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The Dynamics of Markups and Inventories

  1. The Process of Marking Up Merchandise

Markup is the difference between the current lowest price a dealer offer and the highest price the dealer could charge a customer. It usually varies from one business to another depending on the size of the business. Markups arise when dealers operate as principles that are trading in marketable securities from their own accounts thereby taking the risks by themselves. (Rugledge, 1996)The only compensation for the transaction is the markup which is the difference between price of the marketable security at the time of purchase and the price the dealer charges the retail investor.

It is the amount the seller charges over and above the total cost of producing and selling the product or service. Assuming a total cost of a manufacturer’s product is $ 150, but its selling price is $ 175, then the extra $ 25 is understood to be the markup. Actually Cost + markup = Selling Price. Assuming a retail list price of $ 1.99 and product cost of $ 1.40, then Markup = price _ cost. Thus the Markup = (1.99_ 1.4) = 0.59. It is usually important that before starting a business the markup is established. From the above simple illustration markup is more or less the same as the profit. Markups are therefore determined in advance to enable the business to meet all the expected expenses as well as reductions. (Aguirregabiria, 1999).

  1. Methods of mark up merchandise

Mark up can be expressed in several forms. This attempts to create a better understanding of the markup. Mark up itself is the profit made per item sold. For better comparison to be made on this profit it is expressed as a percentage on cost, selling price or on perishables. When expressed as percentage of cost it is calculated by dividing mark up by cost * 100. Mark up itself is the profit from selling a commodity and it is calculated by subtracting cost from the selling price of a commodity (Nelda et al 1997).

Based on selling price the mark up is expressed as a percentage of the selling price instead. This can be expressed as mark up divided by selling price *100. This makes the mark up on selling price higher than the mark up on cost because the selling price is higher than the cost of the commodity. Percentage Mark up on selling price can be converted to percentage mark up on cost and the vice versa through the following formulas (Nelda et al 1997)

The above formulae coverts percent mark up on cost to percentage mark up on selling price. For the vice versa to be done the formulae below is used

Mc = Ms        where Mc= Mark up on cost

100% – Ms    Ms=Mark up on selling price

(Nelda et al 1997)

Since some of the commodities are perishable they can be sold at a lower price than the actual. This can lead to total loss making the selling price to be higher for compensation of the loss incurred. The mark up is calculated using the basic formulae but the items sold at reduced prices are treated separately (Nelda et al 1997).

  1. Markdown

There are times when the merchandisers don’t sell the commodities at it original selling price. The price is reduced and the markdown is calculated as follows:

Reduced price=original price – markdown

There is no automatic loss to be incurred as there can be a reduced net profit if the price is able to meet all the costs. At this price the merchandisers can be operating at break even point where they are able to meet the costs and the overheads. There is also a possibility of having revenue or the price is below the break even analysis. At this point the merchandisers will be at operating loss. Option for Absolute loss is not an exemption and can occur when the price is below cost (Nelda et al 1997).

Markdown occurs due to stiff competition, retailer are forced to markdown their merchandisers by lowering the price. This will help them maintain a large pool of customers. They will make a reduced net profit per item sold by end up selling more items and they don’t incur Mark up on perishables. The net profit on all sales will be enough for him to make good profits (Nelda et al 1997).

  1. Simple Interest

Simple interest is the return that investors receive from banks for saving their money with the bank for some period of time, T. Equally, the bank will charge some levy (simple interest, I) on borrowed money with which the borrower is expected to repay along with the initial borrowed amount. In other words, simple interest is the opportunity cost on capital.(Nelda et al, 1997)  For an investor to save, they have to forgo or ‘sacrifice’ some level of consumption and have to be rewarded for that ‘sacrifice’. Therefore the bank allows for growth on the deposited money also known as the Principle at a growth rate, R.

Likewise when the bank lends, they forgo other business operations from which they would have generated returns. To account for this forgone opportunity, they have to charge a simple interest rate R on any borrowed amount for the lending period T. Therefore simple interest, I = PRT. Where, I= interest, P =principle, R= rate of interest per year and T= time in years. The interest rate R is usually expressed as a percentage. R can also be expressed semiannually, quarterly or even daily depending on the nature of the transaction. The simple interest rate R is divided by the number of days in a year (usually 360 days) in many Accounting and Finance related transactions although 365 days could also be used (Nelda et al, 1997)

Assuming $ 2600 is invested for 7 months with a total interest of $ 144.08 Given that I = PRT, then $144.08=$26600* R* (7/12) = 1516.67R. Solving for R above, (144.08/1516.57) gives 0.95 or 9.5%. As earlier stated, the above equation can be manipulated to obtain all the three variables at different times and rates. For instance given the same $2600 invested at 10.5% for 180 days, our ordinary interest will be; I = PRT. That is, (2600*0.1058*(180/3600)). Solving the above I=$136.5 Simple interest is usually used by banks because it is simple to administer once the rate of interest has been determined by the bank. (Nelda et al 1997).  Equally, our T will simply be I/PR

  1. The truth in lending law

The lending law basically postulates that there should be a declaration of purpose on behalf of the lending bank t it customer. This law is applied in the sense that customers before they pick any loan with any lender bank. The bank should or have a responsibility of informing the customers seeking loans on the credit terms so that he/she can compare and pick that loan scheme which suit them. This law also prevents unfair billing of the loan holder by the bank an also prevents bans from misleading clients with confusing credit terms. (Dunaway, 2008)

The truth in lending act (1967) which also forms part of the consumer credit protection stipulates that lending banks should disclose methods which they use in calculating charges; this is basically meant to ensure that the banks do not levy hidden charges on its customers. On the other hand the borrowers also have rights of rescission in that they are allowed by law to stop their contract with the bank within three days of enactment; this law is of great importance to the borrowers since one may get into a lending contract with a bank out of false information.

The lending law also faults discrimination in lending by banks/lenders. creditor ought not to discriminate on the basis of where one comes from, sex, creed etc and in any case the borrowers request has not been accepted by the bank due to reasons other than the above then the bank must provide a written notification of not accepting the request. (Baron, 2007)

  1. Amount mad bury loaned

June 18th

3 months=92days thus

Total period =12+20=32

T= 32/360 =0.089

M =P (1+RT) = $10,000(1+0.12× 0.089)

M= $10106.8

Amount Mad bury would receive when the note is rediscounted.

New principle=$10106.8

Time between available after the rediscounting is 60 days i.e. the total period of maturity which was r=three months totaling to 92days-32days which I the period the note took under mad bury this results to 60days

Time = T=60/360=0.167

M=P (1+RT) =10106.8(1+0.11×0.167)

M= $10292.09 

  1. Certificates of Deposits

They are special types of deposit accounts with banks. They are special in that they offer higher interest rates than the ordinary deposit accounts in banks. They normally feature a fixed deposit of up to $100,000 on federal insurance. In CDs the investor deposits a fixed amount of money with the CD for fixed period of time e.g. 1 year. In return, during this period the bank will pay interest at fixed intervals and on redeeming your money you receive an amount of money equal to what you deposited plus the interest accrued. In case the money is redeemed earlier than the fixed time, a penalty has to be paid or some of the accrued interest is forfeited (US Securities and Exchange Commission, 2007).

Though it used to be done by the bankers, of late brokerage firms and independent salespeople have come up. They negotiate with the banks for higher rates with promise of bringing back some deposits and they offer brokered CDs to the customers. Several variations have come up in CDs where the customer can demand for variable rate of interest for long term deposits unlike before where the rates were constant. Also banks can terminate without expiry of the term (US Securities and Exchange Commission, 2007).

From the rate of Zions Bank as at August 29, 2008 accounts with a minimum deposit of $1000, and rate of 4.08% in a year. I found this to offer the best rate for this amount. Annual interest for this account is $408. This translates to a cumulative interest of $2040 in five years. If one redeems the money at the end of five years, he can make an investment of $2040 but incase of an early withdrawal, the earning will be little due to penalties (Bankaholic, 2008)

  1. Comparison between Actuarial Method and 78s

Both rule 78s and actuarial method are methods that are methods that are used in calculating interest. Rule 78 is basically a method of calculating interests on money borrowed by banks to its clients in situations where the borrower is wiling to pay of the loan before the maturity day elapses. This method is also known as the sum of the digits 1-12 of which translates to 78.

On the other hand actuarial funding method is a method of allocating the payments of interests on the amount lent and the lending charges in which a payment is first made to the accumulated finance and the remaining balance made on the unpaid amount lent. The actuarial method can be broadly categorized into accrued benefit funding method which focuses on maintaining a certain level of funding as well as the prospective benefit funding method which in contrast defines to some extent some level of contribution. (Pugh,  2003)

Rule 78 method generally would cost more depending on the number of repayment periods, the more the number of the repayment periods the higher the interest payment through this method unlike in the actuarial method that the costs/interest rate charged basically remains constant depending on the contract.(Teacher and money-online) It’s also important to note that the rule 78 method and the actuarial method of calculating interests are basically not that worlds apart in that they only provide different methods of arriving at the same goal which is determining the amount of interest to be paid by the borrower.

  1. Comparison between Sinking funds and Bonds

A bond is a marketable security. They are long term loans that financial institutions offer to the public through the stock markets. A bond is therefore a source of long term loan to a business or an individual. They usually mature after a specific amount of time which is normally fixed by the lending institution. The return that investors receive from investing in bonds is the yield on bonds.  (Nelda et al 1997) This however does not mean that bonds do not have an element of risk. Just like equity capital or any other source of business finance bonds are also prone to financial risks that are common with sources of business finance.

Normally there are treasury and government bonds and. Bonds are usually not insured. Government bonds are usually offered to the public at a lower price and are of more quality as compared to treasury bonds. To calculate risk in bonds, the monthly Treasury bill is usually subtracted from the total funds generated from each of the months in the operating period. Therefore bonds being long term debts are usually issued to businesses as a way of reducing their debts or even raising their asset values. (Nelda et al 1997)

Sinking funds are also more or less the same as the bonds. However they tend to differ only in some minor ways of operations. Such differences may arise in terms of the length of time that each security takes to mature in the bonds market. In this case it can actually be said that a sinking fund is a special type of a bond. (Nelda et al 1997)  They are similar in the sense that they are both traded in the bonds market and generally issued for the same purposes. For instance even sinking funds don have some elements of risk. The only difference with regards to risk is in the way in which the risk is cushioned or treated.

As opposed to bonds, sinking funds are usually insured with regards top risk. The implication here is that unlike bonds, sinking funds do have some custodian accounts which can always give room for redemptions or buyouts. Likewise unlike bonds which mature after a long period of time, sinking funds mature after a short duration of time. The preferred sinking funds usually require that a compulsory redemption of some fixed percentage of the issues in a year till the issue is completely finished. In the case of sinking funds, the institution that issues the bond is usually allowed through the open market operations to buy the part of the issues that are to be redeemed. (Nelda et al 1997)

10 Annuities

It is a type of insurance product and act as investment especially during retirement. It works by buying an annuity and then making a sequence of payments periodically equal to the amount and period of payment in return. When one buys a lifetime annuity he will in return get payment for the rest of his life.  This payment is tax deferred until the payment is made. They are useful in funding retirement and education costs. Living more the expected lead to someone earning more than paid and living less result to being paid less than what someone paid (Financial Guide, 2008).

When a fixed equal payment or receipts are made over uniform time interval it is called an annuity. They include several examples like insurance premiums or higher purchase payments. In simple annuities, the time or period for interest is the same as the time between the payments. Here annuity is the period between the first payment and the last payment. Beyond this period it is said to have expired and the money available is called future value of annuity (Simic, 2007).

Ordinary annuity is the money or annuity that is paid at the last payment interval.

There are investors that invest in order to meet set targets at some future date. This type of investment is called sinking fund. They are normally used for debt repayment here one normally pay the money with an aim of meeting a set target in a specified date. This lead to the investor regulated payments for the set target to be achieved (Simic, 2007).

References

Aguirregabiria, V. (1999). The Dynamics of Markups and Inventories in Retail

          Firms. Review of Economic Studies

Bankaholic, (2008).  High interest 1yr CD rates

Barron (2007). Consumer Credit Protection Act, Barrons educational series, regulation B.

Dunway, M. (2008). Truth in lending Act-TILA, retrieved on 30th august from,

         www.mathewdunaway.com

Gordon K. Williamson, (1993). All About Annuities: Safe Investment Havens

          for High Profit returns.

Nelda, R., Virginia, H.G., and Michael, D. (1997). Business Mathematics;

           A Collegiate Approach 9th Edition. Pearson Prentice Hall

Pugh, C. (2003).  Report on Funding rules and Actuarial methods

           p17 Teachers and money-compounding at

          http://www.angelfire.com/ca/hennings1/A compounding.html

Rugledge, J. (1996). Pricing for Growth. Forbes.

Simic K (2007) Annuities and Sinking Funds Available at http://math.arizona.edu/%7Eksimic/65.pdf Accesed on August 31, 2008

US Securities and Exchange Commission, (2007) Certificate of deposit: Tips for Investor

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