PRICING Module 7 Learning Objectives: • Compute a target cost when the market determines a product price; • Compute a target selling price using cost- plus pricing; • Determine a transfer price using the negotiated, cost- based, and market- based approaches; • Explain issues involved in transferring goods between divisions in different countries. What is target costing? • Target costing is a system under which a company plans in advance for the price points, product costs, and margins that it wants to achieve for a new product. • Target costing is an excellent tool for planning a suite of products that have high levels of profitability. From a cost standpoint, product development is an extremely important stage that the traditional financial accounting model almost ignores. Financial accounting requires that development costs be expensed as incurred—even though most studies indicate that decisions made during this stage determine approximately 80–90 percent of a product’s total life cycle costs. Although technology and competition have tremendously shortened the time spent in the development stage, effective development efforts are critical to a product’s life cycle profitability. Decisions made during this stage can: • reduce production and life cycle costs through material specifications, • shorten manufacturing time through process design, • increase quality by minimizing potential design defects, and • add flexibility. Manufacturers are acutely aware of the need to focus attention on the product development stage, and the performance measure of time to market is becoming more critical. Thus, the length of the development process must reflect a balance between the short term need for the product to be “first” and the longer-term need for the product to be “good.” Today, most products are designed to be sold at a particular price point that is associated with the preferences of a particular product market segment. To keep production costs in line with the price point, some companies (especially Japanese ones) use a technique called target costing. As expressed in the following formula, target costing develops an “allowable” product cost by analyzing market research to estimate what the market will pay (price point) for a product with specific characteristics. Subtracting an acceptable profit margin and selling and administrative costs from the estimated selling price leaves an implied maximum per-unit target product cost, which is compared to an expected product cost. If the expected cost is higher than the target cost, the company has several alternatives. First, the product design and/or production process can be changed to reduce costs. Cost tables help determine how to make such adjustments. Cost tables are databases that provide information about the impact on product costs of using different input resources, manufacturing processes, and design specifications. Second, a less-than-desired profit margin can be accepted. Third, the company can decide not to enter this particular product market at the current time because it cannot make the desired profit margin. If, for example, the target costing system used by Canon indicated that a product’s life cycle costs were too high to make an acceptable profit, the product would be abandoned unless it were strategically necessary to maintain a comprehensive product line or to create a “flagship” product. Figure 7.1 Target Costing Process TYPES OF TRANSFER PRICES • Cost-based Transfer Prices • Market-Based Transfer Prices • Negotiated Transfer Prices • Transfer Prices in Multinational Settings Cost-based Transfer Prices • A cost-based transfer price would seem simple to implement until one realizes there are many definitions of the term cost, ranging from variable production cost to absorption cost plus additional amounts for selling and administrative costs (and, possibly, opportunity cost) of the selling unit. If only variable costs are used to set a transfer price, the selling division has little incentive to sell to another internal division because no contribution margin is generated on the transfer to help cover fixed costs. • Transfer prices based on absorption cost at least provide a contribution toward covering the selling division’s fixed production overhead. • Cost-based transfer prices are commonly used for low-cost and low-volume services such as temporary maintenance and temporary office staff assistance. Market-Based Transfer Prices • To eliminate the problems of defining “cost,” some companies simply use a market price approach to set transfer prices. Market price is believed to be an objective, arm’s-length measure of value that simulates the selling price that would be offered and paid if the sub units were independent companies. If operating efficiently relative to the competition, a selling division should be able to show a profit when transferring products or services at market prices. Similarly, an efficiently operating buying division would have to pay market price if the alternative of buying internally did not exist. • Market-based transfer prices are effective for common high-cost and highvolume standardized services such as storage and transportation. Several problems can exist, however, with the use of market prices for intracompany transfers: • Transferred products may have no exact counterpart in the external market, which means there is no established market price. • Internal sales reduce packaging, advertising, or delivery expenditures and eliminate bad debts; thus, market price is generally not entirely appropriate. • In instances of a temporary downturn in market demand, the transfer price might be set at the artificially “depressed” price, which could cause inappropriate performance evaluations or decisions to be made. • Different prices, discounts, and credit terms are allowed to different buyers, so there is a question of which is the “right” market price to use. Negotiated Transfer Prices • Because of the problems associated with both cost- and market-based prices, negotiated transfer prices are often set through a process of bargaining between the selling and purchasing unit managers. • Negotiated transfer prices are often used for services because their value—as shown through expertise, reliability, convenience, or responsiveness—is often qualitative and can be assessed only judgmentally from the perspective of the parties involved. The transfer price should depend on the cost and volume level of the service as well as whether comparable substitutes are available. Negotiated transfer prices are commonly used for customized high-cost and high-volume services such as risk management and specialized executive training. Transfer Prices in Multinational Settings • Because of the differences in tax systems, customs duties, freight and insurance costs, import/export regulations, and foreign-exchange controls, setting transfer prices for products and services becomes extremely difficult when the company is engaged in multinational operations. • Multinational companies can use different transfer prices when the same product is sent to, or received from, different countries. However, the company should set transfer pricing policies that are followed consistently. ❖ For example, a company should not price certain parent company services to foreign subsidiaries in a manner that would send the majority of those costs to the subsidiary in the country with the highest tax rate unless that method of pricing is reasonable and equitable to all subsidiaries. The general test of reasonableness is that a transfer price should reflect an arm’slength transaction. Tax authorities in both the home and host countries carefully scrutinize multinational transfer prices because such prices determine which country taxes the income from the transfer. The U.S. Congress is concerned about both U.S. multinationals operating in low-tax-rate countries and foreign companies operating in the United States. In either situation, Congress believes that companies could avoid paying U.S. corporate income taxes because of misleading or inaccurate transfer pricing. Thus, the Internal Revenue Service (IRS) can be quick to investigate U.S. subsidiaries that operate in low-tax areas and have unusually high profits. Figure 7.2 Cross-Discipline Approach to Transfer Pricing Thank you for listening!! Bilog, Melody P. Cabinta, Cheska Ann M. Cacao, Kayla Andrea I. Castillo, Niña Yvonne Margarette D.
