the PLC to make as much

profit as possible, so that the

shareholders will receive a very

handsome dividend per share.

However, the Board of Directors and

the management will often wish to

devote some of the PLC' s resources

to growth and diversification (such as

the introduction of new products) and

this will clash with the shareholders'

desire for maximum profits. This is

known as the divorce of ownership

and control.

The PLC has to publish its annual

accounts (known as disclosure of

accounts) and therefore is extremely

vulnerable to investors' and bankers'

perceptions about its progress and

success. Following on from this, a PLC

is also at risk from a takeover from an

outside body, if they manage to

accumulate over 50% of the shares in

the PLC.

Franchising

Franchising has led to a rapid growth

in the presence of many high-street

stores in the UK over the past 10 years

(e.g. McDonalds, Tie Rack, Perfect

Pizza, and The Body Shop). A

business franchise involves the

franchisor (the owner of the business)

selling a business format to a

franchisee (the purchaser of the

business name) in return for a fixed

sum of money and a percentage

royalty on sales revenue.

The franchisee

will be based

locally and is

likely to be

making his

initial business

venture. He

buys the

business format, which has been tried

and tested in other areas, and it is

therefore a far less risky venture than

setting up his own business.

The franchisee has a licence to trade

under the franchisor's name and also

to use the logos, trademarks, etc. the

licence that the franchisee buys is

usually restricted to a specific

geographical area and for a limited

period of time.

53 | P a g e

This process of selling the rights to use

a company's name, logo, etc. can

result in the parent company

experiencing rapid expansion in a

country, with little of the investment

that would have been required had the

company bought the outlets itself. The

franchisee is provided with a ready-

made product, financial and

management help and advice, lower

start-up costs than for a business of

his own, and help with the store layout.

However, the royalty must be paid to

the franchisor even if a loss is made

and the franchisee can have strict

restrictions placed on their actions and

promotions within the store, not

leaving the franchisee much room for

initiative and flair.

Sources of finance

Why business needs finance

Finance refers

to sources of money for a business.

Firms need finance to:

Start up a business, eg pay for

premises, new equipment and

advertising.

Run the business, eg having enough

cash to pay staff wages and suppliers

on time.

Expand the business, eg having funds

to pay for a new branch in a different

city

or

coun

try.

New

busi

ness

es

find it difficult to raise finance because

they usually have just a few

customers and many competitors.

Lenders are put off by the risk that the

start-up may fail. If that happens, the

owners may be unable to repay

borrowed money.

Some sources of finance are short

term and must be paid back within a

year. Other sources of finance are

long term and can be paid back over

many years.

Creditors and debtors

A creditor is

an individual

or business

that has lent

funds to a

business and

is owed

money. A

debtor is an

individual or business who has

borrowed funds from a business and

so owes it money.

There is a cost in borrowing funds.

Money borrowed from creditors is paid

back over time, usually with an

additional payment of interest. Interest

54 | P a g e

is the cost of borrowing and the reward

for lending.

A business owner's house could be

used as collateral

Creditors often ask for security before

lending funds. This means sole traders

and partners may have to offer their

own house as a guarantee that monies

will be repaid. A company can offer

assets, eg offices as collateral.

The type of finance chosen depends

on the type of business. Start ups and

small firms are considered very high

risk and find it difficult to raise external

finance. The only source of funds

migh

t be

the

own

er's

own

savi

ngs,

retained profits and borrowing from

friends. Companies can issue extra

shares to raise large amounts of

capital in a rights issue.

Internal and External Sources of

Capita The amount of finance required

by a business will depend on a range

of factors, including the age of the

business, the track-record and

profitability of the business, the

industry that it is in and the state of the

economy.

Internal finance is generated from

within the business and is likely to

come from one of three sources:

Retained profit refers to profits made

from previous years, which have

remained after corporation tax has

been paid to the Inland Revenue and

after dividends have been distributed

to shareholders. It is a useful source of

finance to fund new products, etc.

The sale of fixed assets, such as

machinery, vehicles or even land and

buildings which are idle, can also be a

large source of cash to fund new

projects.

Making more effective use of

working capital, such as chasing

debtors for prompt payment, selling off

any available stocks and negotiating

longer credit periods with suppliers all

release cash for use within the

business.

External finance is generated from

outside the business in a variety of

ways:

Bank overdrafts allow the business to

withdraw more money from the bank

than it has in its account. It is a

flexible, short-term method of

borrowing extra cash. However,

interest is calculated on a daily basis

and it can be recalled at very short

notice.

Trade credit involves the business

obtaining goods from another

business, but not paying for them for a

period of time.

Factoring involves a business selling

its debts to a factor company, who will

immediately give the business 80% of

the money owed to it by its customer.

At a later date, having collected the

debt from the customer, the factor

company will give the business the

remainder of the money less a fee.

55 | P a g e

Leasing is a common way to fund new

fixed

assets, as

opposed to

purchasing

them

outright.

The

business will sign a contract

committing it to using some vehicles,

machinery, premises, etc. for a fixed

period of time (often 3-5 years) with a

monthly payment made to the

company who owns the assets. The

business leasing the assets cannot put

these items on its balance sheet (since

it never owns them).

Loans and mortgages are often used

to purchase new fixed assets

(machinery, vehicles and land and

property). They require monthly

repayments to be made for a

significant period of time (up to 25

years for a mortgage) and the bank will

also want an item to be placed as

security (collateral) to cater for the

event of the business defaulting on it

loan repayments. The danger is that

too many loans and mortgages will

increase the company's gearing to a

dangerously high level.

Debentures are sold by companies to

investors as a way of raising finance

for use within the company. They are

long-term, marketable securities,

which will pay the holder a fixed

amount of money every year until its

maturity date - at which time the holder

will be able to sell the debenture back

to the company for it market price.

However, debentures, like loans and

mortgages, will increase the gearing

level of a company.

Venture capital is a very risky type of

investment that entrepreneurs (called

venture capitalists) will make in a

small to medium sized business, which

they believe has massive growth

potential. These funds will clearly help

the business to grow and achieve its

potential.

Whichever source of finance is

chosen, the business must ensure that

it is adequate for the needs of the

business (i.e. it is enough to pay for

the new product development, new

buildings, etc.) and that it is

appropriate (i.e. it will not leave the

business with large monthly interest

repayments, when they are already

burdened with high gearing).

The overall objective in raising finance

for a company is to avoid exposing the

business to excessive high

borrowings, but without unnecessarily

diluting the share capital. This will

ensure that the financial risk of the

company is kept at an optimal level.

56 | P a g e

Sources of Finance: Activity

Task:

You will be given a variety of different business scenarios. You must decide what type of finance the business in question should go for and why. Of course, there could be more than one appropriate source of finance - you could decide on a combination but again, ensure that you explain why you have decided on this route.

The Cases:

Case 1

A medium-sized engineering firm with an annual turnover of £2.5 million has decided to install a new piece of machinery to help improve its productivity. The equipment needs to be housed in a new building to be constructed on the site. The forecast cost of the building is £150,000 and the equipment £400,000.

Case 2

An individual has been made redundant after 20 years with a major organisation and has received a lump sum redundancy payment of £70,000. The individual is planning to set up a bookmakers and has identified a suitable premises valued at £180,000 near to a major town centre shopping precinct.

Case 3

A large plc is planning on moving a major part of its production facility to Cornwall. It has identified a site near a former chalk pit that is now not used. The estimated cost of the facility is £4.5 million.

Case 4

A local Do It Yourself (DIY) store has experienced problems with acquiring goods from its suppliers because it has been an erratic payer of its bills with them. The reasons it has experienced these problems is that it has contracts to supply building materials to a number of local firms all of whom only pay the bills for their orders every 3 months.

Case 5

A rugby club is anticipating turning fully professional after the team secured promotion

to the Zurich premiership. To take its place in the league, the league committee have insisted that it also improves facilities at the ground. It has been estimated that the cost of these two measures will be £550,000.

Case 6

A major UK plc is planning the takeover of a rival business. The move has been investigated by the Competition Commission and permission has been granted. The

57 | P a g e

current share price of the rival firm is 260p and the firm has made an offer of 340p per share. The current market capitalisation of the target firm is £4.5 billion.

Case 7

A small partnership business has developed a new piece of software that would massively improve the efficiency of personnel management processes at large sized business organisations of all kinds. The software has massive potential but at present is not commercially viable because of lack of funds. The partners are contemplating their next move.

Case 8

A small newsagent in a rural village centre has decided to purchase a new freezer cabinet and oven/roasting unit to provide hot meals for village workers and for students at the secondary school which serves the surrounding area which is located half a mile from the village centre. The cost of the units is £3,500.

Case 9

A large charity organisation has followed a consultancy programme on streamlining its records. The consultants have suggested investing

into a software package that will provide a sophisticated database programme that will do all the things that the charity will require for the next 10 years. The cost of the software package is £65,000.

Case 10

Following the construction of a new housing estate on the outskirts of a major city, a group of 10 ambitious young professionals has decided to try to exploit the type of resident moving into the area by setting up a gym and health centre on earmarked land within the development. The building has been bought by the group for £800,000 but needs to be furnished and fitted out for the purpose intended. The cost of the bar, restaurant and gym facilities is estimated at £95,000 but the other major cost is the swimming pool, spa and sauna area. This could be utilised on a separate project to the fitness centre as the local council want to secure use for local school children and elderly residents - this being part of the purchase arrangements associated with the new housing development.

58

1.5.1 Sources of finance: Need for finance Internal/external Appropriateness Finance & time Legal structures of business Liability

101-104 29-33

jan 2009 q5 jan 2009 q9b

sample paper q6 sample paper q9d

may 2010 q 11

Past paper questions

59

Section 6

Measuring the potential success of a business idea

Product

Products can generally be classified

under two headings - consumer

products and producer products...

Consumer products

Purchased and used by individuals /

citizens for use within their homes and

these products fall into 3 categories:

Convenience products. Fast-moving

consumer goods (f.m.c.gs) sold in

supermarkets, such as soap,

chocolate, bread, toilet paper, etc.

These often carry a low profit-margin.

Shopping products. These are

durable products which are only

purchased occasionally, such as

dishwashers, televisions and furniture.

They often carry a very high profit-

margin.

Speciality products. These are very

expensive items that consumers often

spend a large amount of time

deliberating over, due to the large

investment requires to purchase the

product. Examples include cars and

houses. The profit-margins are, again,

very high.

Producer products

Purchased by businesses and are

either used in the production of other

products, or in the running of the

business. For example, raw materials

(timber, steel), machinery, delivery

vehicles, and components used to

make larger products (e.g. tyres and

headlights for vehicles).

A product line is the term used to

describe a related group of products

that a business produces (e.g. a

business may produce televisions, and

its product line may include portable

televisions, 12-inch screen models, 18-

inch screen models, televisions with a

built-in video facility, etc). Product mix

is the term used to describe the

different collection of product lines that

a business produces (eg the same

business may also produce video

recorders, camcorders and computers,

as well as televisions).

Most businesses will wish to change

their product portfolio over time. This

can be the result of changing

consumer tastes, replacing those

products which have entered the

'decline' phase of the product life-cycle

or to try to break into new markets or

new segments within an existing

product. There are generally

considered to be a number of

stages in the development of new

products:

The generation of ideas. A number of

issues need to be considered, such as

will the new product meet the

objectives of the business? Does the

business have the spare capacity to

produce the product? Will the new

product contribute to the continued

growth of the business? Will new

personnel be required, or will the

business have to re-train the existing

staff?

60 | P a g e

Testing the

new concept. Is

there a sufficient

market for the

new product?

This stage of the

product

development

process will

involve carrying

out extensive primary market research

to test consumers' reactions to the

suggested product. Consumers may

suggest slight alterations and

modifications to the suggested product

in order to make it more marketable

and desirable.

Analysing the costs/revenues. What

will be the costs of production? How

many units will the business be able to

produce? What will the selling price be

set at ? What will be the profitability of

the new product?

Developing a prototype. The design,

materials, quality and safety of the

product will now become paramount. A

prototype of the product will be

developed using the details that the

market research indicated that

consumers wanted. It is essential to

ensure that this stage of the

development process is detailed and

extensive, since to make alterations

and modifications at a later date will be

extremely expensive and time-

consuming.

Test marketing the new product.

The business may often decide to test

market the new product in a small

geographic area, in order to test

consumer response, before it launches

the product nationally. If the consumer

response is favourable, then the

product is likely to be launched

nationally. However, if the consumers

indicate that some element of the

marketing mix is ineffective (price,

packaging, advertising, etc) then this is

likely to be changed before the

national launch of the product.

National launch. This is where the

product enters the 'Introductory' stage

of its product life-cycle. This is a very

costly operation, since a national

launch needs to be supported by

extensive advertising and promotional

campaigns.

It is inevitable that many new product

ideas will not get to the market place,

and many of those that do succeed in

being launched will fail within a few

months of their commercialisation.

However, the businesses which seem

to be most successful in bringing new

products to the market place tend to

meet a number of vital criteria:

they develop 2 to 3 times the number

of new products as their competitors;

they get the product to the market

place quickly;

they compete in many different

markets;

they provide strong after-sales service.

Price

The price level that a business decides

to sell its product(s) at will affect both

the quantity of sales and the profit-

margin received per unit. There are

many considerations that a business

will need to take into account before it

61 | P a g e

decides upon a selling price for a new

product, such as:

The objectives of the business if the

main objective of the business is to

maximise profit, then it is likely that the

product will be priced at a high level.

The degree of competition in the

industry the number of competitors in

the industry will affect the price level

that the business decides upon for its

product(s).

The channels of distribution the

more intermediaries that are used in

getting the product from the factory to

the consumer, then the higher the

selling price is likely to be.

The business image if the image of

the business is prestigious and up-

market, then a higher price is likely to

be charged for the product(s).

There are many methods and

strategies that a business can use in

order to arrive at a selling price for its

products:

Cost-plus pricing. Cost-based pricing

involves setting a price by adding a

fixed amount or percentage to the cost

of making or buying the product. In

some ways this is quite an old-

fashioned and somewhat discredited

pricing strategy, although it is still

widely used. After all, customers are

not too bothered what it cost to make

the product – they are interested in

what value the product provides them.

The most common method of cost-

based pricing is cost-plus (or “mark-

up”) pricing. It is widely used in

retailing, where the retailer wants to

know with some certainty what the

gross profit margin of each sale will be.

Here is an example of cost-plus

pricing, where a business wishes to

ensure that it makes an additional £50

of profit on top of the unit cost of

production.

Unit cost: £100

Mark-up: 50%

Selling price: £150

How high should the mark-up

percentage be? That largely depends

on the normal competitive practice in a

market and also whether the resulting

price is acceptable to customers.

For example, in the UK a standard

retail mark-up is 2.4 times the cost the

retailer pays to its supplier (normally a

wholesaler). So, if the wholesale cost

of a product is £10 per unit, the retailer

will look to sell it for 2.4x £10 = £24.

This is equal to a total mark-up of £14

(i.e. the selling price of £24 less the

bought cost of £10).

The main advantage of cost-based

pricing is that selling prices are

relatively easy to calculate. If the

mark-up percentage is applied

consistently across product ranges,

then the business can also predict

more reliably what the overall profit

margin will be.

The main disadvantage is that cost-

plus pricing may lead to products that

are priced un-competitively. Another

potential issue is that firms may

experience changes in their production

costs which are not then reflected in

the selling prices offered, leading to

lower profit margins.

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Mark-up pricing. This is where the

business adds a profit mark-up to the

direct cost for each unit in order to

arrive at the selling price. This profit

mark-up will need to cover the fixed

overheads and then contribute towards

profit.

Predatory (or destroyer) pricing. This

method of pricing involves a business

setting its prices at such a low level

that other (often smaller) competitors

cannot compete profitably, and as a

result they are forced out of the

industry. This leaves the larger

business in a dominant position, and it

can then raise its prices to a much

higher level in order to recoup any

losses that they incurred when their

prices were low.

Skimming pricing. This is a pricing

strategy for a new product, designed to

create an up-market, expensive image

by setting the price at a very high level.

It is a strategy often used for new,

innovative or high-tech. products, or

those which have high production

costs which need recouping quickly.

Penetration pricing. This is a pricing

strategy for a new product, designed to

undercut existing competitors and

discourage potential new rivals from

entering the market. The price of the

product is set at a low level in order to

build up a large market share and a

high degree of brand loyalty. The price

may be raised over time, as the

product builds up a strong brand-

loyalty.

Prestige pricing. This strategy is used

where the business has a prestigious,

up-market image, and it wishes to

reflect this

through high

prices for its

products (e.g.

Rolls Royce).

Demand-orientated pricing. This

method of pricing involves setting the

price of the product at a level based

upon customers' perceptions of the

quality and value of the product.

Competition-orientated pricing. This

method of pricing ignores both the

costs of production and the level of

customer demand. Instead it bases the

price level on the prices charged by

the competitors in the industry -either

undercutting the competitors, charging

a higher price, or charging the same

price. 'Going rate' pricing is the term

used to describe a business charging

a similar price to competitors for a

similar product.

Psychological pricing is a pricing

tactic that is designed to appeal to

customers who use emotional rather

than rational responses to pricing

messages.

Sometimes prices are set at what

seem to be unusual price points. For

example, why are DVD’s priced at

£12.99 or £14.99? The answer is the

perceived price barriers that customers

may have. They will buy something for

£9.99, but think that £10 is a little too

much. So a price that is one pence

lower can make the difference

between closing the sale, or not!

The aim of psychological pricing is to

make the customer believe the product

is cheaper than it really is. Pricing in

63 | P a g e

this way is intended to attract

customers who are looking for “value”.

For example, a new car might be

priced at £12,995 rather than at

£13,000. A rational customer would

know that the price difference of £5 is

tiny for such a high value item as a

new car. However, customers don’t

necessarily behave rationally. Some

may look at that price and “round it

down” to £12,000, making the

perceived difference more significant!

The main advantage of psychological

pricing is that it allows a business to

influence the way that customers view

a product without the need to actually

change the product.

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Costs

Variable and Total Costs

Generally speaking, a business will

incur two types of cost when it

produces goods and provides services

to consumers:

Fixed costs & Variable costs.

A fixed cost is one which is totally

independent of the level of output,

and it would be incurred even when

output was zero. Examples include

rent, mortgage payments, managers'

salaries, and loan repayments. They

are often referred to as overheads.

Total fixed costs (TFC)

Variable costs are those which vary

directly with output (i.e. as the level

of output increases, then variable

costs increase). Examples include raw

materials, production wages, other

direct production costs, and utility bills.

Total variable costs (TVC)

When fixed costs are added to variable

costs, then the total costs (TC) of the

business can be calculated.

In other words, TFC + TVC = TC.

This helps the business to calculate its

total costs at any given level of output.

Total costs

Note that TC starts at the same point

as TFC.

Average costs (AC) are calculated by

dividing total costs by the level of

output.

In other words:

Average costs

65 | P a g e

It is clear to see that average costs will

also start to decline over time. When

this occurs in the long-run, then the

business is said to have achieved

economies of scale.

However, the business is likely to

reach a level of output where average

costs (the cost per unit) will start to rise

again. In these circumstances, the

business is said to be experiencing

diseconomies of scale.

When average fixed costs are added

to average variable costs, then the

average total costs (AC) of the

business can be calculated.

In other words:

AFC + AVC = AC

This helps the business to calculate its

average cost at any given level of

output.

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Contribution Analysis

Contribution is the term given to the

amount of money that remains after all

direct and variable costs have been

deducted from the sales revenue of

the business.

It is called 'contribution' because it

represents the amount of money which

is available to contribute towards

covering the fixed costs of the

business and, once these are covered,

it represents the amount of money

which will contribute towards the profit

of the business. In other words,

contribution - fixed costs = profit.

Contribution can be analysed in two

ways:

Contribution per unit sold

Contribution per unit sold = Sales price

per unit - Variable costs per unit.

For example, if a product has a selling

price of £ 10, and its variable costs

(labour, raw materials, etc) is £ 3 per

unit, then it has a contribution of £ 7

per unit.

If a product is loss-making, but it

nevertheless makes a contribution

towards covering the fixed costs of a

business, then it would be unwise to

delete the product from the product

portfolio. This is because the total

profit of the business will actually

decrease if the contribution from the

loss-making product is no longer

received. Therefore it is vital that a

loss-making product is not deleted

simply because it fails to produce a

profit - if it produces a contribution

towards fixed costs, then it is still

worthwhile to produce it.

Total contribution

Total contribution = Total sales

revenue - Total direct and variable

costs.

For example, if a business has total

sales revenue of £ 4 million, and its

total variable and direct costs are £ 2.5

million, then the total contribution for

the business is £ 1.5 million. This

contribution will hopefully cover the

fixed costs and then contribute

towards profit.

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Break-Even Charts

This is a graph showing the total

revenue and the total costs of a

business at various levels of output. It

is a form of Management Accounting

and it enables a manager to see the

expected profit or loss that a product

will face at different levels of output.

The break-even point is the point on

a break-even chart where the total

revenue (T.R) of a business (or

product) is equal to its total cost

(T.C).

It can also be calculated

mathematically by using the following

formula:

For example:

A business produces just one product,

which it sells for £ 9 per unit. The

variable cost of each unit is £ 4 and

the business faces fixed costs per year

of £ 1 million.

The business currently produces and

sells 500,000 units.

What is the break-even level of

output and what profit will the

business make if it sells all of its

output?

In order to assist the drawing of the

break-even chart, we can calculate the

break-even level of output and the

amount of profit using simple formulae:

In other words, the business will need

to produce 200,000 units before it

breaks-even.

Any level of output below 200,000 will

yield a loss.

Any level of output above 200,000 will

yield a profit.

The profit is equal to total revenue

minus total cost (or profit = TR -

TC).

Total revenue (TR) is calculated by

multiplying the selling price by the

number of units sold.

In this example, the selling price is £ 9

and the number of units sold is

500,000.

Therefore the total revenue (TR) is £ 9

x 500,000 = £ 4.5 million.

The total cost (TC) is calculated by

adding together the total fixed costs

(TFC) to the total variable costs

(TVC).

In this example, the fixed costs are £ 1

million and the total variable costs are

£ 4 x 500,000 units = £ 2 million.

Therefore the total cost (TC) is £ 3

million.

The profit is, therefore, TR - TC,

which gives us: £ 4.5 million - £

3million = £ 1.5million.

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We can now draw a break-even chart

and check the figures on the chart with

the answers above.

In order to have an accurate break-

even chart, three lines must be

plotted:

Total Fixed Costs (TFC),

Total Costs (TC)

Total Revenue (TR).

The x-axis is labelled as 'Output' (in

units). In this example, the axis will go

up to 500,000 units.

The y-axis is labelled as 'Costs,

Revenue and Profit' (in £ ). In this

example, the axis will go up to £ 4.5

million.

As you can see, the answers on the

chart correlate with the answers

calculated using the two formulae

above. The break-even point (shown

as a red dot) is the point where the TC

and the TR lines cross. This is then

measured by dropping a vertical red

line down to the x-axis, to give 200,000

units.

The profit at 500,000 units is then

calculated by taking a red vertical line

up from the 500,000 unit mark to

where it hits the TC line. This is then

measured across to the y-axis (again

using a red line) to give us total costs

of £ 3 million.

The vertical red- line from the 500,000

unit mark is then extended to where it

hits the TR line. Again, this is then

measured across to the y-axis to give

us a total revenue of £ 4.5 million.

Therefore, the profit is the

difference between TR and TC (i.e. £

1.5 million).

Although break-even analysis is a very

useful tool, it does have several

drawbacks:

It assumes that the TFC, the TC and

the TR functions are linear. In reality,

this is very unlikely.

It assumes that the selling price is

constant, in reality the selling price is

likely to vary from customer to

customer and region to region.

It assumes that the business only

produces one product.

It assumes that the business can sell

all of its output. In reality, very few

businesses will be able to do this and

some will remain as unsold stock.

The data used to construct the break-

even chart may well be out-of-date and

therefore inaccurate.

69 | P a g e

Profit and Loss Account

The profit and loss account is a

financial statement which represents

the revenue that the business has

received over a given period of time,

and the corresponding expenses

which have been paid.

It also shows the profit that the

business has made over a period of

time (usually 12 months) and the uses

to which the profits have been put.

Revenue

Revenue is the inflow of money to the

business in the course of the ordinary

activities of the enterprise.

There are a number of different

sources of revenue;

cash sales

credit sales (i.e. where the business

has sold goods to customers, but has

not yet received the cash)

interest

royalties

dividends that the business receives

on its investments or

fees for hiring-out the resources of the

business to a third party.

Revenue is recognised at either the

receipt of the cash OR at the point of

sale (if the goods are sold on credit).

Expenses

Expenses are expired costs (i.e. costs

from which all benefits have been

extracted during an accounting

period). Examples include wages, raw

materials, and utility bills -often known

as revenue expenditure.

It must be remembered that expenses

are not necessarily the same as

costs.

For example, if a business purchases

a new fixed asset (such as a machine)

then it will clearly incur the monetary

cost of purchasing the machine (say

£50,000).

However, this £50,000 will not be

written-off as an expense, since the

benefits from the machine will last for

more than a single accounting period

(i.e. for more than 12 months). Instead

of writing-off the total cost of the

machine, a portion of the £50,000 will

be written-off as an expense each year

over the useful life of the machine -this

is known as a 'depreciation charge'.

Format of the Profit and Loss

account

The usual layout for a profit and loss account

is as below:

£000 £000

Sales Revenue

1,000

Cost of Sales:

Materials 300

Direct labour 200

Production overheads 100

70 | P a g e

(600)

Gross profit

400

Less selling expenses 100

Less administrative expenses 120

(220)

Trading [Operating] Profit

180

Add non-operating income

(10)

Profit before interest and tax

190

Less interest expense

(30)

Profit before tax [Net Profit]

160

Less taxation

(60)

Profit after tax

100

Less dividends

(20)

Retained Profit

80

The first line gives the Sales

Revenue for the business from selling

its goods and services.

From this, we deduct the "Cost of

goods sold" (costs directly associated

with the production of the goods and

services - such as the cost of the raw

materials, the labour charges

associated with the production, and

the production overheads. These are

sometimes referred to as direct

materials, direct labour and direct

overheads).

Sales revenue less C.o.G.S. is

known as Gross profit.

However, we have not yet accounted

for selling and administrative expenses

(such as advertising costs, distribution

costs, salaries, utility bills, etc.).

When these are deducted from the

Gross Profit, the result is known

as trading or operating profit. These

refer to the profit made from normal

trading activities.

The next adjustment is to add on any

income from other activities, known as

non-operating income (e.g. renting out

premises). The resulting figure is

known as profit before interest and

tax.

We then deduct a figure for interest

charges. The resulting figure is known

as profit before tax or net profit.

The final part of the account is known

as the appropriation account. It

provides information on the way in

which the profit is dispersed.

Some is taken in corporation tax and

goes to the Inland Revenue, some is

drawn from the business as

dividends to be distributed to the

shareholders and the remainder

is retained within the business for re-

investment.

71 | P a g e

Ratio Analysis - Introduction

Ratio analysis is an accounting tool,

which can be used to measure the

solvency, the profitability, and the

overall financial strength of a business,

by analysing its financial accounts

(specifically the balance sheet and the

profit and loss account).

Accounting ratios are very easy to

calculate and they enable a business

to highlight which areas of its finances

are weak and therefore require

immediate attention.

There are two main ratios that can be used to measure the profitability of a business:

1. The gross profit margin. 2. The net/operating profit margin.

The gross profit margin

This measures the gross profit of the

business as a proportion of the sales

revenue. It is calculated using the

following formula:

For example, if a business has gross

profit of £4 million and sales revenue

of £6 million, then the gross profit

margin would be:

This means that for every £1 of sales

revenue, £0.67 remains after all direct

expenses have been deducted. This

money then contributes towards

covering the other expenses of the

business.

The business would want this margin

to be as high as possible, since a high

margin will leave more profit for

covering the remaining expenses and,

if the business is a 'company', for

covering the dividend payments to

shareholders.

The net/operating profit margin

This measures the net profit of the

business as a proportion of the sales

revenue. It is calculated using the

following formula:

For example, if a business has gross

profit of £1 million and sales revenue

of £6 million, then the net profit margin

would be:

This means that for every £1 of sales

revenue, 16.7 pence remains after all

direct and indirect expenses have

been deducted. This money then

contributes towards covering the

corporation tax that must be paid on

profits to the Inland Revenue and, if

the business is a 'company', covering

the dividend payments to

shareholders.

Any profit which remains is kept in the

business for re-investment and is

called 'retained profit'. Again, the

business would want this margin to be

as high as possible, allowing both

large dividend payments to

shareholders and a significant amount

of profit to be retained for growth.

72 | P a g e

73 | P a g e

Improving profit margins

Mars bars shrink in size

The size of Mars and Snickers

chocolate bars has been shrunk by

more than 7 per cent as the company

tries to cut costs.

A Mars bar

While the best-selling treats have been

reduced from 62.5g to 58g, their prices

have remained the same.

The change happened in the second

half of last year and the downsized

versions are now on sale in the shops,

where a Mars bar still costs 37p and a

Snickers is 41p.

Mars UK claimed the switch to smaller

sizes was designed to help tackle the

nation's obesity crisis.

However, the move was not advertised

despite claims it was for a public

health initiative.

The reduced Mars contains just 19

fewer calories at 261, while the

Snickers has 23 fewer at 296.

Mars UK has now confirmed that the

change was triggered by rising costs,

according to the Daily Mail.

"Like all food manufacturers, we have

seen continued cost increases over

the last few years," it said in a

statement.

"We look to absorb the vast majority of

these costs by being more efficient,

but on occasion we have to consider

increasing prices.

"By slightly reducing portion sizes on

Mars and Snickers we were able to

continue to responsibly meet

consumer demands for healthier

lifestyles whilst not increasing our

prices."

Consumer Focus, the customer body

set up by the Government, is

concerned that firms are attempting to

fool consumers.

"Shrinking the size of chocolate bars

should be part of a drive to combat

obesity. However, shrinking size but

not price could damage consumers'

trust in the brands they love," said its

policy expert Lucy Yates.

Mars UK's sister operator in Australia

is shrinking the size of 90 products

while keeping prices the same.

The change there has been handled

very differently by being presented in a

major advertising campaign as a public

health measure.

The tactic of cutting product sizes,

known as the Grocery Shrink Ray in

America, is a tactic being used by

many British companies.

74 | P a g e

There are a number of ways a firm can

improve its profit margins:

1. Reduce the number of special

offers.

2. Buy cheaper raw materials

3. Stock a wider range of products

4. Increase prices

5. Reduce wastage

6. Stock more seasonal items.

What are the effects of each of these

on the profit and loss account?

What could be the consequences?

1.6.1

Sales volume & revenue: Goods/services Sales volume Total revenue Pricing: demand-based cost-based competition-based psychological.

72-73 184-188

may 2009 q9 May 2010 q12

1.6.2

Business Costs: Fixed costs Variable costs Total costs

73-75

1.6.3

Profit & contribution Calculating profit Contribution: selling price – variable costs

82

Sample paper q5

1.6.4 Break-even revenue level. Break-even analysis Break-even point Actions Chart/formula Margin of safety Limitations of break-even

82-87

Sample paper q4 Jan 2009 q9c May 2010 q8

1.6.5 Profit & Loss account Calculating profit & loss Gross Profit Cost of Sales Expenses Net/Operating Profit

377-382

May 2009 q10

1.6.6 Measurement of profit Use of P & L account Ratio analysis: Gross Profit Margin Net Profit Margin Improving Profit Margins Limitations of ratio analysis

394-404

May 2009 q4 Sample paper q2

75 | P a g e

Past paper questions

76

Section 7: Putting a business idea into practice

Once an entrepreneur has recognised

an opportunity, he/she must draw up a

business plan. This is a document

which outlines the marketing,

production and financial plans for the

proposed business. It is used to try

and persuade investors (banks, etc.) to

lend money to the entrepreneur to fund

his/her new business.

The main sections of a business

plan include:

- the aims and objectives of the

business

- details of the new product or service

being offered

- an outline of the existing market

details (i.e. size of the market, number

of existing competitors)

- how and where the product will be

produced

- the proposed number of employees

- a cashflow forecast, a projected

profit and loss account and balance

sheet for the end of the first year's

trading

- details of the finance required and

the forecasted rate of return on this.

Most small businesses have very

limited resources. Research is costly

and can seem like a poor use of time.

Some entrepreneurs ignore planning

and analysis and instead rely on their

gut instinct. They launch products they

believe customers want and

competitors cannot match. Poor

planning

is a

major

cause of

busines

s failure.

Busines

ses are

more likely to succeed if their strategy

is carefully planned

There is an alternative. A business

plan is a report by a new or existing

business that contains all of its

research findings and explains why the

firm hopes to succeed. A business

plan includes the results of market

research and competitor analysis.

Analysis is when a business

interprets information.

Drawing up a business plan forces

owners to think about their aims, the

competition they will face, their

financial needs and their likely profits.

Business plans help to reduce risk and

reassure stakeholders, such as banks.

77 | P a g e

Cash Flow Forecast

Cash Flows

Cash is the most liquid of all the assets

of a business -it represents the bank

balance and the cash that the

business has available on the

premises (otherwise known as 'petty

cash').

Cash flow refers to the difference

between the cash flowing into the

business (e.g. through sales revenue)

and the cash flowing out of the

business (e.g. bills and wages).

Cash flow problems

Having a positive cash flow is vital for

the survival of a business, since

without the ability to pay workers and

suppliers then the business will soon

have to cease trading.

This potential problem is compounded

by the fact that businesses often have

to pay many expenses several weeks

or even months before any cash

actually flows into the business.

For example, wages and salaries will

have to be paid to employees,

suppliers will have to be paid for any

raw materials, and the rent or

mortgage payments will have to be

paid before the products can be

manufactured and sold to customers.

Further to this point, if the products are

sold on credit to customers, then the

time delay between the cash outflows

and the cash inflows will be even

longer.

The major causes of cash flow

crises for a business are:

1. Overtrading -where the

business attempts to expand

too rapidly, without a sufficient

financial base.

2. Having too much money

invested in stocks.

3. Allowing too much credit to

their customers.

4. Unexpected changes in

demand for their products.

5. Overborrowing -therefore

having large monthly loan

repayments, which have to be

met.

There are many actions that a

business can take when it is

experiencing a liquidity crisis:

1. Offering price discounts to

boost sales and sales

revenue.

2. Selling off fixed assets.

3. A 'sale and lease back'

arrangement.

4. Chasing debtors for the

monies owed to the business.

5. Selling off stocks.

Whatever action is decided upon, the

business must ensure that it is

implemented quickly and that a careful

eye is kept on the liquidity (cash flow)

position in the future.

Cashflow statement

A cash flow statement is a Financial

Accounting document, which shows

the cash inflows and the cash outflows

78 | P a g e

for a business over the past 12

months.

It indicates those months in which the

business suffered a cash flow crisis

(where cash outflows were greater

than cash inflows) and it will also

highlight those months in which the

business was cash-rich (i.e. more cash

inflows than cash outflows).

It allows a business to prepare a cash

flow forecast for the forthcoming year,

by basing the estimated cash inflows

and outflows on the results from the

previous year.

Cashflow forecast

A cash flow forecast is a

Management Accounting document,

which outlines the forecasted future

cash inflows (from sales) and the

outflows (raw materials, wages, etc)

per month for a business over an

accounting period.

Example:

Total

£ Jan Feb Mar Apr

Sales

revenue 2850 900 850 750 350

Other

revenue 650 200 200 100 150

Total cash

inflows 3500 1100 1050 850 500

Total cash

outflows 3400 700 950 1200 550

Net

monthly

cash flow

100 400 100 (350) (50)

Bank

balance 300 600 700 350 300

The business forecasts that in January

it will experience cash inflows of

£1,100 and cash outflows of £700,

leaving a positive net monthly cash

flow of £400.

This is added to the £200 bank

balance which existed at the end of

December, to give a forecasted bank

balance at the end of January of £600.

In February, the forecasted cash

inflows are only £100 more than the

forecasted outflows, leaving a bank

balance of £700.

However, in the months of March and

April, the business is forecast to

experience negative net monthly cash

flows (i.e. its cash outflows are

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forecast to be greater than its cash

inflows).

This gradually reduces the bank

balance to just £300 by the end of

April.

It is important for a business to

produce a cash flow forecast, so that it

can prepare for those months in which

it is forecast to experience a cash flow

crisis (i.e. the business needs to

arrange extra borrowing or overdraft

facilities to provide extra cash).

Alternatively, in the months where the

business is forecast to be cash-rich, it

can use this money profitably

elsewhere within the business (e.g.

new product development).

1.7.1

Creation of a business plan What is a business plan? Contents

Cash flow management

21-25

79-86

may 2009 q 7 may 2010 q 5

may 2011 q12

80

Past Paper questions

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Revision

http://www.wordle.net/create

Create a word cloud that identifies the keywords from Unit 1!

The clouds give greater prominence to words that appear more

frequently in the source text. You can tweak your clouds with different

fonts, layouts, and color schemes. The images you create with Wordle

are yours to use however you like. You can print them out, or save

them to the Wordle gallery to share with your friends.

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Revision

Create a power-point presentation that answers one of the following tasks:

Entrepreneur

a) Identify an entrepreneur, what does he/she do, why, and how?

Examples: Steve Jobs, Mark Zuckerberg, Anita Roddick, Giorgio Armani. What

were their motives?

Supply and Demand

b) Draw and label a supply and demand curve showing their interaction. Explain

what happened if one of the main factors (determinants) changes. Eg price of

substitutes.

Market research

c) Identify 3 other methods of market research. What are the advantages and

disadvantages of these methods? Find suitable examples of poor market

research eg Coca-Cola Dasani

Market Niche

d) Identify 2 companies that have a Market Niche. What does this mean and

what are the specific segments they have identified?

Product Positioning

e) Think of a small café/restaurant you have visited in Valencia. How have they

positioned themselves? Who are the competition? Why are they different

(competitive advantage) and which methods to they use toa dd value? Eg

How to they persuade us to pay 1,50 for a coca cola that costs 50c in the

supermarket?

Product Trial

f) Identify a product Trial that has taken place that you are familiar with. How did

they test market? What were the advantages and disadvantages? Was it/Is it

successful?

Stakeholders

g) Identify a small business you are familiar with. Who are the stakeholder

groups involved. How are they involved? How could they be affected by the

current economic recession?