Pricing Decisions
EMBA 5412
Fall 2010
Pricing in today’s theory and
practice*

Not too much research on pricing- company and academic

Managers have a general tendency to believe that price is
an important issue for customers. Research, however,has
shown that customers are frequently unaware of prices paid
and that price is one of the least important purchase criteria
for them.
the impact of even small increases in price on profitability
by far exceeds the impact of other levers of operational
management, as shown in Fig. 1 (based on a sample of
Fortune 500 companies).
A 5% increase in average selling price increases earnings
before interest and taxes (EBIT) by 22% on average,
compared with the increase of 12% and 10% for a
corresponding increase in turnover and reduction in costs of
goods sold, respectively.


Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
2
Fig. 1. Pricing and its impact on
profitability
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
3
Fig. 2. High price and large market share—not as incompatible as
commonly believed
In conclusion,
it seems that
managers, as
price setters,
have a
general
tendency to
overestimate
the
importance of
price for
actual and
potential
customers
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
4
Pricing and Business
 How companies price a product or
service ultimately depends on the
demand and supply for it
 Three influences on demand and
supply:
1. Customers
2. Competitors
3. Costs
5
Influences on Demand and Supply



Customers – influence price through their
effect on the demand for a product or
service, based on factors such as quality
and product features
Competitors – influence price through their
pricing schemes, product features, and
production volume
Costs – influence prices because they
affect supply (the lower the cost, the
greater the quantity a firm is willing to
supply)
6
Time Horizons and Pricing
 Short-run pricing decisions have a time
horizon of less than one year and include
decisions such as:
 Pricing a one-time-only special order with no
long-run implications
 Adjusting product mix and output volume in a
competitive market
 Long-run pricing decisions have a time
horizon of one year or longer and include
decisions such as:
 Pricing a product in a major market where there
is some leeway in setting price
7
Pricing
 External sales- outside
 Target pricing-Competition-based pricing
 Cost plus pricing
 Variable cost pricing
 Customer based pricing-value-based pricing
 Time and material pricing
 Internal-within the company among divisions
 Negotiated transfer prices
 Cost based transfer prices
 Market based transfer prices
 Effect of outsourcing on transfer prices
 Transfers between divisions in different countries
8
Profit Maximization
Economic Theory
 The quantity demanded is a function of
the price that is charged
 Generally, the higher the price, the lower
the quantity demanded
Pricing
 Management should set the price that
provides the greatest amount of profit
9
Determining the ProfitMaximizing Price and Quantity
Profit is maximized where
marginal cost equals
marginal revenue, resulting
in price p* and quantity q*.
Dollars
per unit
p*
Demand
Marginal
cost
Marginal
revenue
q*
Quantity made
and sold
per month
10
Example 1
 The editor of EMBA Magazine is considering three
alternative prices for her new monthly periodical. Her
estimate of price and quantity demanded are:
Price
TL 6
TL 5
TL 4
Quantity
22,000
28,000
32,000
Monthly costs of producing and delivering the magazine
include TL90,000 of fixed costs and variable costs of
TL1.50 per issue.
 Which price will yield the largest monthly profit?
11
Solution Example 1
Price(TL) Demand
6
22.000
5
28.000
4
38.000
Variable Contribution
Income
Cost per Margin per Total CM
Fixed
Before
unit(TL)
unit(TL)
(TL)
Costs (TL) Tax (TL)
1,5
4,5
99.000
90.000
9.000
1,5
3,5
98.000
90.000
8.000
1,5
2,5
95.000
90.000
5.000
Choose TL 6 TL based on quantitative factors given.
Need to consider qualitative factors as well.
12
Determining the ProfitMaximizing Price and Quantity
Total cost
Total revenue
Dollars
p*
Total profit at the
profit-maximizing
quantity and price,
q* and p*.
q*
Quantity made
and sold
per month
13
Price Elasticity
The impact of
price changes on
sales volume
Demand is elastic if
a price increase has a
large negative impact
on sales volume.
Demand is inelastic if
a price increase has
little or no impact
on sales volume.
14
Who determines the price?
 Price takers- when there is a competitive market and
the company has no influence on price
 Once competition enters the market, the price of a
product becomes squeezed between the cost of the
product and the lowest price of a competitor.
 Price makers- companies that influence the price
•
Organizations that choose to compete by offering
innovative products and services have a more difficult
pricing decision because there is no existing price for
the new product or service.
15
Markets and Pricing
 Competitive Markets – use the
market-based approach
 Less-Competitive Markets – can use
either the market-based or costbased approach
 Noncompetitive Markets – use costbased approaches
16
Influences on Price




Customer demand
Competitors’ behavior/prices/actions
Costs
Regulatory environment – legal,
political and image related
17
Differences Affecting Pricing:
Long Run vs. Short Run


Costs that are often irrelevant for shortrun policy decisions, such as fixed costs
that cannot be changed, are generally
relevant in the long run because costs can
be altered in the long run
Profit margins in long-run pricing decisions
are often set to earn a reasonable return
on investment – prices are decreased
when demand is weak and increased when
demand is strong
18
Alternative Long-Run Pricing
Approaches
 Market-Based: price charged is based
on what customers want and how
competitors react
 Cost-Based: price charged is based
on what it cost to produce, coupled
with the ability to recoup the costs
and still achieve a required rate of
return
19
Market-Based Approach
 Starts with a target price
 Target Price – estimated price for a
product or service that potential
customers will pay
 Estimated on customers’ perceived
value for a product or service and
how competitors will price competing
products or services
20
Understanding the
Market Environment
 Understanding customers and competitors
is important because:



Competition from lower cost producers has
meant that prices cannot be increased
Products are on the market for shorter periods
of time, leaving less time and opportunity to
recover from pricing mistakes
Customers have become more knowledgeable
and demand quality products at reasonable
prices
21
22
Pricing approaches
 Cost plus mark-up
 Variable – contribution margin approach,
contribution margin( reflecting mark-up) should
cover desired return on investment, all fixed
costs
 Absorption – common- mark-up covers all
expenses except cost of goods sold plus the
desired return on investment
 Target costing– price is known
(competitor’s), desired return on
investment is known, price is known =
determine the maximum cost per unit
23
Cost-Plus Pricing
Company estimates cost of production
 Adds a markup to cost to arrive at price
which allows for a reasonable profit
Benefits
 Simple approach
Limitations
 What % markup to use?
 Inherently circular for manufacturing firms
 Requires considerable judgment and
experimentation
24
Product Life Cycle
25
http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf
Life Cycle Costing
 Life cycle costs are the total costs estimated to be
incurred in the design, development, production,
operation, maintenance, support, and final disposition
of a product/system over its anticipated useful life
span (Barringer and Weber, 1996).
 Product Life-Cycle spans the time from initial R&D on
a product to when customer service and support are
no longer offered on that product (orphaned)
 The best balance among cost elements is achieved
when the total LCC is minimized (Barringer and
Weber, 1996).
26
27
Life-Cycle Product
Budgeting and Costing
 Life-Cycle Budgeting involves estimating
the revenues and individual value-chain
costs attributable to each product from its
initial R&D to its final customer service and
support
 Life-Cycle Costing tracks and accumulates
individual value-chain costs attributable to
each product from its initial R&D to its final
customer service and support
28
Important Considerations for
Life-Cycle Budgeting
 Nonproduction costs are large
 Development period for R&D and
design is long and costly
 Many costs are locked in at the R&D
and design stages, even if R&D and
design costs are themselves small
29
Example

Murmur company produces electronic components that typically
have about 27-month life cycle. In October 2008, a new
component was proposed. Below are the budgeted costs and
profits over the life cycle of the product.
Unit production cost
unit life cycle cost
unit whole life cost
budgeted unit selling price
Budgeted costs
development
production
logistics
annual
post purchase costs-born by the customer
Annual total
Units produced and sold
6
10
12
15
2008
(200.000)
(200.000)
(200.000)
2009
(240.000)
(80.000)
(320.000)
(80.000)
(400.000)
40.000
2010
(360.000)
(120.000)
(480.000)
(120.000)
(600.000)
60.000
item total
(200.000)
(600.000)
(200.000)
(1.000.000)
(200.000)
(1.200.000)
30
Example
Budgeted Product Income Statement
Annual
Cumulative
Year
Revenues Costs
Income
Income
2008
(200.000)
(200.000)
(200.000)
2009 600.000
(320.000)
280.000
80.000
2010 900.000
(480.000)
420.000
500.000
Performance Report
Year
Cost Item
Actual Costs
2008 Development
190.000
2009 Production
300.000
Logistics
75.000
2010 Production
435.000
Logistics
110.000
Budgeted
Cost
Variance
200.000
10.000
240.000
(60.000)
80.000
5.000
360.000
(75.000)
120.000
10.000
F
U
F
U
F
110.000 U
31
Cost-Based (Cost-Plus) Pricing
 The general formula adds a markup
component to the cost base to
determine a prospective selling price
 Usually only a starting point in the
price-setting process
 Markup is somewhat flexible, based
partially on customers and
competitors
32
Forms of Cost-Plus Pricing
 Setting a Target Rate of Return on
Investment: the Target Annual Operating
Return that an organization aims to
achieve, divided by Invested Capital
 Selecting different cost bases for the “costplus” calculation:




Variable Manufacturing Cost
Variable Cost
Manufacturing Cost
Full Cost
33
Common Business Practice
 Most firms use full cost for their costbased pricing decisions, because:
 Allows for full recovery of all costs of the
product
 Allows for price stability
 It is a simple approach
34
Cost-plus Pricing
 Selling Price=
Cost + mark-up% x Cost
 Mark-up % =
Desired profit per unit ÷ Unit cost
 Desired profit =
Desired ROI x Investment
35
Which cost?
 Variable manufacturing cost
Price= variable manufacturing costs +
markup% * variable manufacturing cost
Mark-up should cover the remaining costs and provide for the
desired profit, i.e. variable selling and all fixed costs
VSC  FC  ADM  desiredpro fit
markup% 
vmcu * n
VSC: variable selling costs
FC:
fixed costs – manufacturing and selling
ADM: Administrative Expenses
n:
number of units to be sold
vmcu: variable manufacturing cost per unit
36
Which costs?
 Total variable costs
 Variable manufacturing and selling costs
Price= variable costs + markup %* variable costs
FC  ADM  desiredpro fit
markup% 
vmcu * n
37
Which costs?
 Absorption – manufacturing costs
 Unit manufacturing costs – both
variable and fixed
Price= unit manuf. cost + markup %* unit manufacturing cost
S & ADM  desiredpro fit
markup% 
unit cos t * n
S&ADM: Selling and administrative costs
Unit cost : unit manufacturing cost (variable and fixed)
38
Which costs?
 Absorption – total costs
 Total costs – manufacturing and selling
and administrative –fixed (direct or
allocated, variable costs)
Price= unit cost + markup %* unit cost
desiredpro fit
markup% 
Totalunit cos t * n
39
Example - Pricing
Annual sales 480 units
Unit costs:
Variable manufacturing cost
Applied fixed manufacturing cost
Absorption manufacturing cost
Variable selling costs
Allocated and direct fixed selling and administrative costs
Total cost (Manufacturing and S&ADM)
Investment
Desired profit 10% of investment
Annual Fixed Manufacturing Costs
Annual Fixed (allocated and direct) Selling and
$ 400
$ 250
$ 650
$ 50
$ 100
$ 800
$ 600,000
$ 60,000
$ 120,000
Administrative Costs
$ 48,000
40
Cost Plus Pricing Versions
variable manufacturing cost-plus-pricing
Variable manufacturing cost
Total Variable Selling Costs ($50 x 480 units)
Desired profit
Fixed Costs
mark -up %
markup
Price = cost + markup
$400
$24.000
$60.000
$168.000
131,25%
$525
$925
41
Cost Plus Pricing Versions
variable total cost-plus-pricing
Total variable cost per unit
Fixed Costs
Desired Profit
mark -up %
markup
Price = cost + markup
$450
$168.000
$60.000
105,56%
$475
$925
42
Cost Plus Pricing Versions
manufacturing cost per unit
Total variable selling costs
Fixed Selling and Administration
Desired Profit
mark -up %
markup
Price = cost + markup
$650
$24.000
$48.000
$60.000
42,31%
$275
$925
43
Cost Plus Pricing Versions
total absorption- cost-plus-pricing
Total cost per unit
Desired Profit
mark -up %
markup
Price = cost + markup
$800
$60.000
15,63%
$125
$925
44
Cost plus comparison
Cost
plus
type
Mark
up %
Price
Variable
manufac
turing
cost
plus
mark up
131.25
Variable
cost
plus
mark up
Manufac Full cost
turing
plus
costs
mark up
plus
mark up
105.56
42.31
15.63
925
925
925
925
45
Retail cost plus mark-up
 Mark up on cost of goods sold
= (selling and administrative costs +
operating income) / COGS
46
Retail Example
 Yesim Textile’s income statement for 2007 is as follows:
Revenues
Cost of goods sold
Gross profit
Selling and Administrative Exp
Operating profit
Mark up %
TL1.427.010
(713.500)
713.510
(535.750)
TL177.760
100,00%
47
Project Example
 EMBA Consultancy Co needs to bid for a project.
EMBA’s recent income statement appears below:
Revenues
Cost of Services
Material
Personnel
Overhead
Total Cost of services
Gross profit
Selling and Administrative Exp
Operating profit
Mark up %
TL1.627.010
(TL45.000)
(650.000)
(555.000)
(1.250.000)
377.010
(235.750)
TL141.260
30,16%
Man-hour rate TL 65; overhead application 0.85 of
personnel costs
48
Project Example
 EMBA Consultancy needs to bid for a new project.
Material costs will be TL 5.000; 150 man hours will
be used. What would be a guiding bidding price?
Material
Man-hour (150 man hourx65)
Overhead (0.85*man-hour cost)
Total Cost
mark up percentage
bid price
TL5.000,00
9.750,00
8.287,50
23.037,50
30,16%
TL29.985,79
49
Pros and Cons of Cost plus pricing
 Easy to compute
 No consideration to the demand side
 Sales volume plays an important roleallocation of fixed costs over the
products sold
 If variable cost plus used then fixed
costs might not be covered if not
calculated correctly
50
Pricing Special Orders
In some cases, it may be beneficial
for a company to charge a price lower
than its full cost
 Only if the order will not affect demand
for its other products
51
Special Orders – Premier Lens
Example
Given the following information, should Premier Lens
produce 20,000 lenses to be sold to Blix Camera for
$73 per lens?
52
Special Orders – Premier Lens
Example
The incremental analysis shows that it should. Note
that the fixed costs are not incremental and need not
be included in the decision making.
53
Target Costing
54
Five Steps in Developing
Target Prices and Target Costs
1. Develop a product that satisfies the needs of
potential customers
2. Choose a target price



price is the same as the competition
set price to increase customer base
seek larger market share through price
3. Derive a target cost per unit:

Target Price per unit minus Target Operating Income
per unit
4. Perform cost analysis
5. Perform value engineering to achieve target
cost
55
Value Engineering
 Value Engineering is a systematic
evaluation of all aspects of the value
chain, with the objective of reducing
costs while improving quality and
satisfying customer needs
 Managers must distinguish valueadded activities and costs from nonvalue-added activities and costs
56
Value Engineering Terminology
 Value-Added Costs – a cost that, if
eliminated, would reduce the actual or
perceived value or utility (usefulness)
customers obtain from using the product or
service
 Non-Value-Added Costs – a cost that, if
eliminated, would not reduce the actual or
perceived value or utility customers obtain
from using the product or service. It is a
cost the customer is unwilling to pay for
57
Value Engineering Terminology
 Cost Incurrence – describes when a
resource is consumed (or benefit
forgone) to meet a specific objective
 Locked-in Costs (Designed-in Costs)
– are costs that have not yet been
incurred but, based on decisions that
have already been made, will be
incurred in the future
 Are a key to managing costs well
58
Problems with Value Engineering
and Target Costing
1. Employees may feel frustrated if they fail
to attain targets
2. A cross-functional team may add too many
features just to accommodate the wishes
of team members
3. A product may be in development for a
long time as alternative designs are
repeatedly evaluated
4. Organizational conflicts may develop as
the burden of cutting costs falls unequally
on different business functions in the firm’s
value chain
59
Example Target costing
Nownew company feels that there is a market niche for a
mouse with special new features. After surveying the
features and prices of available mouses on the
market, Marketing department believes that a price of
TL 30 would be about right for the new mouse.
Marketing department estimates to sell about 40.000
mouses. To design, develop and produce these new
mouses and investment of TL 2.000.000 would be
required. The company desires 15% ROI on all new
projects. What is the highest target cost to
manufacture, sell and service the new product?
60
Example target costing
Projected Sales
Less Desired profit
Target Cost for
Target Cost per mouse
40000 mouse
30
15% 2.000.000
40000 mouse
1.200.000
300.000
900.000
TL22,50
61
Customer-based pricing
 Value based pricing-the price is based on
the customer ‘demand’ or need for the
product
 Unique product – value based pricing might be
helpful to create demand
 use price to support product image
 set price to increase product sales
 design a price range to attract many
consumer groups
 set price to increase volume sales
 price a bundle of products to reduce
inventory or to excite customers
62
concept of economic (or
customer) value

Two interpretations:

the difference between the consumer’s willingness to pay
and the actual price paid, which is equal to the ‘‘consumer
surplus,’’ the excess value retained by the consumer.
the maximum amount a customer would pay to obtain a
given product, that is, the price that would leave the
customer indifferent between the purchase and foregoing
the purchase. Customer value in this sense is equal to the
microeconomic concept of a customer’s ‘‘reservation price’’
and the use value of goods.
product’s economic value is the price of the
customer’s best alternative—reference value—plus
the value of whatever differentiates the offering from
the alternative— differentiation value (Nagle &
Holden, 1999).


63
To quantify economic value
 Step 1: Identify the cost of the competitive
product and process that consumer views
as best alternative
 put oneself in the eyes and in the shoes of
customers and ask what they view as best
alternative to the purchase of the product
being analyzed
 Step 2: Segment the market
 e.g. Microsoft, for example, is known for
handing out beta-versions of its latest
enterprise software products to particularly
knowledgeable companies and customer
segments
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
64
To quantify economic value
 Step 3: Identify all factors that differentiate
the product from the competitive product
and process.
 Step 4: Determine the value to the
customer of these differentiating factors.
 Conjoint analysis is a simple tool which aims to
capture trade-offs in product features in a
systematic way and to assign monetary values
to specific attributes (Auty, 1995). Customers
are presented with a set of two similar products
differing in price and other qualitative features
and are forced to indicate which set of attributes
they prefer
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
65
To quantify economic value
 Step 5: Sum the reference value and
the differentiation value to determine
the total economic value.

The product’s economic value is simply the
sum of the price of the reference product
plus its differentiation value.
 Step 6: Use the value pool to estimate
future sales at specific price points.
 For each price point, sales can be expected
to comprise a significant share of all market
segments, which value the product higher
than the specific price examined
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
66
Example of value based pricing
 Japanese industrial equipment manufacturer.
 In its home market, its standard model was priced at
the equivalent of US$80,000 compared with
US$50,000 for a similar model by its main competitor
from the United States.
 In Japan, the company sold about 80% more units
than its U.S. competitor, while in the United States,
where the company had a weaker distribution system,
both companies had roughly the same unit sales,
although historical growth rates of the Japanese
company had by far exceeded the growth rates of its
U.S. rival.
 What is the reason that the Japanese company was
able to achieve both a high relative market share and
a significant price premium?
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
67
WHY?
 For each industry segment,the Japanese
company had developed detailed
financial models of different cost and
benefit components of its own
equipment versus its main competitor
 For a customer in the printing ink
industry, the positive and negative
differentiation value was quantified in
the following way:
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
68
69
Analysis
 Under this angle, the price premium of
the Japanese company is modest. If an
interest rate of 8% is applied to the net
benefits gained over the average life
cycle of this equipment of 4 years, the
positive differentiation value amounts to
well over US$300,000. Customers are
expected to pay only a small fraction—
less than 10% and US $30,000—of the
product’s economic value.
Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial
Marketing Management 33 (2004) 765– 778
70
Analyzing Customer Profitability
Customer Profitability Measurement
System (CPM)
 Indirect costs of servicing customers are
assigned to cost pools
 For example the cost of processing orders and
handling returns
 Costs are allocated to specific customers
using cost drivers to determine customer
profitability
71
Customer Profitability Measurement
System
72
Example – Customer profitability

Delta Products has determined the following costs:
Order processing/order
Additional handling cost per rush order
Customer service calls/call
Relationship management costs/customer

In addition to these costs, product costs amount to 90% of sales.
In the prior year, Delta had the following experience with Johnson
Brands:
Sales
Number of orders
Percent of orders marked rush
Calls to customer service

$5.00
$8.50
$10.00
$2,000.00
$53,800
200
60
140
Calculate the profitability of the Johnson Brands account.
73
Example Solution
 Profitability of Johnson Brand account
Sales
Less:
Cost of good sold (.9 × $53,800)
Order processing (200 × $5.00)
Rush handling (.6 × 200 × $8.50)
Customer service (140 × $10.00)
Relationship management costs
Profitability of Johnson Brands account
$53,800
$48,420
$1,000
$1,020
$1,400
$2,000 $53,840
$(40)
74
Time and Material Pricing
 Determine a charge for labor that
includes overhead
 Determine a charge for materials that
includes handling and storage costs
 Include a profit
 Sum = price
 Used in service companies mainly;
appropriate for construction
companies as well
75
Example
Investment
Desired profit 10% of investment
Annual labor hours
Hourly charge to cover profit margin
Labor rate per hour
Annual overhead costs:
Material handling and storage
Other overhead costs(supervision,utilities,
insurance,and depreciation)
Annual cost of materials used in repair
department
4% x
1.000.000
$700,000.00
$70,000.00
10,000
$7.00
$18.00
$40,000.00
$200,000.00
$1,000,000.00
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Time and Material Charges
Time Charge per hour =
hourly labor cost +
(annual overhead [excluding material
overhead] /
annual labor hours) +
hourly charge to cover profit margin
= $18 + ($200,000 / 10,000 hours) + $7
= $ 45 per labor hour
77
Time and Material Charges
Material Charge formula
Material cost incurred on job
+[material cost incurred on job *
(material handling and storage costs / annual cost
of materials used in Repair Department)]
= material costs incurred on job +[material
costs incurred on job *
($40,000/$1,000,000)]
=1.04 x material costs incurred on job
4% of material costs
78
Example con’t
JOB NO 101
Labor hours
cost of materials
total price of job 101
material cost
handling and storage
total material cost
Labor rate
labor hours
TOTAL COST OF JOB 101
200
$8.000
$8.000
$320
$8.320,00
$45,00
200
$9.000,00
$17.320,00
79
Activity-Based Pricing
 Customers are presented with separate
prices for services they request in addition
to the cost of goods purchased

Customers will carefully consider the services they request
 Example
80
Other Important Considerations
in Pricing Decisions
 Price Discrimination – the practice of
charging different customers different
prices for the same product or service
 Legal implications
 Peak-Load Pricing – the practice of
charging a higher price for the same
product or service when the demand
for it approaches the physical limit of
the capacity to produce that product
or service
81
The Legal Dimension of
Price Setting
 Price Discrimination is illegal if the
intent is to lessen or prevent
competition for customers
 Predatory Pricing – deliberately
lowering prices below costs in an
effort to drive competitors out of the
market and restrict supply, and then
raising prices
82
The Legal Dimension of
Price Setting
 Dumping – a non-US firm sells a product in
the US at a price below the market value in
the country where it is produced, and this
lower price materially injures or threatens
to materially injure an industry in the US
 Collusive Pricing – occurs when companies
in an industry conspire in their pricing and
production decisions to achieve a price
above the competitive price and so restrain
trade
83
Transfer pricing
Transfer Price is:
the internal price charged by one segment of a
firm for a product or service supplied to
another segment of the same firm
Such as:
 Internal charge paid by final assembly division
for components produced by other divisions
 Service fees to operating departments for
telecommunications, maintenance, and
services by support services departments
84
Transfer Pricing
 The transfer price creates revenues
for the selling subunit and purchase
costs for the buying subunit, affecting
each subunit’s operating income
 Intermediate Product – the product or
service transferred between subunits
of an organization
85
Effects of Transfer Prices
Performance measurement:
 Reallocate total company profits among
business segments
 Influence decision making by purchasing,
production, marketing, and investment
managers
Rewards and punishments:
 Compensation for divisional managers
Partitioning decision rights:
 Disputes over determining transfer prices
86
Three Transfer Pricing Methods
1. Market-based Transfer Prices
2. Cost-based Transfer Prices
3. Negotiated Transfer Prices
87
Market-Based Transfer Prices
 Top management chooses to use the
price of a similar product or service
that is publicly available. Sources of
prices include trade associations,
competitors, etc.
88
Market-Based Transfer Prices
 Lead to optimal decision making
when three conditions are satisfied:
1. The market for the intermediate product
is perfectly competitive
2. Interdependencies of subunits are
minimal
3. There are no additional costs or benefits
to the company as a whole from buying
or selling in the external market instead
of transacting internally
89
Market-Based Transfer Prices
 A perfectly competitive market exists when
there is a homogeneous product with
buying prices equal to selling prices and no
individual buyer or seller can affect those
prices by their own actions
 Allows a firm to achieve goal congruence,
motivating management effort, subunit
performance evaluations, and subunit
autonomy
 Perhaps should not be used if the market is
currently in a state of “distress pricing”
90
Cost-Based Transfer Prices
 Top management chooses a transfer price
based on the costs of producing the
intermediate product. Examples include:




Variable Production Costs
Variable and Fixed Production Costs
Full Costs (including life-cycle costs)
One of the above, plus some markup
 Useful when market prices are unavailable,
inappropriate, or too costly to obtain
91
Cost-Based Transfer Pricing
Alternatives
 Prorating the difference between the
maximum and minimum cost-based
transfer prices
 Dual-Pricing – using two separate
transfer-pricing methods to price
each transfer from one subunit to
another. Example: selling division
receives full cost pricing, and the
buying division pays market pricing
92
Negotiated Transfer Prices
 Occasionally, subunits of a firm are free to
negotiate the transfer price between
themselves and then to decide whether to
buy and sell internally or deal with external
parties
 May or may not bear any resemblance to
cost or market data
 Often used when market prices are volatile
 Represent the outcome of a bargaining
process between the selling and buying
subunits
93
Comparison of
Transfer-Pricing Methods
Criteria
MarketBased
CostBased
Negotiated
Achieves Goal
Congruence
Yes, when
markets are
competitive
Often, but not
always
Yes
Useful for
Evaluating Subunit
Performance
Yes, when
markets are
competitive
Difficult unless
transfer price
exceeds full cost
and even then is
somewhat
arbitrary
Yes, but transfer
prices are affected
by bargaining
strengths of the
buying and selling
divisions
94
Comparison of
Transfer-Pricing Methods
Criteria
MarketBased
CostBased
Negotiated
Motivates
Management
Effort
Yes
Yes, when based on
budgeted costs;
less incentive to
control costs if
transfers are based
on actual costs
Yes
Preserves Subunit
Autonomy
Yes, when
markets are
competitive
No, because it is
rule-based
Yes, because it is
based on
negotiations
between subunits
95
Comparison of
Transfer-Pricing Methods
Criteria
Other Factors
MarketBased
CostBased
Negotiated
No market may
Useful for
Bargaining and
exist or
determining
negotiations
markets may
full cost of
take time and
be imperfect or products; easy may need to be
in distress
to implement
reviewed
repeatedly as
conditions
change
96
Ideal Transfer Pricing
Ideal transfer price would be
 Opportunity cost, or the value forgone by not using the
transferred product in its next best alternative use
 Opportunity cost is the greater of variable production
cost or revenue available if the product is sold outside of
the firm
97
Minimum Transfer Price
 The minimum transfer price in many
situations should be:
Minimum
Transfer Price
=
Incremental cost per unit
incurred up to the point of
transfer
+
Opportunity Cost per unit
to the selling subunit
 Incremental cost is the additional cost of
producing and transferring the product or
service
 Opportunity cost is the maximum contribution
margin forgone by the selling subunit if the
product or service is transferred internally
98
Transfer Pricing Methods

External market price
 If external markets are comparable

Variable cost of production
 Exclude fixed costs which are unavoidable

Full-cost of production
 Average fixed and variable cost

Negotiated prices
 Depends on bargaining power of divisions
99
Transfer Pricing
Implementation

Disputes over transfer pricing occur frequently because transfer
prices influence performance evaluation of managers

Internal accounting data are often used to set transfer prices, even
when external market prices are available

Classifying costs as fixed or variable can influence transfer prices
determined by internal accounting data

To reduce transfer pricing disputes, firms may reorganize by
combining interdependent segments or spinning off some
segments as separate firms
100
Transfer Pricing for International Taxation
When products or services of a multinational firm are transferred
between segments located in countries with different tax rates, the
firm attempts to set a transfer price that minimizes total income
tax liability.
Segment in higher tax country:
Reduce taxable income in that country by charging high prices on
imports and low prices on exports.
Segment in lower tax country:
Increase taxable income in that country by charging low prices
on imports and high prices on exports.
Government tax regulators try to reduce transfer pricing manipulation.
101