CHAPTER Pricing ASSIGNMENT CLASSIFICATION TABLE A Problems B Problems 3, 4, 5, 6, 1A, 2A 1B, 2B 8, 9, 10 3A 3B 7, 8, 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, 1, 2, *2 Compute a target selling price using cost-plus pricing 3, 4, 5, 6, 7, 2, 3, 4, *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 20–30 2A Use cost-plus pricing to determine various amounts Simple 20–30 3A Use time-and-material pricing to determine bill Simple 20–30 4A Determine minimum transfer price with no excess capacity and with excess capacity Moderate 20–30 5A Determine minimum transfer price with no excess capacity Moderate 20–30 6A Determine minimum transfer price under different situations Moderate 20–30 *7A* Compute the target price using absorption-cost pricing and variable-cost pricing Moderate 30–40 *8A* Compute various amounts using absorption-cost pricing and variable-cost pricing Complex 40–50 1B Use cost-plus pricing to determine various amounts Simple 20–30 2B Use cost-plus pricing to determine various amounts Simple 20–30 3B Use time-and-material pricing to determine bill Simple 20–30 4B Determine minimum transfer price with no excess capacity and with excess capacity Moderate 20–30 5B Determine minimum transfer price with no excess capacity Moderate 20–30 6B Determine minimum transfer price under different situations Moderate 20–30 *7B* Compute the target price using absorption-cost pricing and variable-cost pricing Moderate 30–40 *8B* Compute various amounts using absorption-cost pricing and variable-cost pricing Complex 40–50 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 Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems BLOOM’S TAXONOMY TABLE STUDY OBJECTIVES COMPUTE A TARGET COST WHEN THE MARKET DETERMINES A PRODUCT PRICE COMPUTE A TARGET SELLING PRICE USING COSTPLUS PRICING USE TIME-AND-MATERIAL PRICING TO DETERMINE THE COST OF SERVICES PROVIDED DETERMINE A TRANSFER PRICE USING THE NEGOTIATED, COST-BASED, AND MARKET-BASED APPROACHES 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 (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 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) 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 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 (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) The cost-plus approach has a major advantage: it is simple to compute However, the cost model does not give consideration to the demand side—that 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 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 (S.O 3) Under time and material pricing, the company sets two pricing rates—one 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 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 Park’s 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 X 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 X 8-9 Variable Cost Per Unit ) = Target Selling Price LECTURE OUTLINE A External Sales 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 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 price—it 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 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 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 A company chooses the segment of the market it wants to compete in (its market niche) in a competitive market 8-10 When companies transfer goods internally, the price used to record the transfer between the divisions is the transfer price 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 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 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 Opportunity cost is the contribution margin per unit of goods sold externally 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 Given excess capacity (zero opportunity cost) to the selling division, it would be in the company’s best interest for the buying division to purchase goods internally as long as the selling division’s variable cost is less than the outside price 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 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) Under negotiated transfer pricing, the selling division, establishes, a minimum transfer price and the purchasing division establishes a maximum transfer price Companies often 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 One method of determining transfer prices is to base the transfer price on the costs incurred by the division producing the goods A cost-based transfer price may be based on full cost, variable cost, or some modification including a markup 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 The cost-based approach does not provide the selling division with proper incentive In addition, this approach does not reflect the selling division’s true profitability, and doesn’t even provide adequate incentive for the selling division to control costs since the division’s costs are passed on to the buying division 8-15 H Market-Based Transfer Prices 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 When the selling division has no excess capacity, it receives market price and the purchasing division pays market price 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 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 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 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 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 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 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 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 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 The target selling price is computed as: Manufacturing cost per unit + (Markup percentage X Manufacturing cost per unit) 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 company’s 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 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 Variable-cost pricing is more useful for making short-run decisions because it considers variable cost and fixed cost behavior patterns separately Variable-cost pricing involves the following steps: a Compute the unit variable cost b Compute the markup percentage c Set the target selling price 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 The target selling price is computed as: Variable cost per unit + (Markup percentage X Variable cost per unit) 8-18 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 Once a company has determined the target price, it can determine its target cost by setting a desired profit True False In a competitive, common-product environment the company must set a target selling price using cost-plus pricing True False Under cost-plus pricing, the markup percentage is computed by dividing desired ROI per unit by variable cost per unit True False 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 The charges for any particular job are the sum of the labor charge, the materials charge, and the material loading charge True False An appropriate transfer price should assist the company in making proper purchasing decisions True False An advantage of the cost-based transfer price approach is that it can increase a division manager’s control over the division’s performance True False The market-based transfer price approach provides a fairer allocation of the company’s contribution margin to each division than the cost-based approach True False 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 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 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 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 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 True False False True True *10 True False True True False Multiple Choice *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: Negotiated price (minimum transfer price will range between external purchase price/unit and the sum of unit variable cost and opportunity cost) Cost-based (transfer price may be based on full cost or variable cost) Market-based (minimum transfer price = variable cost + opportunity cost) 8-26 ILLUSTRATION 8-5 ABSORPTION-COST APPROACH VS VARIABLE-COST APPROACH Cost base 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 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 ... determined by the target audience 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... set the price—it 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 In some... 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