Transcript LO1 - Wiley

Cost Management, Second Canadian Edition
LO1 Compare the different pricing methods and calculate
prices using each method
LO2 Discuss other market-based sources of pricing
information
LO3 Explain the uses and limitations of cost-based and
market-based pricing
LO4 Explain price elasticity of demand and its impact on
pricing
LO5 Discuss the additional factors that affect price
LO6 Compare the different pricing methods used for
transferring goods and services within an organization
LO7 Discuss the uses and limitations of different transfer
pricing methods
LO8 Discuss additional factors that affect transfer prices
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 3
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A selling price that is computed as the product’s
cost plus a markup is known as a cost-based
price.
The costs included in the base cost can be
variable costs only or variable plus fixed costs.
Some companies include only production costs
in the cost base and others include production,
selling, and administrative costs.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 5
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In service organizations, cost-based pricing is
determined by calculating a labour rate and a
materials loading charge.
The labour rate includes
1) direct labour salaries plus benefits,
2) selling and administrative costs and related
overhead costs,
3) A desired profit amount.

The materials loading charge includes
1) all costs associated with purchasing, receiving,
handling, and storing materials,
2) a desired profit percentage.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 6
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A product’s selling price depends on the degree
of competition and the degree to which the
company’s product is differentiated from
competitors’ products.
Market-based prices are based on customer
demand for the product.
The sensitivity of customer demand to changes
in the selling price is called the price elasticity of
demand.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 7
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Companies sometimes use competitors’ prices
to establish their own market prices.
The Internet makes it possible to learn about
market prices for items.
The Internet and global competition have
forced an increasingly large number of
organizations to use market-based pricing.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 9
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A major drawback of cost-based pricing is that
it ignores customer demand.
With cost-based prices, sales volumes
inappropriately influence the price, causing a
downward demand spiral, known as the death
spiral.
The major benefit of using cost-based pricing is
its simplicity. Prices are calculated from readily
available cost data.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 11
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Using market-based prices to estimate
revenues, managers make better decisions
about sales volumes or whether to sell goods or
services.
The disadvantage is that estimating market
demand and prices is often difficult.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 12
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The sensitivity of sales to price increases is called
the price elasticity of demand.
When small increases in price result in large
decreases in demand, the demand for that
product is considered elastic.
The profit-maximizing price occurs when
marginal costs equal marginal revenues.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 14
Elastic demand:
Total
Revenue
Selling
price
=
Quantity of units
sold
x
Inelastic demand:
Total
Revenue
© John Wiley & Sons, 2012
=
Selling
price
x
Eldenburg, Cost Management, 2ce,
Chapter 13
Quantity of units
sold
Slide 15
Using the price elasticity of demand, we can determine a
profit-maximizing price and a mark-up percentage for the
product. The steps for these calculations are:
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 16
Ted’s Trailers sells horse trailers in a competitive market. The variable costs
of producing the one-horse trailer are $850 per unit. Information from prior
years indicates that a 10% increase in the trailer’s selling price results in a
15% decrease in customer demand. Calculate the price elasticity of demand
and the profit-maximizing price for the one-horse trailer.
Price elasticity of
=
demand
Profit-maximizing
price
=
© John Wiley & Sons, 2012
ln(1 - 0.15)
ln(1 + 0.10)
-1.70516
-0.70516
=
-0.16252
0.09531
x
= -1.70516
$850 = $2,055
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 17
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Some industries charge different prices at different
times to reduce capacity constraints, a practice called
peak load pricing.
Price skimming occurs when a higher price is charged
for a product or service when it is first introduced than
later on.
Penetration pricing is the practice of setting low prices
when new products are introduced, to increase market
share.
Price gouging is the practice of charging a price viewed
by consumers as too high.
Transfer prices are the prices charged for transactions
that take place within an organization.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 19
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NPOs have objectives other than maximization on profits
which results in more complex pricing decisions.
NPOs do not necessarily expect to recover all costs of their
products.
NPOs receive funding from government funding, grants,
donations, etc.
Prices may reflect organizational goals.
Prices that are based on income with the objective of
making services accessible to the wider population.
Tuition fees reduced for high-performing students to
attract quality students to a learning institution.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 20
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In Canada, illegal pricing practices are regulated
under the Competition Act.
Price fixing is an agreement between competitors
to sell a common product at the same price.
Bid rigging, considered a form of price fixing, is
an agreement with another person that interferes
with the bidding process.
Price maintenance occurs if a business uses its
influence to encourage an increase or discourage
a decrease in the price of a product in Canada.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 21
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Price discrimination is the practice of setting
different prices for different customers.
Predatory pricing is the deliberate act of setting
prices low to drive competitors out of the market
and then raising prices.
Dumping occurs when a foreign-based company
sells products in an international market at prices
that are below the market value in the country
where the product is produced.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 22
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A transfer price is the price used to record revenue
and cost when goods or services are transferred
between departments within an organization.
The perfect transfer price would be the
opportunity cost of transferring goods and
services internally.
If external demand is zero, and the selling division has
excess capacity, the transfer price would be the variable
cost.
 If capacity is limited and goods or services can be sold
externally, then the opportunity cost would be the
market price.
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© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 24
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Cost-Based Transfer Price.
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Activity-Based Transfer Price.
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The cost of the good or service transferred is used as
the basis of cost-based transfer pricing.
The purchasing unit is charged for the unit-level,
batch-level, and possibly some product-level costs of
products transferred, plus an annual fixed fee that is
a portion of the facility-level costs.
Market-Based Transfer Prices.

Competitors’ prices or supply-and-demand
relationships are the basis for market-based transfer
prices.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 25
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Dual-Rate Transfer Prices.
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The selling department is credited for the market
price and the purchasing department is charged the
variable cost under dual-rate transfer pricing.
Negotiated Transfer Prices.
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Negotiated transfer prices are based on agreements
reached between the managers of the selling and
purchasing departments.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 26
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When compensation is tied to the financial
performance of subunits, managers tend to
overlook their contribution to the entire
organization and focus instead on how
decisions affect only their subunit’s financial
performance.
Conflicts arise among managers, leading to
suboptimal operating decisions.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 28
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For organizations that do business
internationally, the taxable location of profit is
affected by transfer price policies.
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An organization with subsidiaries located in hightax and low-tax countries could potentially charge a
high transfer price in the low-tax countries so that
most of the contribution margin arises where taxes
are lowest.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 30
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When support departments provide services
without charge to user departments, the user
departments tend to use the support services
inefficiently.
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In turn, inefficient use tends to encourage support
departments to grow unnecessarily large.
High transfer prices can encourage user
departments to outsource the support services.
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This can cause internal services to be duplicated,
resulting in excess capacity and inefficient use of
resources.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 31
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Because top managers prefer to have support
services used efficiently, they want to set
transfer prices that motivate this behaviour.
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The best transfer price policy may be seen as an
opportunity cost approach.
Implementing a transfer price policy based on
opportunity costs may be problematic because
opportunities change over time with changes in
demand and capacity.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 32
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A particular type of transfer price occurs when
corporate overhead costs are allocated to
departments.
Under responsibility managers should be held
accountable only for costs they control.
Because they have little or no control over
corporate costs, they should not be held
responsible for those costs in performance
evaluations.
© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 33
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© John Wiley & Sons, 2012
Eldenburg, Cost Management, 2ce,
Chapter 13
Slide 34