Managerial Accounting
Weygandt • Kieso • Kimmel
CHAPTER 8
PRICING
Prepared by
Dan R. Ward
Suzanne P. Ward
University of Louisiana at Lafayette
John Wiley & Sons, Inc. © 2005
CHAPTER 8
PRICING
Study Objectives
Compute a target cost when a product price is
determined by the market.
Compute a target selling price using cost-plus
pricing.
Use time and material pricing to determine the
cost of services provided.
Study Objectives: Continued
Determine a transfer price using the negotiated,
cost-based, and market-based approaches.
Explain the issues that arise when transferring
goods between divisions located in countries
with different tax rates.
EXTERNAL SALES
 Many factors affect price
 Product price should cover costs and earn a reasonable
profit
 Must have a good understanding of market forces for
appropriate price
EXTERNAL SALES - Continued
 Price taker - a company whose
price is set by the competitive
market (supply and demand)
 Market sets price when product
cannot be easily differentiated
from competing products
 farm products
 minerals
EXTERNAL SALES - Continued
 Company sets the price when
 Product is specially made - one of a kind product
 No one else produces the product
 Company can differentiate its product from others
 Examples
 Designer dress
 Patent or copyright on a unique process
 Starbucks – premium cup of coffee
TARGET COSTING
Study Objective 1
 In a highly competitive market:
Price is largely determined by supply and demand
 Must control costs to earn a profit
 Target cost - cost that provides the desired profit
on a product when the seller does not have control
over the product’s price
TARGET COSTING
Steps
 Find market niche
 Select segment to compete in
 For example, luxury goods or economy goods
 Determine target price
 Price that company believes would place it in the
optimal position for its target audience
 Use market research
TARGET COSTING
Steps - Continued
 Determine target cost
 Difference between target price
and desired profit
 Includes all product and period
costs necessary to make and
market the product
 Assemble expert team
 Includes production, operations,
marketing, finance
 Design and develop a product
that meets quality specifications
while not exceeding target cost
COST-PLUS PRICING
Study Objective 2
 May have to set own price where there is little or
no competition
 Price typically a function of product cost
 Steps:
 Establish a cost base
 Add a markup (based on desired operating income or
return on investment)
COST-PLUS PRICING - Continued
Example – Cleanmore Products
 Manufactures wet/dry shop vacuums
 Per unit variable cost estimates:
 Fixed cost per unit $52 = $28 fixed manufacturing overhead
+ $24 fixed selling and administrative expenses (based on a
budgeted volume of 10,000 units)
COST-PLUS PRICING
Example – Continued
 Markup = 20% ROI of $1,000,000
 Expected ROI = $200,000 ÷ 10,000 units
 Sales price per unit = $132
COST-PLUS PRICING
Example – Continued
 Steps for using a markup on cost to set selling price:
 Compute markup percentage for desired ROI:
 Compute target selling price using markup percentage:
COST-PLUS PRICING
LIMITATIONS
 Advantage - Easy to compute
 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 higher price to meet
desired ROI
COST-PLUS PRICING – LIMITATIONS
Example – Continued
 Reduce budgeted sales volume to 8,000 units:
 Variable cost per unit remain the same,
 Fixed cost per unit increases from $52 per unit to:
 Desired 20% ROI now results in a per unit ROI of
$25 [(20% X 1,000,000) ÷ 8,000]
COST-PLUS PRICING – LIMITATIONS
Example – Continued
 New selling price:
 The lower the budgeted volume, the higher the per
unit price
 Fixed costs and ROI spread over fewer units
 Fixed costs and ROI per unit increase
 Opposite effect occurs if budgeted volume is higher
VARIABLE COST PRICING
 Alternative pricing approach:
Simply add a markup to variable costs
 Avoids using poor cost information related to
fixed costs per unit
 Useful in pricing special orders or when excess
capacity exists
 Major disadvantage:
Prices set too low to cover fixed costs
Let’s Review
Cost-plus pricing means that:
a. Selling price = Variable cost + (Markup
percentage + Variable cost)
b. Selling price = Cost + (Markup percentage X
Cost)
c. Selling price = Manufacturing cost + (Markup
percentage + Manufacturing cost)
d. Selling price = Fixed cost + (Markup
percentage X Fixed cost)
Let’s Review
Cost-plus pricing means that:
a. Selling price = Variable cost + (Markup
percentage + Variable cost)
b. Selling price = Cost + (Markup percentage X
Cost)
c. Selling price = Manufacturing cost + (Markup
percentage + Manufacturing cost)
d. Selling price = Fixed cost + (Markup
percentage X Fixed cost)
TIME AND MATERIAL PRICING
Study Objective 3
 An approach to cost-plus pricing in which the
company uses two pricing rates:
 One for the labor used on a job
 One for the material
 Widely used in service industries, especially
professional firms
 Public accounting
 Law
 Engineering
TIME AND MATERIAL PRICING
Steps
Calculate the labor
charge
Calculate the
material loading
charge
Calculate the charges
for a job
TIME AND MATERIAL PRICING
Example – Lake Holiday Marina
 Budgeted data:
TIME AND MATERIAL PRICING
Example - Continued
 Determine a charge for labor time
 Express as a rate per hour of labor
 Rate includes:
• Direct labor cost of employees (includes fringe benefits)
• Selling, administrative, and similar overhead costs
 Allowance for desired profit (ROI) per hour of employee time
 Labor rate for Lake Holiday Marina for 2005 based on:
• 5,000 hours of repair time
• Desired profit margin of $8 per hour
TIME AND MATERIAL PRICING
Example – Lake Holiday Marina (Continued)
Per Hour
Total
Cost
Hourly labor rate for repairs
Mechanics wages/benefits
$103,500
Overhead Costs
Office employees salaries/benefits 20,700
Office overhead
26,800
Total hourly cost
$151,000
Profit Margin
Rate charged per hour of labor
÷
Total
Hours
=
Per Hour
Charge
÷
5,000
=
$20.70
÷
÷
÷
5,000
5,000
15,000
=
=
=
4.14
5.36
$30.20
8.00
$38.20
TIME AND MATERIAL PRICING
Example - Continued
 Calculate the Material Loading Charge
 Material loading charge added to invoice price of materials to
determine materials price
 Estimated annual costs of purchasing, receiving, handling,
storing + desired profit margin on materials
 Expressed as a percentage of estimated annual parts and
materials cost:
Estimated purchasing, receiving,
handing, storing costs
desired profit margin
Estimated costs of parts/materials
on materials
TIME AND MATERIAL PRICING
Example – Lake Holiday Marina (Continued)
Material
Total Invoice
Material
Loading ÷ Cost, Parts, = Loading
Charges
and Materials
Percentage
Overhead costs
Parts managers salary/benefits
Office employees salary
Other overhead
$11,500
2,300
$13,800
÷
$120,000
=
11.50%
14,400
$28,200
÷
÷
120,000
120,000
=
=
12.00%
23.50%
Profit margin
20.00%
Material Loading Percentage
43.50%
TIME AND MATERIAL PRICING
Example – Continued
 Calculate Charges for a
Particular Job =
 Labor charges
+
 Material charges
+
 Material loading charge
TIME AND MATERIAL PRICING
Example – Continued
Determine a price quote to refurbish a pontoon boat:
Estimated 50 hours of labor
Estimated $3,600 parts and materials
INTERNAL SALES
 Vertically integrated companies – grow in direction of
customers or supplies
 Frequently transfer goods to other divisions as well as outside
customers
How do you price goods when they are “sold” within the company?
INTERNAL SALES
Study Objective 4
 Transfer price - price used to record the transfer
between two divisions of a company
 Ways to determine a transfer price:
 Negotiated transfer prices
 Cost-based transfer prices
 Market-based transfer prices
 Conceptually - a negotiated transfer price is best
 Due to practical considerations, other two methods
are more widely used
NEGOTIATED TRANSFER PRICE
Determined by
agreement of the
division managers
when no external
market price is
available
NEGOTIATED TRANSFER PRICE
Example – Alberta Company
 Sells hiking boots as well as soles for work & hiking boots
 Structured into two divisions: Boot and Sole
 Sole Division - sells soles externally
 Boot Division - makes leather uppers for hiking boots
which are attached to purchased soles
 Each Division Manager compensated on division
profitability
 Management now wants Sole Division to provide at least
some soles to the Boot Division
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
Divisional Contribution Margin Per Unit
(Boot Division purchases soles from outsiders)
What would be a fair transfer price if the Sole Division sold
10,000 soles to the Boot Division?
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
 Sole Division has no excess capacity
 If Sole sells to Boot, payment must at least cover
variable cost per unit plus its lost
contribution margin per sole (opportunity cost)
 The minimum transfer price acceptable to Sole:
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
Maximum Boot Division will pay is
what the sole would cost from an outside buyer
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
 Sole Division has excess capacity
 Can produce 80,000 soles, but can sell only 70,000
 Available capacity of 10,000 soles
 Contribution margin is not lost
 The minimum transfer price acceptable to Sole:
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
Negotiate a transfer price between $11 (minimum acceptable to
Sole) and $17 (maximum acceptable to Boot)
NEGOTIATED TRANSFER PRICE
Variable Costs
 In the minimum transfer price formula,
variable cost is the variable cost of units sold
internally
 May differ - higher or lower - for units sold
internally versus those sold externally
 The minimum transfer pricing formula can still
be used – just use the internal variable costs
NEGOTIATED TRANSFER PRICE
Summary
 Transfer prices established:
 Minimum by selling division
 Maximum by the buying division
 Often not used because:
 Market price information sometimes not available
 Lack of trust between the two divisions
 Different pricing strategies between divisions
 Therefore, companies often use cost or market
based information to develop transfer prices
COST-BASED TRANSFER PRICES
 Uses costs incurred by the division producing the
goods as its foundation
 May be based on variable costs or variable costs
plus fixed costs
 Markup may also be added
 Can result in improper transfer prices causing:
 Loss of profitability for company
 Unfair evaluation of division performance
COST-BASED TRANSFER PRICES
Example – Alberta Company
 Base transfer price on variable cost of sole and no excess capacity
 Bad deal for Sole Division – no profit on transfer of 10,000 soles
and loses profit of $70,000 on external sales
 Boot Division increases contribution margin by $6 per sole
COST-BASED TRANSFER PRICES
Example – Alberta Company (Continued)
No Excess Capacity
COST-BASED TRANSFER PRICES
Example – Alberta Company (Continued)
 Sole Division has excess capacity:
Continues to report zero profit but does not lose the
$7 per unit due to excess capacity
 Boot Division gains $6
 Overall, company is better off by
$60,000 (10,000 X 6)
 Does not reflect Sole Division’s true profitability
COST-BASED TRANSFER PRICES
Summary
 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
 Advantages
 Simple to understand
 Easy to use due to availability of information
 Market information often not available
 Most common method
MARKET-BASED TRANSFER PRICES
 Based on existing market prices of competing products
 Often considered best approach because:
 Objective
 Economic incentives
 Indifferent between selling internally and externally if
can charge/pay market price
 Can lead to bad decisions if have excess capacity
Why? No opportunity cost
 Where there is not a well-defined market price,
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 of their
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
Study Objective 5
 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
TRANSFERS BETWEEN DIVISIONS IN
DIFFERENT COUNTRIES
Example – Alberta Company
 Boot Division is in a country with 10% tax rate
 Sole Division is located in a country with a 30% rate
 The before-tax total contribution margin is $44 regardless of
whether the transfer price is $18 or $11
 The after-tax total is
 $38.20 using the $18 transfer price, and
 $39.60 using the $11 transfer price
Why? More of the contribution margin is attributed to the
division in the country with the lower tax rate
TRANSFERS BETWEEN DIVISIONS IN
DIFFERENT COUNTRIES
Example – Alberta Company (Continued)
APPENDIX:
ABSORPTION COST APPROACH
Study Objective 6
 Consistent with GAAP
 Both variable and fixed selling and
administrative costs are excluded from the cost
base
 Steps in approach:
 Compute the unit manufacturing cost
 Compute the markup percentage
 Set the target selling price
APPENDIX: ABSORPTION COST APPROACH
Example – Cleanmore Products, Inc. – Step 1
 Unit manufacturing costs at volume of 10,000 units:
 Selling and administrative expenses per unit and desired ROI
per unit
APPENDIX: ABSORPTION COST APPROACH
Example – Cleanmore Products, Inc. – Step 2
 Compute markup percentage:
Percentage must cover desired ROI and
the selling and administrative expenses
APPENDIX: ABSORPTION COST APPROACH
Example – Cleanmore Products, Inc. – Step 3
 Set the target price
 Because of the fixed cost element, if more than 10,000 units
are sold, the ROI will be greater than 20% and vice versa
 Most companies that use cost-plus pricing use either
absorption (or full) cost as the basis
APPENDIX: ABSORPTION COST APPROACH
Example – Cleanmore Products, Inc
 A target price of $132 produces the desired 20% ROI
APPENDIX:
ABSORPTION COST APPROACH
Summary
 Used by most companies
that use cost-plus pricing
 Reasons:
 Information readily
available – cost effective
 Use of only variable costs
may result in too low a
price – suicide price cutting
 Most defensible base for
justifying prices
APPENDIX: CONTRIBUTION
(VARIABLE COST) APPROACH
 Cost base consists of all variable costs associated
with a product – manufacturing, selling,
administrative
 Since fixed costs are not included in base,
markup must provide for fixed costs (manufacturing,
selling, administrative) and the target ROI
 Useful for making short-run decisions because
considers variable and fixed cost behaviors
separately
APPENDIX: CONTRIBUTION
(VARIABLE COST) APPROACH
Steps
Compute unit
variable cost
Compute markup
percentage
Set target selling
price
APPENDIX: CONTRIBUTION
(VARIABLE COST) APPROACH
Example – Cleanmore Products, Inc – Step 1
 Compute the unit variable cost
APPENDIX: CONTRIBUTION
(VARIABLE COST) APPROACH
Example – Cleanmore Products, Inc – Step 2
 Determine the markup percentage:
APPENDIX: CONTRIBUTION
(VARIABLE COST) APPROACH
Example – Cleanmore Products, Inc – Step 3
 Set the target selling price:
APPENDIX: CONTRIBUTION
(VARIABLE COST) APPROACH
Example – Cleanmore Products, Inc
 A target price of $132 produces the desired ROI of 20%
APPENDIX: CONTRIBUTION
(VARIABLE COST) APPROACH
Summary
 Avoids blurring effects of cost behavior on
operating income
 However, basic accounting data less accessible
 Reasons contribution approach used:
 More consistent with CVP analysis
 Provides data for pricing special orders by showing
incremental cost of accepting one more order
 Avoids arbitrary allocation of common fixed costs to
individual product lines
Summary of Study Objective (Appendix)
 Determine prices using the absorption cost approach and the
contribution (variable cost) approach.
 Absorption cost approach uses manufacturing cost as the cost base and
provides for selling and administrative expenses and the target ROI
through markup
• Target selling price:
Manufacturing cost per unit +
(Markup percentage X Manufacturing cost per unit)
 Contribution approach uses all variable costs, including selling and
administrative, as the cost base
• Provides for fixed costs and target ROI through markup
• Target selling price:
Variable cost per unit +
(Markup percentage X Variable cost per unit)
Let’s Review
The following information is provided for
Mystique Co. for the new product it recently
introduced.
Total unit cost
$30
Desired ROI per unit
$10
Target selling price
$40
What would be Mystique Co.’s percentage
markup on cost?
a. 125%
c.
33 1/3%
b. 75%
d.
25%
Let’s Review
The following information is provided for
Mystique Co. for the new product it recently
introduced.
Total unit cost
$30
Desired ROI per unit
$10
Target selling price
$40
What would be Mystique Co.’s percentage
markup on cost?
a. 125%
c.
33 1/3%
b. 75%
d.
25%
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