Professional Documents
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Pricing
Brief A B
Study Objectives Questions Exercises Exercises Problems Problems
*4. Determine a transfer price 11, 12, 13, 7, 8, 9 11, 12, 13, 4A, 5A, 6A 4B, 5B, 6B
using the negotiated, cost- 14, 15, 16, 14, 15
based, and market-based 17
approaches.
*6. Determine prices using 19, 20 10, 11 16, 17, 18 7A, 8A 7B, 8B
absorption-cost pricing
and variable-cost pricing.
*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix
to the chapter.
8-1
ASSIGNMENT CHARACTERISTICS TABLE
*7A* Compute the target price using absorption-cost pricing and Moderate 3040
variable-cost pricing.
*8A* Compute various amounts using absorption-cost pricing and Complex 4050
variable-cost pricing.
*7B* Compute the target price using absorption-cost pricing and Moderate 3040
variable-cost pricing.
*8B* Compute various amounts using absorption-cost pricing and Complex 4050
variable-cost pricing.
8-2
Correlation Chart between Blooms Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems
8-3
Q8-17 E8-11 P8-6A
E8-12 P8-4B
E8-13 P8-5B
E8-14 P8-6B
*5. Explain issues involved in Q8-18
transferring goods between
divisions in different countries.
*6. Determine prices using Q8-19 Q8-20 E8-18
absorption-cost pricing BE8-10 P8-7A
and variable-cost pricing. BE8-11 P8-8A
E8-16 P8-7B
E8-17 P8-8B
Broadening Your Perspective Exploring the Web Real-World Manag. Analysis Decision Making Decision Making
Ethics Case Focus Communication Across the Across the
All About You Ethics Case Organization Organization
Manag. Analysis Real-World Focus
Real-World Communication
Focus Ethics Case
STUDY OBJECTIVES
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.
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:
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.
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:
Time Material
Charges Charges
Repair service employee wages $26,000 $ 5,000
Administrative assistant salary 1,950 1,000
Other overhead (supplies, depreciation,
advertising, utilities) 4,940 3,000
Total budgeted costs $32,890 $ 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
Per Hour Total Cost Total Hours = Charge
Hourly labor rate for repairs
Repair service employee $26,000 1,300 = $20.00
Overhead costs
Administrative assistant 1,950 1,300 = 1.50
Other overhead 4,940 1,300 = 3.80
$32,890 1,300 = $25.30
Profit margin 6.00
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:
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:
Material charges
Cost of parts and materials $150.00
Material loading charge (40% X 150) 60.00 210.00
Total price of labor and materials $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.
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.
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.
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.
*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.
Selling and
Desired + =
Markup X Manufacturing
ROIper unit Adminstrative Percentage Cost Per Unit
Expenses Perr Unit
8-8
*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.
8-9
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.
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.
TEACHING TIP
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.
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.
TEACHING TIP
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).
7. The charges for any particular job are the sum of the
a. Labor charge,
E. Internal Sales.
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.
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).
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.
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
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. 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:
8-17
b. Basing the cost-plus formula on only variable costs could encourage
managers to set too low a price to boost sales.
TEACHING TIP
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.
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:
b. This approach provides the type of data managers need for pricing
special orders.
8-19
20 MINUTE QUIZ
1. Once a company has determined the target price, it can determine its target cost by
setting a desired profit.
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
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.
8-21
ANSWERS TO QUIZ
True/False
1. True 6. True
2. False 7. False
3. False 8. True
4. True 9. True
5. True *10. False
Multiple Choice
1. c.
2. b.
3. c.
4. c.
*5. d.
8-22
ILLUSTRATION 8-1
PRICING FACTORS
8-23
ILLUSTRATION 8-2
COMPUTATION OF MARKUP PERCENTAGE AND TARGET
SELLING PRICE
Markup
Percentage = Desired ROI Per Unit Total Unit Cost
Target Total
Selling = Unit +
Price
Per Unit
Cost ( Total Markup
Unit Percentage
Cost )
8-24
ILLUSTRATION 8-3
TIME AND MATERIAL PRICING STEPS
8-25
ILLUSTRATION 8-4
TRANSFER PRICING APPROACHES
8-26
ILLUSTRATION 8-5
ABSORPTION-COST APPROACH VS. VARIABLE-COST
APPROACH
ABSORPTION VARIABLE
COST COST
Direct materials + Direct materials +
Direct labor + Direct labor +
1. Cost base Variable and fixed Variable manufacturing
manufacturing overhead and variable
overhead selling/administrative
expenses
Absorption:
3. Target
selling
price
Manufacturing
Cost Per Unit +
(
Markup Manufacturing
Percentage Cost Per Unit )
Variable:
Variable
Cost Per Unit +
(
Markup Variable
Percentage Cost Per Unit )
8-27