Transcript Pricing Decisions - METU | Middle East Technical University

Pricing Decisions
EMBA 5411
Budgeting and Pricing
Pricing
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External sales- outside
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Target costing
Cost plus pricing
Variable cost pricing
Time and material pricing
Internal-within the company among divisions
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Negotiated transfer prices
Cost based transfer prices
Market based transfer prices
Effect of outsourcing on transfer prices
Transfers between divisions in different countries
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Profit Maximization
Economic Theory

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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
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Determining the ProfitMaximizing Price and Quantity
Dollars
per unit
Profit is maximized where
marginal cost equals
marginal revenue, resulting
in price p* and quantity q*.
p*
Demand
Marginal
cost
q*
Marginal Quantity made
revenue
and sold
per month
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Determining the Profit-Maximizing
Price and Quantity
Total cost
Total revenue
Dollars
Total profit at the
profit-maximizing
quantity and price,
q* and p*.
q*
Quantity made
and sold
per month
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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.
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Who determines the price?
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Price takers- when there is a competitive market
and the company has no influence on price
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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.
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Influences on Price
Customer demand
 Competitors’ behavior/prices/actions
 Costs
 Regulatory environment – legal, political
and image related
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Pricing approaches
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Cost plus mark-up
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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, desired return on
investment is known, price is known = determine
the maximum cost per unit
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Product Life Cycle
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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).
 The best balance among cost elements is
achieved when the total LCC is minimized
(Barringer and Weber, 1996).
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Cost-plus Pricing
Cost + mark-up = price
 Mark-up = cost x desired % return
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Which cost?
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Variable manufacturing cost
Price= vari.man. costs + markup% * var.man.cost
Mark-up should cover the remaining costs and
provide for the desired profit, i.e. variable selling
and all fixed costs
Desired profit = desired % return * investment
var.selling  fixed costs  desiredprofit
m arkup% 
var.m an. costperunit* num berofun
itproduced
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Which costs?

Total variable costs

Variable manufacturing and selling costs
Price= variable costs + markup %* variable costs
fixed costs  desiredprofit
m arkup% 
variablecostperunit* num berofunitproduced
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Which costs?
Absorption – manufacturing costs
 Unit manufacturing costs – both variable
and fixed
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Price= unit manuf. cost + markup %* unit manufacturing cost
sellingandadm. expenses  desiredprofit
m arkup% 
unitm anuf. cost * num berofun
itproduced
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Which costs?
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Absorption – total costs
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Total costs – manufacturing and selling and
administrative –fixed (direct or allocated,
variable costs)
Price= unit cost + markup %* unit cost
desiredprofit
m arkup% 
unit cost * num berofun
itproduced
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Example - Pricing
Annual production 480 units
Unit costs:
Variable manufacturing cost
$ 400
Applied fixed manufacturing cost
$ 250
Absorption manufacturing cost
$ 650
Variable selling costs
$ 50
Allocated and direct fixed selling and administrative costs
$ 100
Total cost
$ 800
Investment
$ 600,000
Desired profit 10% of investment
$ 60,000
Annual Fixed Manufacturing Costs
$ 120,000
Annual Fixed (allocated and direct) Selling and Administrative
Costs
$ 48,000
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Cost Plus Pricing Versions
variable manufacturing cost-plus-pricing
Variable manufacturing cost
Total Variable Selling Costs ($50 x 480 units)
mark -up %
markup
Price = cost + markup
$400
$24,000
131.25%
$525
$925
variable total cost-plus-pricing
Total variable cost per unit
mark -up %
markup
Price = cost + markup
$450
105.56%
$475
$925
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Cost Plus Pricing Versions
absorption manufacturing cost-plus-pricing
manufacturing cost per unit
Total variable selling costs
mark -up %
markup
Price = cost + markup
$650
$24,000
42.31%
$275
$925
total absorption- cost-plus-pricing
manufacturing cost per unit
mark -up %
markup
Price = cost + markup
$800
15.63%
$125
$925
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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

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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
$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 hour
Material Charge formula
4% of material costs
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
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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
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Internal Pricing – Transfer pricing issue
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
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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
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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
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Transfer Pricing Methods
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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
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Transfer Pricing Implementation
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Disputes over transfer pricing occur frequently because transfer prices
influence performance evaluation of managers
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Internal accounting data are often used to set transfer prices, even when
external market prices are available
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Classifying costs as fixed or variable can influence transfer prices
determined by internal accounting data
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To reduce transfer pricing disputes, firms may reorganize by combining
interdependent segments or spinning off some segments as separate firms
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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.
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