CHAPTER 8

Pricing
ASSIGNMENT CLASSIFICATION TABLE
A
Problems

B
Problems

3, 4, 5,
6, 7

1A, 2A

1B, 2B

8, 9, 10

3A

3B

7, 8, 9

11, 12, 13,

14, 15

4A, 5A, 6A

4B, 5B, 6B

10, 11

16, 17, 18

7A, 8A

7B, 8B

Study Objectives

Questions

Brief
Exercises

Exercises

*1.

Compute a target cost when

the market determines a
product price.

1, 2

1, 2, 3

*2.

Compute a target selling

price using cost-plus
pricing.

3, 4, 5, 6,
7, 8

2, 3, 4, 5

*3.

Use time-and-material
pricing to determine the
cost of services provided.

9, 10

*4.

Determine a transfer price

using the negotiated, costbased, and market-based
approaches.

11, 12, 13,

14, 15, 16,
17

*5.

Explain issues involved

in transferring goods
between divisions in
different countries.

18

*6.

Determine prices using

absorption-cost pricing
and variable-cost pricing.

19, 20

*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix
to the chapter.

8-1

ASSIGNMENT CHARACTERISTICS TABLE

Problem
Number

Description

Difficulty
Level

Time
Allotted (min.)

1A

Use cost-plus pricing to determine various amounts.

Simple

2030

2A

Use cost-plus pricing to determine various amounts.

Simple

2030

3A

Use time-and-material pricing to determine bill.

Simple

2030

4A

Determine minimum transfer price with no excess capacity

and with excess capacity.

Moderate

2030

5A

Determine minimum transfer price with no excess capacity.

Moderate

2030

6A

Determine minimum transfer price under different situations.

Moderate

2030

*7A*

Compute the target price using absorption-cost pricing and

variable-cost pricing.

Moderate

3040

*8A*

Compute various amounts using absorption-cost pricing and

variable-cost pricing.

Complex

4050

1B

Use cost-plus pricing to determine various amounts.

Simple

2030

2B

Use cost-plus pricing to determine various amounts.

Simple

2030

3B

Use time-and-material pricing to determine bill.

Simple

2030

4B

Determine minimum transfer price with no excess capacity

and with excess capacity.

Moderate

2030

5B

Determine minimum transfer price with no excess capacity.

Moderate

2030

6B

Determine minimum transfer price under different situations.

Moderate

2030

*7B*

Compute the target price using absorption-cost pricing and

variable-cost pricing.

Moderate

3040

*8B*

Compute various amounts using absorption-cost pricing and

variable-cost pricing.

Complex

4050

8-2

8-3

Broadening Your Perspective

*6. Determine prices using

absorption-cost pricing
and variable-cost pricing.

Q8-19

Q8-20
BE8-10
BE8-11
E8-16
E8-17

BE8-6
E8-8
E8-9
E8-10

Q8-4
Q8-7
Q8-8
BE8-2
BE8-3
BE8-4
BE8-5
E8-3

E8-1
E8-2
E8-3

E8-18
P8-7A
P8-8A
P8-7B
P8-8B

P8-3A
P8-3B

E8-4
E8-5
E8-6
E8-7
P8-1A
P8-2A
P8-1B
P8-2B

Application

Exploring the Web Real-World

Ethics Case
Focus
All About You

Q8-18

Q8-9

*5. Explain issues involved in

transferring goods between
divisions in different countries.

Q8-10

*3. Use time-and-material pricing

to determine the cost of
services provided.

Q8-6

Q8-11
Q8-12
Q8-14
Q8-17

Q8-3
Q8-5

*2. Compute a target selling price

using cost-plus pricing.

Q8-2
BE8-1

Comprehension

*4. Determine a transfer price using Q8-13

the negotiated, cost-based, and Q8-15
market-based approaches.
Q8-16

Q8-1

Knowledge

*1. Compute a target cost when

the market determined a
product price.

Study Objective

E8-15
P8-4A
P8-5A
P8-6A
P8-4B
P8-5B
P8-6B

Synthesis

Manag. Analysis Decision Making

Communication Across the
Ethics Case
Organization
Manag. Analysis
Real-World
Focus

BE8-7
BE8-8
BE8-9
E8-11
E8-12
E8-13
E8-14

Analysis

Decision Making
Across the
Organization
Real-World Focus
Communication
Ethics Case

Evaluation

Correlation Chart between Blooms Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOMS TAXONOMY TABLE

STUDY OBJECTIVES
1. COMPUTE A TARGET COST WHEN THE MARKET
DETERMINES A PRODUCT PRICE.
2. COMPUTE A TARGET SELLING PRICE USING COSTPLUS PRICING.
3. USE TIME-AND-MATERIAL PRICING TO DETERMINE
THE COST OF SERVICES PROVIDED.
4. DETERMINE A TRANSFER PRICE USING THE
NEGOTIATED, COST-BASED, AND MARKET-BASED
APPROACHES.
5. EXPLAIN ISSUES INVOLVED IN TRANSFERRING GOODS
BETWEEN DIVISIONS IN DIFFERENT COUNTRIES.
*6. DETERMINE PRICES USING ABSORPTION-COST PRICING AND VARIABLE-COST PRICING.

8-4

CHAPTER REVIEW
External Sales
1.

(S.O. 1) Some of the many factors that can affect pricing decisions include:
a. Pricing Objectives
Gain market share
Achieve a target rate of return
b. Environment
Political reaction to prices
Patent or copyright protection
c. Demand
Price sensitivity
Demographics
d. Cost Considerations
Fixed and variable costs
Short-run or long-run

2.

In most cases, a company does not set prices. Instead the price is set by the competitive market
(laws of supply and demand). These companies are called price takers and price taking often
happens when the product is not easily differentiated from competing products, such as farm
products (corn or wheat) or minerals (coal or sand).

3.

Companies can set prices (1) where the product is specially made for a customer, (2) when there
are few or no other producers capable of manufacturing a similar item, or (3) when a company
can effectively differentiate its product or service from others.

Pricing in a Competitive Market

4.

Once a company has identified its segment of the market, it does market research to determine
the target price. The target price is the price that the company believes would place it in the
optimal position for its target audience. Once the company has determined the target price, it can
determine its target cost by setting a desired profit. The difference between the target price and
the desired profit is the target cost of the product. The target cost includes all product and period
costs necessary to make and market the product.

Cost-Plus Pricing
5.

(S.O. 2) When the price is set by the company, price is commonly a function of the product or
service. Cost-plus pricing involves establishing a cost base and adding to this cost base a
markup to determine a target selling price. The size of the markup (the plus) depends on the
desired operating income return on investment (ROI) for the product line, product, or service. The
cost-plus pricing formula is expressed as follows:
Target selling price = Cost + (Markup Percentage X Cost)

6.

The cost-plus approach has a major advantage: it is simple to compute. However, the cost model
does not give consideration to the demand sidethat is, will the customers pay the price. In
addition, sales volume plays a large role in determining per unit costs. The lower the sales
volume, the higher the price a company must charge to meet its desired ROI (because fixed costs
are spread over fewer units and therefore the fixed costs per unit increases).

8-5

7.

Instead of using both fixed and variable costs to set prices, some companies simply add a markup
to their variable costs. Using variable costing as the basis avoids the problem of using poor cost
information related to fixed cost per unit computations.

Time and Material Pricing

8.

(S.O. 3) Under time and material pricing, the company sets two pricing ratesone for the labor
used on a job and another for the material. The labor rate includes direct labor time and other
employee costs. The material charge is based on the cost of direct parts and materials used and
a material loading charge for related overhead costs.

9.

Using time and material pricing involves three steps: (1) calculate the per-hour labor charge,
(2) calculate the charge for obtaining and holding materials, and (3) calculate the charges for a
particular job.
The per-hour labor charge typically includes the direct labor cost of an employee, selling,
administrative, and similar overhead costs, and an allowance for a desired profit of employee
time. The charge for materials typically includes the invoice price of any materials used on the job
plus a material loading charge. The charges for any particular job are then a result of (1) the labor
charge, (2) the direct charge for materials, and (3) the material loading charge.

10.

To illustrate a time and material pricing situation, assume the following data for Rancho Park Golf
Club Repair Service:
Rancho Park Golf Club Repair Service
Budgeted Costs for the Year 2009

Repair service employee wages

Administrative assistant salary
Other overhead (supplies, depreciation,
advertising, utilities)
Total budgeted costs

Time
Charges
$26,000
1,950

Material
Charges
$ 5,000
1,000

4,940
$32,890

3,000
$ 9,000

Step 1: During 2009 Rancho Park budgets 1,300 of hours for repair time, and it desires a profit
margin of $6 per hour of labor. Computation of the hourly charges are as follows:
Per Hour
Hourly labor rate for repairs
Repair service employee
Overhead costs
Administrative assistant
Other overhead

Total Cost

Total Hours

Per Hour
Charge

$26,000

1,300

$20.00

1,950
4,940
$32,890

1,300
1,300
1,300

=
=
=

1.50
3.80
$25.30
6.00

Profit margin
Rate charged per hour
of labor

$31.30

8-6

Step 2: Rancho Park estimates that the total invoice cost of parts and materials used in 2009 will
be $30,000 and it desires a 10 percent profit margin markup on the invoice cost of parts and
materials. The computation of the material loading charge used by Rancho Park during 2009 is as
follows:
Material
Total Cost
Overhead costs
Parts manager salary
Administrative assistant
Other overhead

Total Invoice
Cost, Parts
and Materials

Material
Loading
Charge

$5,000
1,000
6,000

$30,000

20.00%

3,000
$9,000

30,000
30,000

=
=

10.00%
30.00%
10.00%
40.00%

Profit margin
Material loading charge

Step 3: Rancho Park prepares a price quotation to estimate the cost to fix a set of woods for a
patron. Rancho Park estimates the job will require a half hour of labor and $150 in parts and
materials. Rancho Parks price quotation is as follows:
Rancho Park Golf Club Repair Service
Time and Materials Price Quotation
Job: Arnold Palmer, repair of set of woods
Labor charges: half hour @ $31.30

$ 15.65

Material charges
Cost of parts and materials
Material loading charge (40% X 150)
Total price of labor and materials

$150.00
60.00

210.00
$225.65

Internal Sales
11.

(S.O. 4) Divisions within vertically integrated companies normally transfer goods or services to
other divisions within the same company, as well as to customers outside the company. When
goods are transferred internally, the price used to record the transfer between the two divisions
is called the transfer price. Three possible approaches for determining a transfer price are
(1) negotiated transfer prices, (2) cost-based transfer prices, and (3) market-based transfer prices.

Negotiated Transfer Prices

12.

The negotiated transfer price is determined through agreement of division managers. Using the
negotiated transfer pricing approach, a minimum transfer price is established by the selling
division, and a maximum transfer price is established by the purchasing division.
Calculating the minimum transfer price depends on whether the selling division has excess
capacity or not. If the selling division has no excess capacity, then the minimum transfer price is
the variable cost plus its lost contribution margin (also known as opportunity cost). If the selling
division has excess capacity, then the minimum transfer price is the variable cost.

8-7

Cost-Based Transfer Prices

13.

Another method of determining transfer prices is to base the transfer price on the costs incurred
by the division providing the goods. If a transfer price is used, the transfer price may be based on
variable costs alone, or on variable costs plus fixed costs. A markup may be added to these cost
numbers. This method, however, may lead to a loss of profitability for the company and unfair
evaluations of division performance.

Market-Based Transfer Prices

14.

The market-based transfer price is based on existing market prices of competing goods or
services. A market-based system is often considered the best approach because it is objective
and generally provides the proper economic incentives. Unfortunately, however, there is often not
a well-defined market for the good or service being transferred and thus companies resort to a
cost-based system.

Transfers Between Divisions in Different Countries

15.

(S.O. 5) As more companies globalize their operations, an increasing number of transfers are
between divisions that are located in different countries. Companies must pay income tax in
the country where income is generated. In order to maximize income, and minimize income tax,
many companies prefer to report more income in countries with low tax rates, and less income in
countries with high tax rates. This is accomplished by adjusting the transfer prices they use on
internal transfers between divisions located in different countries. The division in the low-tax-rate
country is allocated more contribution margin, and the division in the high-tax-rate country is
allocated less.

*Absorption Cost Pricing

*16. (S.O. 6) Absorption cost pricing is consistent with generally accepted accounting principles
(GAAP) because it defines the cost base as the manufacturing cost. Both variable and fixed
selling and administrative costs are excluded from this cost base. Thus, selling and administrative
costs plus the target ROI must be provided through the markup.
The steps in using the absorption cost approach are as follows:
a.
Compute the unit manufacturing cost.
b.
Compute the markup percentage using the formula:

Desired
ROIper unit
c.

Selling and
Adminstrative
Expenses Perr Unit

Markup
Percentage

X Manufacturing
Cost Per Unit

Set the target selling price using the formula:

Manufacturing
Cost Per Unit

Markup
Percentage

8-8

Manufacturing
Cost Per Unit

Target
Selling Price

*Variable-Cost Pricing
*17. Under variable-cost pricing, the cost base consists of all of the variable costs associated with a
product, including variable selling and administrative costs. Because fixed costs are not included
in the base, the markup must provide for fixed costs (manufacturing and selling and
administrative) and the target ROI. The contribution approach is more useful for making short-run
decisions because it displays variable cost and fixed cost behavior patterns separately.
The steps in using the contribution approach are as follows:
a.
b.

Compute the unit variable cost.

Compute the markup percentage using the formula:

Desired ROI Per Unit

+
Fix
xed Costs Per Unit
c.

= Markup Percentage X

Variable Costs
Per Unit

Set the target selling price using the formula:

Variable
Cost Per Unit

Markup
Percentage

8-9

Variable
Cost Per Unit

Target
Selling Price

LECTURE OUTLINE
A.

External Sales.
1. Establishing the price for any good or service is affected by the following
factors: pricing objectives, environment, demand, and cost considerations.

TEACHING TIP

ILLUSTRATION 8-1 identifies the factors that can affect pricing decisions.
Emphasize that few management decisions are more important than setting
prices.
2. In the long run a company must price its product to cover its costs and
earn a reasonable profit. In most cases, a company does not set the
priceit is set by the competitive market (laws of supply and demand).
In this situation, companies are called price takers because the price of
the product is set by market forces.
3. In some situations the company does set the price. This occurs where
the product is specially made for a customer or when there are few or no
other producers capable of manufacturing a similar item. It also occurs
when a company can effectively differentiate its product from others.
B.

Target Costing.
1. In a competitive market, the price of a product is greatly affected by
supply and demand. No company in the market can affect the price to a
significant degree.
2. A company chooses the segment of the market it wants to compete in
(its market niche) in a competitive market.

8-10

3. Once the company has identified its market segment, it conducts market
research to determine the target price. The target price is the price
the company believes would place it in the best position for its target
audience.
4. Once the company determines the target selling price it determines its
target cost by setting a desired profit.
5. The difference between the target price and the desired profit is the
target cost of the product. The target cost includes all product and period
costs necessary to make and market the product.

C.

Cost-Plus Pricing.
1. In a noncompetitive environment, the company is faced with the task of
setting its own price, which is commonly a function of the cost of the
product.
2. The typical approach is to use cost-plus pricing which involves establishing a cost base and adding to this cost base a markup to determine a
target selling price.
3. The size of the markup depends on the desired return on investment
(ROI) for the product line or product.
4. The cost-plus pricing formula is expressed as follows: Target Selling
Price = Cost + (Markup Percentage X Cost). Markup Percentage is
computed by dividing Desired ROI Per Unit by Total Unit Cost.
TEACHING TIP

Use ILLUSTRATION 8-2 to explain the computation of the markup percentage

and target selling price using the cost-plus pricing approach.
Also available as teaching transparency.

8-11

5. The cost-plus pricing approachs major advantage is that it is simple to

compute. However, it does not give consideration to the demand side. In
addition, sales volume plays a large role in determining per unit costs
which in turn affect selling price.
6. The lower the sales volume, the higher the selling price the company
must charge to meet its desired ROI. This occurs because fixed costs
are spread over fewer units and the fixed cost per unit increase.

D.

Time-and-Material Pricing.
1. Under time-and-material pricing, the company sets two pricing rates
one for the labor used on a job and another for the material.
2. The labor rate includes direct labor time and other employee costs. The
material charge is based on the cost of direct parts and materials used
and a material loading charge for related overhead costs.
3. Using time-and-material pricing involves three steps:
a.

Calculate the per hour labor charge.

b.

Calculate the charge for obtaining and holding materials.

c.

Calculate the charges for a particular job.

TEACHING TIP

ILLUSTRATION 8-3 lists the steps involved in time-and-material pricing.

Emphasize that both the labor charge and the material loading charge contain a
desired profit margin.
Also available as teaching transparency.

8-12

4. The charge for labor time is expressed as a rate per labor hour which
includes:
a.

The direct labor cost of the employee (hourly rate or salary and
fringe benefits).

b.

Selling, administrative, and similar overhead costs.

c.

An allowance for a desired profit or ROI per hour of employee time.

5. The charge for materials typically includes a material loading charge

which covers the costs of purchasing, receiving, handling, and storing
materials, plus any desired profit margin on the materials themselves.
6. The material loading charge is expressed as a percentage of the total
estimated costs of parts and materials for the year. The company
determines this percentage by doing the following:
a.

Estimating the total annual costs for purchasing, receiving, handling,

and storing materials.

b.

Dividing the amount in a. by the total estimated cost of parts and

materials.

c.

Adding a desired profit margin on the materials themselves.

7. The charges for any particular job are the sum of the

E.

a.

Labor charge,

b.

Charge for materials, and

c.

Material loading charge.

Internal Sales.
1. The transfer of goods between divisions of the same company is called
internal sales. Divisions within vertically integrated companies normally
sell goods to other company divisions as well as to outside customers.
8-13

2. When companies transfer goods internally, the price used to record the
transfer between the divisions is the transfer price.
3. Setting a transfer price is often complicated because of competing
interests among divisions within the company. A transfer price that is too
high will benefit the selling division, but hurt the purchasing division.
4. There are three possible approaches for determining a transfer price:

F.

a.

Negotiated transfer prices.

b.

Cost-based transfer prices.

c.

Market-based transfer prices.

Negotiated Transfer Prices.

1. The negotiated transfer price is determined through agreement of
division managers. It will range between the external purchase price per
unit and the sum of the unit variable cost plus unit opportunity cost.
2. Opportunity cost is the contribution margin per unit of goods sold
externally.
3. The minimum transfer price equals variable cost plus opportunity cost
whether the seller is at full capacity or has excess capacity. However,
opportunity cost will vary depending on whether a division is at full
capacity or has excess capacity.
4. Given excess capacity (zero opportunity cost) to the selling division, it
would be in the companys best interest for the buying division to purchase
goods internally as long as the selling divisions variable cost is less than
the outside price.
5. When the selling division has excess capacity, it will receive a positive
contribution margin from any transfer price above its variable cost while
the buying division will benefit from any price below the outside price.
8-14

6. In the minimum transfer price formula, variable cost is defined as the

variable cost of units sold internally which will differ from the variable
cost of units sold externally in some instances (i.e. reduced selling
expenses for internal sales).
7. Under negotiated transfer pricing, the selling division, establishes, a
minimum transfer price and the purchasing division establishes a
maximum transfer price.
8. Companies often do not use negotiated transfer pricing because:

G.

a.

Market price information is sometimes not easily obtainable.

b.

A lack of trust between the two negotiating divisions may lead to a

breakdown in negotiations.

c.

Negotiations often lead to different pricing strategies from division

to division which is sometimes costly to implement.

Cost-Based Transfer Prices.

1. One method of determining transfer prices is to base the transfer price
on the costs incurred by the division producing the goods.
2. A cost-based transfer price may be based on full cost, variable cost, or
some modification including a markup.
3. The cost-based approach often leads to poor performance evaluations
and purchasing decisions. Under this approach, divisions sometimes
use improper transfer prices which leads to a loss of profitability and
unfair evaluations of division performance.
4. The cost-based approach does not provide the selling division with
proper incentive. In addition, this approach does not reflect the selling
divisions true profitability, and doesnt even provide adequate incentive
for the selling division to control costs since the divisions costs are
passed on to the buying division.
8-15

H.

Market-Based Transfer Prices.

1. The market-based transfer price is based on existing market prices of
competing goods. This system is often considered the best approach
because it is objective and generally provides the proper economic
incentives.
2. When the selling division has no excess capacity, it receives market
price and the purchasing division pays market price.
3. If the selling division has excess capacity, the market-based system can
lead to actions that are not in the best interest of the company.
4. In many cases, there is not a well-defined market for the good being
transferred. As a result, a reasonable market value cannot be developed,
and companies must resort to a cost-based system.

TEACHING TIP

Use ILLUSTRATION 8-4 to explain the different transfer price approaches.

Emphasize that the total contribution margin to the company is the same under
all three approaches.
Also available as teaching transparency.
I.

Transfers Between Divisions in Different Countries.

1. An increasing number of transfers are between divisions that are located
in different countries. Differences in tax rates across countries can
complicate the determination of the appropriate transfer price.
2. Companies must pay income tax in the country where they generate the
income. Many companies prefer to report more income in countries with
low tax rates in order to maximize income, and minimize income tax.

8-16

3. Companies maximize income by adjusting the transfer prices they use

on internal transfers between divisions located in different countries. They
allocate more contribution margin to the division in the low-tax-rate country
while they allocate less to the division in the high-tax-rate country.
4. Adjusting the transfer prices to maximize income can result in inappropriate purchasing decisions and unfair evaluations. In addition, a company
must consider whether it is legal and ethical to use a lower transfer price
when the market price is clearly higher.

*J. Absorption-Cost Approach.

1. The absorption-cost approach uses total manufacturing cost as the cost
base and provides for selling/administrative costs plus the target ROI
through the markup.
2. The absorption-cost approach involves three steps:
a.

Compute the unit manufacturing cost.

b.

Compute the markup percentage (the percentage must cover both

the desired ROI and selling and administrative expenses).

c.

Set the target selling price.

3. The markup percentage is computed by dividing the sum of the desired

ROI per unit and selling and administrative expenses per unit by the
manufacturing cost per unit.
4. The target selling price is computed as: Manufacturing cost per unit +
(Markup percentage X Manufacturing cost per unit).
5. Most companies that use cost-plus pricing use either absorption cost or
full cost as the basis because:
a.

Absorption-cost information is most readily provided by a companys

cost accounting system.
8-17

b.

Basing the cost-plus formula on only variable costs could encourage

managers to set too low a price to boost sales.

c.

Absorption-cost or full-cost pricing provides the most defensible base

for justifying prices to managers, customers, and government.

TEACHING TIP

ILLUSTRATION 8-5 compares the absorption-cost approach and the variablecost approach. Emphasize that the markup percentage provides for selling and
administrative costs plus target ROI under the absorption approach while it
covers fixed costs plus target ROI under the variable-cost approach.
Also available as teaching transparency.
*K. Variable-Cost Pricing.
1. Variable-cost pricing uses all of the variable costs, including selling and
administrative costs, as the cost base and provides for fixed costs and
target ROI through the markup.
2. Variable-cost pricing is more useful for making short-run decisions
because it considers variable cost and fixed cost behavior patterns
separately.
3. Variable-cost pricing involves the following steps:
a.

Compute the unit variable cost.

b.

Compute the markup percentage.

c.

Set the target selling price.

4. The markup percentage is computed by dividing the sum of the desired

ROI per unit and fixed costs per unit by the variable cost per unit.
5. The target selling price is computed as: Variable cost per unit + (Markup
percentage X Variable cost per unit).
8-18

6. The specific reasons for using Variable-cost pricing are:

a.

It is more consistent with cost-volume-profit analysis used to measure

the profit implications of changes in price and volume.

b.

This approach provides the type of data managers need for pricing
special orders.

c.

It avoids arbitrary allocation of common fixed costs to individual

product lines.

8-19

20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Once a company has determined the target price, it can determine its target cost by
setting a desired profit.
True

False

2. In a competitive, common-product environment the company must set a target selling

price using cost-plus pricing.
True

False

3. Under cost-plus pricing, the markup percentage is computed by dividing desired ROI per
unit by variable cost per unit.
True

False

4. The labor charge includes the direct labor cost of employees, selling, administrative, and
similar overhead costs; and an allowance for a desired profit per hour.
True

False

5. The charges for any particular job are the sum of the labor charge, the materials charge,
and the material loading charge.
True

False

6. An appropriate transfer price should assist the company in making proper purchasing
decisions.
True

False

7. An advantage of the cost-based transfer price approach is that it can increase a division
managers control over the divisions performance.
True

False

8. The market-based transfer price approach provides a fairer allocation of the companys
contribution margin to each division than the cost-based approach.
True

False

9. In order to maximize income, and minimize income tax, companies can adjust the
transfer prices they use on transfers between divisions located in different countries.
True

False

*10. The absorption cost approach is more consistent with cost-volume-profit analysis used to
measure the profit implications of changes in price and volume.
True

False
8-20

Multiple Choice
1.

The target cost of a product

a. includes product costs but not period costs.
b. is determined before the target price is established.
c. is the difference between the target price and the desired profit.
d. is determined by the target audience.

2.

In the cost-plus pricing approach, the markup percentage is computed by dividing the
a. desired ROI/unit by variable cost/unit.
b. desired ROI/unit by total unit cost.
c. total unit cost by desired ROI/unit.
d. selling price/unit by desired ROI/unit.

3.

All of the following are steps in the time-and-material pricing approach except calculating the
a. labor charge.
b. material loading charge.
c. manufacturing overhead charge.
d. charges for a particular job.

4.

The total contribution margin to a company in the market-based transfer price approach is
a. greater than in the cost-based approach.
b. less than in the cost-based approach.
c. the same as in the cost-based approach.
d. either greater than or less than in the cost-based approach.

*5.

The absorption-cost approach

a. includes all variable costs in the cost base.
b. excludes fixed manufacturing overhead from the cost base.
c. provides the data needed for pricing special orders.
d. uses a markup percentage that covers the desired ROI and the selling and
administrative expenses.

8-21

ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.

True
False
False
True
True

6.
7.
8.
9.
*10.

True
False
True
True
False

Multiple Choice
1.
2.
3.
4.
*5.

c.
b.
c.
c.
d.

8-22

ILLUSTRATION 8-1
PRICING FACTORS

Factors That Affect Pricing Decisions

Pricing Objectives
Gain market share
Achieve target return

Environment
Political reaction to prices
Patent/copyright protection

Demand
Price sensitivity
Demographics

Cost Considerations
Fixed and variable costs
Short-run or long-run

8-23

ILLUSTRATION 8-2
COMPUTATION OF MARKUP PERCENTAGE AND TARGET
SELLING PRICE

MARKUP PERCENTAGE COMPUTATION

Markup
Percentage = Desired ROI Per Unit Total Unit Cost
SELLING PRICE COMPUTATION
Target
Total
Selling = Unit +
Price
Cost
Per Unit

Total
Markup
Unit Percentage
Cost

8-24

ILLUSTRATION 8-3
TIME AND MATERIAL PRICING STEPS

Step1: Calculate the Labor Charge per hour. The labor

charge includes:
a. Direct labor cost of employees.
b. Selling, administrative, and similar overhead costs.
c. An allowance for a ROI per hour.
Step 2: Calculate the Material Loading Charge. The material
loading charge is computed by:
a. Estimating total annual material purchasing, handling,
and storing costs.
b. Dividing amount in a. by total estimated materials costs.
c. Adding a desired profit margin.
Step 3: Calculate Charges for a Particular Job. The charges
for a particular job are computed by adding the:
a. Labor charge.
b. Charge for the materials.
c. Material loading charge.

8-25

ILLUSTRATION 8-4
TRANSFER PRICING APPROACHES

Three Approaches for Determining Transfer Prices:

1. Negotiated price (minimum transfer price will range
between external purchase price/unit and the sum of unit
variable cost and opportunity cost).
2. Cost-based (transfer price may be based on full cost or
variable cost).
3. Market-based (minimum transfer price = variable cost +
opportunity cost).

8-26

ILLUSTRATION 8-5
ABSORPTION-COST APPROACH VS. VARIABLE-COST
APPROACH

1. Cost base

2. Markup
percentages

ABSORPTION
COST
Direct materials +
Direct labor +
Variable and fixed
manufacturing
overhead

Absorption:

VARIABLE
COST
Direct materials +
Direct labor +
Variable manufacturing
overhead and variable
selling/administrative
expenses

Desired ROI/Unit + Selling

and Administrative Expenses/Unit
Manufacturing Cost/Unit

Variable: Desired ROI/Unit + Fixed Costs/Unit

Variable Cost Per Unit

3. Target
selling
price

Absorption:
Manufacturing
Markup Manufacturing
+
Cost Per Unit
Percentage Cost Per Unit

Variable:
Variable
Markup Variable
+
Cost Per Unit
Percentage Cost Per Unit

(
(

8-27