Pricing Decision
By Ghanendra Fago
(Ph. D Scholar, M. Phil, MBA)
For MBA, Ace Institute of Management
Pricing Decision
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Price is the value of goods and services.
Setting price for goods or services
Pricing is always determined for making profit.
Factors of pricing decision are cost of goods and
services, demand of the customers and pricing of the
competitors
Pricing Methods
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Pricing for external sales.
Pricing for internal transfers.
External Pricing
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Under this system, a certain percentage mark up is
added to estimated cost for determination of selling price
of goods and services.
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Cost plus pricing system maintains a certain percentage
of profit on cost, so that there is rare chance for making
loss in the organization.
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Cost plus pricing technique is based on the following
formula.
Price = Cost + (Mark up percentage  Cost price)
External Pricing Systems
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Full cost pricing system.
Variable cost pricing system.
Activity Based Costing (ABC) pricing system.
Target cost pricing system.
Return on Investment (ROI) pricing system.
Target Pricing
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Target pricing is based on the target costing.
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Target costing is a method of determining the cost of product
based on target price that customers are willing to pay.
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A target price is determined by the marketing department before
designing and introducing a new product.
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Target Cost = Anticipated selling price – Desired profit
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Under this method, product cost is calculated by deducting
anticipated profit from anticipated selling price.
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If the product cost is above the target cost, then the product
designer focuses on modification of design of the product so that
it reduces the cost of product to target cost.
A company is going to produce hair dye product. The marketing manager
of the company estimates the following costs for production and sale of the
hair dye into market.
Direct materials
Direct labor
Overheads
Estimated Total Cost
Add mark up 40%
Expected selling price
Rs. 40
30
20
90
36
126
The market research department reveals that the similar types of hair dye is
selling at Rs. 100 by the competitors in to market.
Required:
1. Should the company produce hair dye, if it is using target pricing?
2. Should the company expand this product line, if standard mark up 40% is
applied with decreasing of Rs. 6 and Rs. 7 on materials and labour
respectively?
Computation of Target Cost
Particulars
Amount (Rs.)
Direct materials
40
Direct labour
30
Overheads
20
Estimated total cost
90
Target selling price
100
Target profit
10
Decision: If company uses target pricing, it can earn profit at Rs.10 per
unit.
Computation of Target cost and price with
change in cost
Particulars
Amount (Rs.)
Direct materials (40 – 6)
34
Direct labour (30 – 7)
23
Overheads
20
Estimated Total Cost
77
Target profit
Estimated price
30.8
107.8
Target price
100
Difference in profit
7.8
Decision: If 40% standard mark up is applied under given condition, the estimated
price will be higher than target price. Thus, the company should not expand its
product line.
The management of a company present you the
following estimates of cost for sales of one unit of its
proposed product X.
Direct materials
Rs. 50
Direct labour (4 hrs. @ Rs. 10)
40
Overheads (50% of DL)
20
Estimated Total Cost
110
Add: Mark up 30%
33
Selling price
143
The sales agent and middlemen have reported that similar type of product is
selling into market by the competitors at Rs. 125.
Required:
a.Should the product be expanded by the company if it used target pricing?
b.What would be the selling price if it charges 15% profit on cost?
c.Should the company expand the product at 15% margin on cost?
The company’s market research department has discovered a market
for such a part. The market research department has indicated that the
new part would likely sell for Rs. 450. A similar part currently being
produced has the following manufacturing cost:
Particular
Per unit (Rs.)
Variable manufacturing cost
280
Variable selling and administrative cost
20
Fixed manufacturing cost (based on 10,000 units)
70
Fixed Selling and Administrative Cost (based on 10,000
units)
20
Required:
1. Should the company manufacture the part, if it is using Target Pricing?
2. What price would the company charge for the product if the company
wants 20% profit on cost?
Transfer Pricing
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Transfer prices represent the value of goods or services
transfer to other division.
When one division of an organization provides goods and
services to another division it charges price to the division.
Transfer prices are the amounts charged by one division of an
organization for goods and services that is supplied to another
division of the same organization.
Transfer pricing is also known as Intra Company pricing.
The transfer pricing is a revenue to one division on the return of
providing goods and services
where as it is a cost to another division for acquiring of goods
and services.
Transfer Pricing Methods
(a)
(b)
i.
ii.
(c)
(d)
Market based transfer pricing
Cost based transfer pricing
Full cost transfer pricing
Variable cost transfer pricing
Negotiated transfer pricing
General formula approach
Market Based Transfer Pricing
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Transfer price based on market value of the product or services
is known as market based transfer pricing.
Generally, market price is used for determination of transfer
pricing of the product.
Market based transfer pricing is appropriate when both buying
and selling divisions are operating at full capacity.
Both the buying and selling divisions can buy and sell at market
price. The internal transfer price may be then external market
price less marketing cost.
Transfer price = Market price – Selling and distribution
expenses
Cost Based Transfer Pricing
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Most of the companies transfer its price based on
cost.
Cost based transfer pricing is used when
Market price is not available like for semi–finished
goods
It is difficulty for determining the market price
Product manufactured is of secret nature
There are many possible definitions of cost.
Some company use only variable cost, others use
full cost and still others use full cost plus profit.
Variable Cost Based Transfer Pricing
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When the market price is not applicable at
that condition variable cost transfer pricing
also can be used in practice.
In this method, only the variable costs, i.e.
direct material, direct labour and variable
factory overhead are taken into consideration
as the transfer price.
General Formula Approach To Transfer
Pricing
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There is no any hard and fast rule for transfer pricing
which would lead to optimal decisions for an
organization as a whole. According to general rule,
the transfer price is set in that point which helps to
recover the variable costs plus opportunity cost.
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Transfer price = Outlay cost (Variable cost) per
unit + Opportunity cost per unit
Opportunity Cost
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Opportunity cot is the amount or revenue foregone
by the company as a whole when the product or
services is transferred internally.
The selling divisions opportunity cost depends upon
its operating capacity.
If the selling division is operating at full capacity,
external demand can not satisfy.
At this situation, the opportunity cost will be the
contribution margin foregone from the sales cost but
opportunity cot may be zero if the division has idle
capacity and can satisfy to the external demand
CASE 1 Transfer Pricing
Division X of a company produces parts. The division transfers some of its
products to the division Y and sells some of its products to other companies
in the external market under different levels. The following valuable costs are
incurred to produce part and transport it to a buyer:
Production:
Standard variable cost per unit (including packaging) Rs. 400
Transportation: Standard variable cost per unit Rs. 15
Division X can sell its product to outside buyer at a market price of Rs. 655
per unit.
Required: What transfer price does the general rule yield, if there is:
(i)
No excess capacity?
(ii)
Excess capacity?
Outlay cost per unit:
Rs.
Standard variable cost
400
Standard variable transportation cost
15
415
Opportunity cost per unit:
Selling price per unit in external market
655
Outlay cost per unit
415
Opportunity cost (foregone contribution margin)
240
General–Transfer–Pricing Rules:
(i) Transfer Price = Outlay cost + Opportunity cost = Rs.415 + Rs.240 = Rs. 655
(ii) Transfer Price under excess capacity = Outlay cost + Opportunity cost =Rs.
415 + 0 = Rs. 415
CASE 2
A company has there divisions ; X, Y and Z. Division X can buy a part
from division Y or from external company , which will meet Y’s market
price of Rs. 20 per unit. If X buys from A co., A co. in terms buys a
component from division Z for Rs. 4 per unit. The outlay costs to division
Z of supplying their component are Rs. 2 per unit. In filling X’s order, Y
would incur, outlay costs of Rs. 16.5 per unit. Assume that division Y is
working at full capacity and can provide to an outside buyer (i.e. company
A) at the same market price of Rs. 20 per unit and with the same outlay
costs of Rs. 16.5 per unit.
Required:
(i)
What alternative would be the best for company as a whole buying
from company A or division Y? Show supporting calculations.
(ii)
What transfer price should be used to guide the manger of division X
and Y so as to maximize overall net income (cash flow)?
(iii)
Suppose that division Y has enough extra capacity to supply to both
division X and the outside buyer at the same time. How would this
change your answer in part (i) and (ii) ? show supporting calculation.
The optimal action from the standpoint of company as a
whole can be analyzed as follows:
Particulars
Buy from
division Y
Buy from
Co. A
(16.5)
(20)
Division Z (4 – 2)
-
2
Division Y (20 – 16.5)
-
3.5
(16.5)
(14.5)
Outflow to the company as a whole
Cash in flows:
Net cash outflow to the company as a whole
Since a net outflow of Rs. 14.5 is less than a net outflow of Rs. 16.5,
division X should buy from Co. A.
(ii)
Transfer Price = Variable cost + Opportunity cost