PRICING Chapter 9 – COMM 305 Target costing Product price should cover costs and earn a profit To set an appropriate price for their product or service an organization needs to understand both market forces and the cost of the product or service. in a highly competitive market price is largely determined by supply and demand. Target cost: cost that yields the desired profit when seller does not control the product’s price. Market price – Desired profit = target cost • • • • Target Costing Other Costing Methods Firm becomes a price taker • Firm is a price maker Price is set by the market, not by the firm • Price is set by the firm and not the market Cost is the residual after the price and the profit • Price is the residual after the cost structure and the margin profit margin Cost control becomes key to success • In a competitive market price maker method no longer effective PRICING Target costing steps: 1. Find market niche o Select segment to compete in, for example, luxury goods or economy goods 2. Find the target price: Price the company believes will place it in the best position for its target audience; based on market research 3. Determine target cost: Difference between target price and desired profit o Includes all product and period costs necessary to make and market the product 4. Assemble expert team to design and develop a product that meets quality specifications while not exceeding target cost o Includes production, operations, marketing, finance Total cost-plus pricing: Unit Cost + (Markup Percentage × Unit Cost) = Target Selling Price per unit Markup %: Desired ROI per unit / total unit cost base = Markup % Advantage Easy to calculate Disadvantages: Does not consider demand side Will the customer pay the price? Fixed cost per unit changes with change in volume At lower sales volume, company must charge a higher price to meet desired ROI Absorption cost-plus pricing Cost base includes only manufacturing costs both variable and fixed. Price must cover selling and administrative costs + target ROI PRICING Cost-plus pricing motives: 1. Cost accounting systems provide absorption cost information most easily making it cost-effective to use for pricing. 2. Basing the cost-plus formula on only variable costs could encourage managers to set too low a price in order to boost sales. Managers may substitute variable cost for total cost which can lead to repeated price-cutting. 3. Both absorption cost or total cost are easy to defend when prices need to be justified to interested parties—managers, customers, and governments. Variable cost-plus pricing Cost base includes all variable costs all fixed costs are not included. Markup covers all fixed costs + target ROI Best suited for making short-term decisions because it considers variable-cost and fixed-cost behaviour patterns separately. Advantage By using only variable costs as the cost base, aid to management decision makers Variable cost per unit stays the same regardless of volume – reduces need for price changes Disadvantages: Price may be set too low Requires higher markup percentage to cover all fixed costs plus the R O I Time-and-material pricing A cost-plus pricing variation with two pricing rates: One for the labour used on a job - Includes actual labour costs and all benefits One for material used - Includes actual material cost plus any handling cost. Widely used in service industries especially professional firms. PRICING Transfer pricing for internal sales Vertically integrated frequently transfer goods to other divisions as well as outside customers - Divisions will ‘purchase’ from another division rather than purchase from an outside source - Keeps company’s labour force productive - Utilizes any available or spare capacity - Ensures in-house quality control Transfer price: price used to record the transfer between two divisions of a company. A firm’s transfer price policy should accomplish three objectives: Promote goal congruence – promote maximization of company’s earnings as a whole plus allow each manager to make decisions that maximize division earnings Maintain divisional autonomy Provide accurate performance evaluation General transfer price formula: Formula provides the minimum acceptable transfer price for the ‘selling’ division The maximum acceptable transfer price for the ‘purchasing’ division is the external price (if available) Available capacity plays a role in determining the transfer price. No Excess Capacity - If the firm is operating at capacity, then the transfer would ‘take away’ the contribution margin (CM) earned from any lost external sales - The lost CM is the opportunity cost of the transfer and becomes part of the transfer price There is Excess Capacity - If the firm has available capacity for the transfer, there is no opportunity cost, as there are no lost external sales PRICING Negotiated transfer price Negotiated transfer price is determined by agreement of division managers when no external market price is available Conceptually - a negotiated transfer price is best Due to practical considerations, the other two methods are more widely used In minimum transfer price formula switch VC for VC of units sold internally. Potential problems with negotiated approach: Market price information may not be available Lack of trust between the two divisions Different pricing strategies between divisions Cost based transfer prices Uses costs incurred by the division producing the goods at the cost base. May be based on VC or VC + FC. Markup may also be added. Can result in improper transfer prices causing: Loss of profitability for company Unfair evaluation of division performance Advantages Simple to understand Easy to use due to availability of information Market information often not available Disadvantages Does not reflect a division’s true profitability Does not provide an incentive to control costs which are passed on to the next division PRICING Market-Based transfer prices Based on actual market prices of competing products Considered best approach because: Objective Economic incentives Indifferent between selling internally and externally if the market price is used Can lead to bad decisions if there is excess capacity because no opportunity cost When a well-defined market price is not available, companies use cost-based systems. Effect of outsourcing on transfer prices Contracting with an external party to provide a good or service, rather than doing the work internally Virtual companies outsource all production As outsourcing increases, fewer components are transferred internally between divisions. Use incremental analysis to determine if outsourcing is profitable. Transfers between divisions in different countries Going global increases transfers between divisions located in different countries. 60% of trade between countries estimated to be transfers between divisions Different tax rates make determining appropriate transfer price more difficult.
