Introduction to Accounting

Definition of Accounting
Accounting can be defined as a process of reporting, recording, interpreting and summarizing economic
data. The introduction of accounting helps the decision-makers of a company to make effective choices,
by providing information on the financial status of the business. Today, accounting is used by everyone
and a good understanding of it is beneficial to all. Accountancy act as a language of finance. To
understand accounting efficiently it is important to understand the aspects of accounting.

• Economic Events- It is a consequence of a company has to undergo when the number of monetary
transactions is involved. Such as purchasing new machinery, transportation, machine installation
on-site, etc.
• Identification, Measurement, Recording, and Communication- The accounting system should be
outlined in such a way that the right data is identified, measured, recorded, and communicated to
the right individual and at the right time.
• Organization-In refers to the size of activities and level of a business operation.
• Interested Users of Information- It is about communicating important financial information to the
customers, according to which they will make the correct decision.

Fundamentals of Accounting

• Assets- The economic value of an item which is possessed by the enterprise is referred to as
Assets. To put it in other words, assets are those items that can be transformed into cash or that
generates income for the enterprise shortly. It is useful in paying any expenses of the business
entity or debt.
• Liabilities- The economic value of an obligation or debt that is payable by the enterprise to other
establishment or individual is referred to liability. To put it in other words, liabilities are the
obligations that are rising out of previous transactions, which is payable by the enterprise, through
the assets possessed by the enterprise.
• Owner’s Equity- Owner’s equity is one of the 3 vital segments of a sole proprietorship’s balance
sheet and one of the main aspects of the accounting equation: Assets = Liabilities + Owner’s
Equity. It depicts the owner’s investment in the trade minus the owner’s withdrawal from the
trade + the net income since the business concern commenced.

Objectives of Accounting
Main objectives of accounting are:
1. To maintain a systematic record of business transactions

• Accounting is used to maintain a systematic record of all the financial transactions in a book of
accounts.
• For this, all the transactions are recorded in chronological order in Journal and then posted to
principle book i.e. Ledger.
 2. To ascertain profit and loss

• Every businessman is keen to know the net results of business operations periodically.
• To check whether the business has earned profits or incurred losses, we prepare a “Profit &
Loss Account”.

3. To determine the financial position

• Another important objective is to determine the financial position of the business to check the
value of assets and liabilities.
• For this purpose, we prepare a “Balance Sheet”.

4. To provide information to various users

• Providing information to the various interested parties or stakeholders is one of the most
important objectives of accounting.
• It helps them in making good financial decisions.

5. To assist the management

By analysing financial data and providing interpretations in the form of reports, accounting assists
management in handling business operations effectively.

Value: Value in Use and Value in Exchange

Value means the utility of a commodity. However, in economics, the term ‘value’ has two quite different
meanings.

These are explained below:

Value-in-use:
It is the want satisfying power of a commodity. The satisfaction which one obtains from the use of a
commodity is known as the value-in-use. For example water has immense use value, because it quenches
thirst and without it daily life is just impossible. The quality of water is the value-in-use of water.

Value-in-exchange:

It is the amount of goods and services which we may obtain in the market in exchange of a particular
thing. In other words, it is the price of a particular good which can be sold and bought in the market. For
instance, if one kg of rice can be obtained in exchange of one dozen of banana, then we may say that
value of one kg of rice is equal to one dozen of banana.
Capital

Capital can include cash or other assets introduced into a business by the owners.

Generally speaking, the term ‘capital’ refers to any financial resources or assets owned by a business that
are useful in furthering development and generating income.

Other context in which the word capital applies includes;

- Funds raised to support a particular business or project.

- Accumulated wealth of a business represented by its assets less liabilities.

-- Stock or ownership in a company.

Financial position
The financial position definition the status of financial well-being regarding a company, is important to
every single business. The financial position of a company is measured by the performance it takes in
company financial statements: a positive and growing cash flow statement; growing profits in the profit
and loss statement; and a balance of assets, liabilities, and owner’s equity in the balance sheet.

Financial position is the current balances of the recorded assets, liabilities, and equity of an organization.
This information is recorded in the balance sheet, which is one of the financial statements. The financial
position of an organization is stated in the balance sheet as of the date noted in the header of the report.

More broadly, the concept can refer to the financial condition of a business, which is derived by
examining and comparing the information in its financial statements. This typically means calculating a
number of financial ratios from the presented information, examining results on a trend line, and
comparing results to those of other entities in the same industry.

Assets vs. Liabilities

Assets add value to your company and increase your company's equity, while liabilities decrease your
company's value and equity. The more your assets outweigh your liabilities, the stronger the financial
health of your business. But if you find yourself with more liabilities than assets, you may be on the cusp
of going out of business.

Examples of assets are -

• Cash
• Investments
• Inventory
• Office equipment
 • Machinery
• Real estate
• Company-owned vehicles

Examples of liabilities are -

• Bank debt
• Mortgage debt
• Money owed to suppliers (accounts payable)
• Wages owed
• Taxes owed

Balance Sheet

The balance sheet is one of the three fundamental financial statements and is key to both financial
modeling and accounting. The balance sheet displays the company’s total assets, and how these assets
are financed, through either debt or equity. It can also be referred to as a statement of net worth, or a
statement of financial position. The balance sheet is based on the fundamental equation: Assets =
Liabilities + Equity.

As such, the balance sheet is divided into two sides (or sections). The left side of the balance sheet
outlines all of a company’s assets. On the right side, the balance sheet outlines the companies liabilities
and shareholders’ equity. On either side, the main line items are generally classified by liquidity. More
liquid accounts such as Inventory, Cash, and Trades Payables are placed before illiquid accounts such as
Plant, Property, and Equipment (PP&E) and Long-Term Debt. The assets and liabilities are also separated
into two categories: current asset/liabilities and non-current (long-term) assets/liabilities.

Balance Sheet Example

Below is an example of Amazon’s 2017 balance sheet taken from CFI’s Amazon Case Study Course. As
you will see, it starts with current assets, then non-current assets and total assets. Below that is liabilities
and stockholders’ equity which includes current liabilities, non-current liabilities, and finally shareholders’
equity.
How the Balance Sheet is Structured

Balance sheets, like all financial statements, will have minor differences between organizations and
industries. However, there are several common items that are almost always included in common
balance sheets. These include Current Assets, Long-Term Assets, Current Liabilities, Long-term Liabilities,
and Equity.
Current Assets

Cash and Equivalents

The most liquid of all assets, cash, appears on the first line of the balance sheet. Cash Equivalents are also
lumped under this line item and include assets that have short-term maturities under three months or
assets that the company can liquidate on short notice, such as marketable securities. Companies will
generally disclose what equivalents it includes in the footnotes to the balance sheet.

Accounts Receivable
This account includes the balance of all sales revenue still on credit, net of any allowances for doubtful
accounts (which generates a bad debt expense). As companies recover accounts receivables, this account
decreases and cash increases by the same amount.

Inventory
Inventory includes amounts for raw materials, work-in-progress goods, and finished goods. The company
uses this account when it reports sales of goods, generally under cost of goods sold in the income
statement.

Non-Current Assets

Plant, Property, and Equipment (PP&E)

Property, Plant, and Equipment (also known as PP&E) capture the company’s tangible fixed assets. This
line item is noted net of depreciation. Some companies will class out their PP&E by the different types of
assets, such as Land, Building, and various types of Equipment. All PP&E is depreciable except for Land.

Intangible Assets
This line item includes all of the company’s intangible fixed assets, which may or may not be identifiable.
Identifiable intangible assets include patents, licenses, and secret formulas. Unidentifiable intangible
assets include brand and goodwill.

Current Liabilities

Accounts Payable
Accounts Payables, or AP, is the amount a company owes suppliers for items or services purchased on
credit. As the company pays off their AP, it decreases along with an equal amount decrease to the cash
account.

Current Debt/Notes Payable

Includes non-AP obligations that are due within one year’s time or within one operating cycle for the
company (whichever is longest). Notes payable may also have a long-term version, which includes notes
with a maturity of more than one year.
Current Portion of Long-Term Debt
This account may or may not be lumped together with the above account, Current Debt. While they may
seem similar, the current portion of long-term debt is specifically the portion due within this year of a
piece of debt that has a maturity of more than one year. For example, if a company takes on a bank loan
to be paid off in 5-years, this account will include the portion of that loan due in the next year.

Non-Current Liabilities

Bonds Payable
This account includes the amortized amount of any bonds the company has issued.

Long-Term Debt
This account includes the total amount of long-term debt (excluding the current portion, if that account is
present under current liabilities). This account is derived from the debt schedule, which outlines all of the
company’s outstanding debt, the interest expense, and the principal repayment for every period.

Financial transaction
A financial transaction is one in which there is some sort of activity that changes the value of the assets,
liabilities, or owner's equity of an organization. These types of transactions are two-part transactions
consisting of a buyer and a seller, and they always involve money in some way. Financial transactions in
accounting are recorded in the accounting journal in chronological order.

Types of Financial Transactions

There are four main types of financial transactions that occur in a business. These four types of financial
transactions are sales, purchases, receipts, and payments. Let's take a minute to learn about each one:

• Sales are the transactions in which property is transferred from buyer to seller for money or
credit. Sales transactions are recorded in the accounting journal for the seller as a debit to cash or
accounts receivable and a credit to the sales account.
• Purchases are the transactions that are required by a business in order to obtain the goods or
services needed to accomplish the goals of the organization. Purchases made in cash result in a
debit to the inventory account and a credit to cash. If the purchase is made with a credit account,
the debit entry would still be to the inventory account and the credit entry would be to the
accounts payable account.
• Receipts are the transactions that refer to a business getting paid for delivering goods or services
to another business. The receipt transaction is recorded in the journal for the seller as a debit to
cash and a credit to accounts receivable.
• Payments are the transactions that refer to a business receiving money for a good or service. They
are recorded in the accounting journal of the business issuing the payment as a credit to cash and
a debit to accounts payable.
The duality of transactions
Duality aspect is the basic principle of accounting.
This concept assumes that every transaction has a dual effect, i.e. it affects two accounts in their
respective opposite sides. Therefore, the transaction should be recorded at two places. It means, both
the aspects of the transaction must be recorded in the books of accounts. For example, goods purchased
for cash has two aspects which are
(i) Giving of cash
(ii) Receiving of goods.

These two aspects are both to be recorded.

The duality principle is the basis of the Double entry accounting system, which is a standard of accounting
worldwide. Under the double entry system, aspects of transactions are classified under two main types:

1. Debit
2. Credit

Debit is the portion of transaction that accounts for the increase in assets and expenses, and the
decrease in liabilities, equity and income.

Credit is the portion of transaction that accounts for the increase in income, liabilities and equity, and the
decrease in assets and expenses.

The classification of debit and credit effects is structured in such a way that for each debit there is a
corresponding credit and vice versa. Hence, every transaction will have 'dual' effects (i.e. debit effects
and credit effects). In essence credit and debit must at the end of the day be equal (i.e balanced)

Profit

Profit is the revenue remaining after all costs are paid. These costs include labor, materials, interest on
debt, and taxes. Profit is usually used when describing business activity when earnings exceed expenses
for the period. It’s also called net income,

When expenses are higher than revenue, that's called a loss. If a company suffers losses for too long, it
goes bankrupt.

Balancing of the books

This is Closing up of accounts at the end of an accounting period, by bringing the totals of their debit and
credit sides into agreement, and thus to determine the profit or loss made during that period.
Trial Balance

Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step towards
the preparation of financial statements. It is usually prepared at the end of an accounting period to assist
in the drafting of financial statements. Ledger balances are segregated into debit balances and credit
balances. Asset and expense accounts appear on the debit side of the trial balance whereas liabilities,
capital and income accounts appear on the credit side. If all accounting entries are recorded correctly and
all the ledger balances are accurately extracted, the total of all debit balances appearing in the trial
balance must equal to the sum of all credit balances.

Purpose of a Trial Balance

Trial Balance acts as the first step in the preparation of financial statements. It is a working paper that
accountants use as a basis while preparing financial statements.

Trial balance ensures that for every debit entry recorded, a corresponding credit entry has been recorded
in the books in accordance with the double entry concept of accounting. If the totals of the trial balance
do not agree, the differences may be investigated and resolved before financial statements are prepared.
Rectifying basic accounting errors can be a much lengthy task after the financial statements have been
prepared because of the changes that would be required to correct the financial statements.

Trial balance ensures that the account balances are accurately extracted from accounting ledgers.

Trail balance assists in the identification and rectification of errors.

ABC LTD
Trial Balance as at 31 Dec 2016
Account Title Debit Credit

Share Capital Ksh Ksh

Share Capital 15000
Furniture & Fixture 5000
Building 10000
Creditor 5000
Debtors 3000
Cash 2000
Sales 10000
Cost of sales 8000
General & Administration
Expense 2000
Total 30000 30000
  Title provided at the top shows the name of the entity and accounting period end for which the
trial balance has been prepared.
 Account Title shows the name of the accounting ledgers from which the balances have been
extracted.
 Balances relating to assets and expenses are presented in the left column (debit side) whereas
those relating to liabilities, income and equity are shown on the right column (credit side).
 The sum of all debit and credit balances are shown at the bottom of their respective columns.

Accounting errors

When doing accounting, one is bound to make errors from time to time. These errors are the ones
auditors come to detect. The following are types of accounting errors

Omission
An error of omission occurs when a transaction is completely omitted from the books of your company.
You may forget to enter an expense transaction or enter the sale of a product or service. These
transactions are difficult to detect.

Reversal
An error of reversal occurs when a transaction that should have been posted as a debit is posted as
credit.

Principle
An error of principle occurs when one wrongly applies an accounting principle.

Commission
An error of commission occurs you enter a transaction to the correct class but the wrong subsidiary
ledger. For example, you will commit this error if you apply a payment to the wrong invoice.

Subsidiary Entry
An error of subsidiary entry occurs when an error is made when entering a transaction. For example, if
you loan a customer ksh.5,000 but enter only ksh.500 as a loan
Calculating profitability

Gross Profit Margin:

Gross profit = Total sales – Total purchases

Gross Profit Margin is calculated using the formula given below

Gross Profit Margin = (Gross Profit / Sales) * 100

Net Profit Margin:

Net profit Margin = Gross profit – expenses

Net Profit Margin is calculated using the formula given below

Net Profit Margin = (Net Income / Sales)* 100 (sales means Total sales)

Fixed Assets
Fixed assets are long-term assets that a company has purchased and is using for the production of its
goods and services.

Fixed assets are noncurrent assets, meaning the assets have a useful life of more than one year. Fixed
assets are also referred to as tangible assets, meaning they're physical assets.

Below are examples of fixed assets:

Vehicles such as company trucks

Office furniture
Machinery
Buildings
Land
Depreciation of fixed assets
The value of an asset is not fixed and will reduce over time depending on various factors, including aging.
In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a
systematic manner until the value of the asset becomes zero or negligible.

Land is the only fixed asset which is an exception to depreciation. Land cannot be depreciated since the
value of land appreciates with time.

An example of Depreciation – If a delivery truck is purchased a company with a cost of ksh.100,000 and
the expected usage of the truck are 5 years, the business might depreciate the asset under depreciation
expense as Ksh.20,000 every year for a period of 5 years. Meaning that in accounting terms, the truck will
have zero value in 5 years.

Accounting for Stocks

Stock refers to the items that a business has bought with the intention of reselling to customers. The
items may be resold without change, or they could be combined into a new product.
Equipment and supplies bought to run business, such as work tools, vehicles and stationery, typically
aren’t treated as stock. They’re recorded as expenses or assets.

Types of stock

There are three broad categories of stock as outlined below;

1. Merchandise you’re reselling

These are items for sale in a shop (and the extra supplies in the store room).

2. Products for installation

Service providers often keep small supplies of products which they sell along with their
labour. A plumber, for example, will sell gaskets and filters as part of a job.

3. Manufacturing stock
There are three types of manufacturing stock as outlined below.

Raw materials stock:

This is stock that will be used to make something. It could be ingredients for a cake, or
metal used in fabrication.
 Work in progress stock:
These are items that aren’t yet ready for sale but have been moved beyond the raw
materials stage.

Finished goods stock:

Once manufacturing is complete and the items are ready to sell, they’re classified as
finished goods.

Stock accounting

Stock has value – even before anything is done with it. Stock is therefore listed as an asset in a business
balance sheet. But it can lose its value fast if it gets old, out of date, damaged, or the market price for that
type of product drops. It also costs money to store.

Stock accounting helps in determining the value and costs of your stock. That’s important for things like
setting prices, getting insured, budgeting, working out taxes, and selling a business.

Benefits of stock management

Stock accounting and management can both save money, and make money. Its benefits are as follows;

- Maximise sales
Make sure you never run out of a product that people are buying.

- Lower bills
Reduce storage costs by ordering fewer of slow-moving items.

- Avoid waste
Keep tabs on write-offs due to damage, product expiry, and theft.

- Shows where the profit is

Properly tracking of stock costs will tell you the true margin that products make.

- Help in marketing
Identifying seasonal sales trends will help plan promotions.

- Help maintain cash flow

Instead of tying up money in slow-moving products, you can keep it as cash and use it for
more productive things like paying down debt or improving the business.
Types of Stock Transactions

There are three main types of stock transactions, which are:

- The sale of stock for cash
- Stock issued in exchange for non-cash assets or services
- The repurchase of stock

Recording Stock
Beginning stock is the goods unsold at the start of the accounting period, and ending stock is the goods
unsold at the end of the accounting period.

Stock or inventory is recorded in the balance sheet of the business at cost, or if lower market value, under
the heading current assets, that means it is expected to be convertible into cash within a year. Cost in this
context means the price paid plus the direct and indirect costs of bringing the item to its existing
condition and location ready for sale.

Bookkeeping and accounting for stock is carried out using three separate accounts as outlined below;

The Sales account which records the reductions in stock at selling prices and is transferred to the
income statement at the period end.

The Purchases account which records the additions to stock at cost and is transferred to the
income statement at the period end.

The Stock Account in the balance sheet which maintains the beginning and ending balances.

The reason for the three accounts is that purchases (increases) are at cost, and sales (decreases) are at
selling price (i.e. they include a profit). If both sales and purchases were recorded on one account the
balance would be a meaningless figure including the profit element, and would not represent the true
beginning and ending balance.

Key terms used in Inventory accounting

There are two key terms when it comes to inventory accounting:

- Cost of goods sold (COGS)

This is the direct costs of producing any goods sold by a company.

- Ending inventory (EI).

This is the value of any unsold, on-hand inventory at the end of an accounting period.
Cost of goods sold (COGS)
Cost of goods sold (COGS) is a core element of measuring a retail business’s profitability and inventory
value.

As the name suggests, COGS refers to the amount it cost a business to produce the products it sold,
including everything that went into it – materials, labour, tools used, etc. But (crucially) without factoring
in costs not directly tied to the production process – like shipping, advertising and sales force costs, etc.

As a result, COGS helps determine the amount of gross profit made in one or more sales.

For example:
If you sell an item valued at Ksh.50 and the COGS is ksh.30, your company has achieved a gross
profit of Ksh.20.

All inventory sold will be listed under the COGS account in income statement at the end of each business
year.

Calculating COGS
To calculate cost of goods sold (COGS) for an accounting period, you’ll need to:

1. Determine what costs can be associated with the production process of your specific
products – like labour, raw materials, tools, etc.
2. Take the cost of beginning inventory (BI).
3. Add the cost of newly purchased inventory during the period in question.
4. Subtract leftover, unsold inventory at the end of the accounting period.

Ending inventory (EI)

It’s highly likely that a business will not sell the entirety of its inventory at the end of each accounting
period. Meaning any on-hand, unsold stock becomes an asset that must be valued and included in
financial statements. This is referred to as ending inventory (EI).

To calculate Ending inventory (EI)

- Take the beginning inventory (the units carried over from the end of the previous financial
period).
- Add any newly purchased inventory throughout the accounting period.
- Subtract any units sold.

This leaves the final inventory figure to be included as a company asset.

Note however: We need to assign an actual value to the unsold inventory figure (i.e. how much this
company asset is worth in monetary terms). This can become a lot more complicated because of the
following;
- Numerous purchases of new stock and raw materials are usually made during a typical 12-
month accounting period.
- Each purchase may have come at a different cost per unit.
- Sales are also being made at the same time, turning inventory into cash.

In this case it’s not possible to identify which cost per unit figure to use to value unsold inventory, since
there are so many moving parts in a typical accounting period. This is where inventory valuation methods
comes in

Inventory valuation methods

Sticking to a specific method for inventory valuation is critical for consistent, accurate and (most
importantly) legally acceptable financial statements.

There are three main valuation methods retail companies use for inventory accounting:

First In, First Out (FIFO)

Last In, First Out (LIFO)
Average Cost Method

One just needs to stipulate which one is being used when submitting financial records and accounts.

1) FIFO
FIFO is a useful inventory management technique to actually use in the handling of stock in your
warehouse. But it’s also a method of valuing unsold inventory.

It assumes inventory that was purchased first, is also the first to be sold. So the oldest on-hand
inventory available is what will be used to fulfil an order.

There are a number of benefits to the FIFO method. Primarily, companies selling perishable goods
(food and drinks) face less risk of their products spoiling or crossing best-before sale date. They
can establish a smooth supply chain and ensure their clients receive the freshest items in their
inventory.

All products received and sold must be recorded individually when using the FIFO accounting
method. It’s possible that the FIFO system can lead businesses to under or overestimate the value
of inventory in the future, due to market changes down the line.
 2) LIFO
The LIFO approach works on the assumption that the most recent products added to your
inventory are the first ones to be sold first.

This system works well for retail businesses specializing in non-perishable goods or those with a
low risk of obsolescence. It can also increase COGS and lessen net profit (therefore reducing
annual tax liability) if more recently purchased goods are more expensive.

3) Average Cost
Average Cost (or weighted-average) inventory accounting method is totally different to the
previous two.

This applies to businesses that choose not to track cost per inventory unit for each separate
purchase delivery. Instead, inventory value is based on the average cost of items throughout the
relevant period.

Average cost is calculated by dividing the overall cost of products for sale by the total number in
the inventory.

Costing a Product or Service

It is important to understand the impact of pricing on profitability and be able to choose the best pricing
strategy for a business. Costing a product or service is straightforward and is determined by the business,
but pricing is essentially set by the marketplace.

The price of a product or service needs to cover all the costs and allow for a profit, but it must also take
account of what competitors are charging and how much customers will be prepared to pay. Setting too
high a price can lead to lost sales. Setting too low a price will reduce profits and possibly result in the
business failing.

Common terms used in costing and pricing

Costs

- Direct costs
The direct cost of a product or service is the cost incurred in producing and supplying the
product or service. These costs are also known as 'variable costs', because they vary in
direct proportion to the number of units produced. Direct costs include, for example, the
 cost of raw materials, bought-in components or goods and direct wages (that is the wages
of staff employed specifically to produce the product or service).

- Fixed costs. Every business has costs that are incurred regardless of whether any products
are produced or sold. These fixed costs are also known as 'overhead costs' and include
items such as the owner's salary or drawings, employee salaries, rent, rates, electricity and
depreciation in the value of any fixed assets such as machinery and equipment.

Pricing

- Cost plus pricing.

This is a traditional method of calculating the price to charge and is often used in pricing
products rather than services. It is based on applying a percentage markup on top of the
direct costs of a product in order to cover fixed costs and make a profit.

- Value-based pricing.
This involves setting a price based on what the market will bear. The impact of factors such
as fashion, convenience and market share affect the price level that can be achieved.

Profit

- Breakeven point. The breakeven point is the point at which revenue from sales exactly
equals all the costs incurred by a business. A higher level of sales will result in a profit;
fewer sales will result in a loss.

- Gross profit. Gross profit is the selling price less the direct costs involved in making a
product or delivering a service.

- Operating profit. A business' operating profit is the gross profit minus the fixed costs.

- Contribution.
As long as a business sells a product for a higher price than the direct cost, the income
received from the sale of the product will make a contribution to the fixed costs of the
business and then to the operating profit. If a business sells a range of products, it should
look at the gross profit generated by each product to compare their contribution. The
product that has the highest volume of sales may not have the highest level of
contribution, but could still be a useful product for the business to offer in order to attract
and retain customers.
Understanding costs

In essence, costing and pricing is very simple - work out all the costs and then charge a price that is higher
than those costs. In practice, the process is more complicated as it is sometimes difficult to identify
exactly what are variable costs and what are fixed costs.

All costs incurred by a business ultimately need to be covered by the sales of its products or services, so
that the more it sells, the less contribution is needed from each unit sold in order to cover the overheads.
Costing does, therefore, depend on an estimate of how many products or hours of time the business can
sell.

Calculating costs for a production-based business

A production-based business can calculate the total cost per unit produced, but it will need to know the
direct costs for each unit, as well as the actual or expected fixed costs for the business. A business
producing just one product will need to divide its total fixed costs by the number of units it expects to
produce. Adding this figure to the direct cost per unit will give the total cost per unit. If a business
produces several products, it will need to apportion its fixed costs to each different product range, and
divide by the number of units produced in each range.

For example, consider a furniture business that makes picture frames. The business expects to make and
sell 100 picture frames during the year. The direct costs of materials used to make each picture frame,
such as wood, glue, screws and packaging, are ksh.50. The total fixed costs or overheads of the business
(which includes the value of the owner's time) for the year are estimated to be Ksh.30,000, which gives a
fixed cost for each picture frame of ksh.300. The total cost to produce each picture frame is therefore
ksh.350.

Assuming that there are no additional costs incurred, the business can significantly reduce the cost of
producing each picture frame by increasing the number made, so the business could consider selling the
picture frames at a lower price if it adopts a cost plus pricing approach, or it could maintain the price and
achieve a much higher profit if it adopts a value-based pricing approach.

Calculating costs for a service-based business

A service-based business will need to be able to calculate its average daily or hourly cost. When
calculating costs, it is important to understand that not all working hours will be productive and that most
service businesses have low direct costs and high fixed costs.

A service-based business needs to consider the amount of time that will be required for promoting the
business, buying supplies, managing the business and doing other administrative jobs. An allowance will
also need to be made for any holidays staff take and any other time off, such as for illness. To calculate
the daily cost, the annual fixed costs of the business should be divided by the number of productive days
expected over the course of the year. It is possible to calculate an hourly cost to the business by dividing
this figure by the number of hours worked each day.

Setting prices

There are two main steps to follow when setting a price:

- Determine the costs of producing and delivering a product or service.

- Set a price that is high enough to cover the costs, but low enough to be competitive.

It is important for any business to research their market carefully to determine the price range that they
will be able to charge. This can be difficult for start ups, since they may have little information on which
to base their pricing decision. They can only refer to the prices charged by their competitors and compare
these with the market research they have carried out with potential customers.

Once a business is established, pricing becomes easier since it can adjust its prices up and down and
review the effect this has on demand.

Prices can always be changed, but there may be customer resistance if an increase is too great or if prices
are changed too frequently. Ultimately, the price that is charged depends on what the market will stand -
that is, on how much the customer is prepared to pay. By understanding the true cost of producing a
product or delivering a service, it is possible to make a decision as to whether it is cost effective for the
business to sell goods or services at that price.

Pricing and sales volumes

The price at which a business sells its products will have an impact on the number of units it is able to sell.
However, just selling a greater volume of products does not mean that the business will generate a higher
profit.

Pricing against competitors

Many start ups have difficulty calculating the direct costs of their products or services before they start
trading and, as a result, effectively let their competitors set the price. They think that as long as they
undercut that price, they will succeed. But this approach to pricing is a strategy that often fails for a new
business. Because a new business lacks the economies of scale necessary to make its price really
competitive, it can end up being unable to make a profit, which is necessary to sustain the business.

Customers frequently quote price as their main buying consideration, but products and services can be
differentiated in comparison to competitors in many ways other than price. Often there are also other
factors involved in customers' buying decisions such as the level of post-sale support provided.
Other pricing considerations

There are a number of other issues that may affect the prices a business charges.

- Flexible pricing
A business might offer special prices across a range of products at different times of the year.

- Volume discounts
There may be a number of advantages to offering price discounts for customers who make bulk
purchases:

The lower gross profit per unit sold is offset by the higher total gross profit generated by the total
bulk order.

There will be lower costs associated with supplying one larger order to one customer.

By achieving higher total sales for a product, a business may be able to achieve lower unit costs for
each product, due to increases in its productivity and buying power. This reduction in cost can
allow the business to increase its gross profit, even though its average unit selling price is lower.

- Total customer value

By understanding the total potential value to a business of an individual customer, it may be able
to achieve a higher gross profit by selling a range of products to that customer at lower prices than
the business would typically charge for each individual product.

It may be possible to negotiate fixed prices for the products that the business supplies, based on
the customer committing to purchase a minimum volume of the products over an agreed term, so
that they will treat the business as their sole or preferred supplier for those products.

Although the business will generate a lower gross profit on individual products sold, the total gross
profit generated from the full range of products sold to that customer will be greater, so the
business will be more profitable.

- Variable prices

A business might charge different prices for providing premium services at unsociable hours or
charging variable rates depending on the season, for example if the business is in the tourism
sector.