managerial accounting, chapter 11 by crosson, needles

Chapter 11

Pricing Decisions, Including Target Costing

and Transfer Pricing

Copyright © Houghton Mifflin Company. All rights reserved. 11 | 2

The PricingDecision and the Manager

Objective 1Identify the objectives and rules used to establish prices of goods and services, and relate pricing issues to the management process.


The Objectives of a Pricing Policy

1. Identifying and adhering to both short-run and long-run pricing strategies

2. Maximizing profits

3. Maintaining or gaining market share

4. Setting socially responsible prices

5. Maintaining a minimum rate of return on investment

6. Being customer focused


Pricing Rules

• Must be competitive

• Should be acceptable to customers

• Seek to recover all costs in bringing the product or service to market

• Should return a profit


Planning

• Managers consider how much to charge for products or services – Identify the maximum price the market will

accept and the minimum price the company can sustain


Performing

• Pricing strategies for products and services are followed

• Products or services are sold either at the specified prices or on the auction market


Evaluating

• Determine which pricing strategies were successful or which failed

• Recommend changes

Review sales


Communicating

Used to assess past pricing strategies and plan future strategies

Analyses of actual prices and profits

versus targeted ones are prepared


Stop & Review

Q. In which management stage do managers determine which pricing strategies were successful and which failed?

A. Evaluating stage


Economic Pricing Concepts

• Objective 2– Describe economic pricing concepts

including the auction-based pricing method used on the Internet.


Economic Approach to Pricing

Based on microeconomic theory

Microeconomic theory states that profit will be maximized when the difference between total revenue and total cost is the greatest


Total Revenue Curve

• As a product is marketed, price reductions will be necessary to sell additional units because of competition and other factors

• Total revenue will continue to increase, but the rate of increase will diminish as more units are sold


Total Cost Curve • Costs per unit will increase as more units

are sold because fixed costs will change

• Variable and fixed costs are fairly predictable, with fixed costs remaining constant and variable costs being the same per unit


Profit

Profit is maximized…

At the point where the difference between total revenue and total cost is the greatest


Marginal Revenueand Marginal Cost Curves

Help determine the optimal price for a good or service

Marginal revenue is the change in total revenue

caused by a one-unit change in

output.

Marginal cost is the change in total cost

caused by a one-unit change in

output.


Auction-Based Pricing

Companies like eBay, Yahoo, and Priceline.com use auction-based pricing

Seller’s auction-based price Buyer’s auction-based price

Company posts a message on the Internet asking for the quantity and price that prospective buyers are willing to pay, then selects the best price

Company or individual posts need for product or service, receives offers, accepts the best offer


Stop & Review

Q. According to microeconomic theory, do costs per unit increase or decrease as more units are sold?

A. The costs per unit will increase as more units are sold because fixed costs will change.


Cost-Based Pricing Methods

• Objective 3

– Use cost-based pricing methods to develop prices.


Pricing Methods Based on Cost

• Gross Margin Pricing (also known as the income statement method)

• Return on Assets Pricing


Gross Margin Pricing

A cost-based pricing approach in which the price is computed using a markup percentage based on a product’s total

production costs

Gross margin markup percentage is composed of selling, general, and

administrative expenses and the desired profit

Desired Profit + Total Selling,

General, and Administrative ExpensesMarkup Percentage

Total Production CostsGross Margin-Based Price Total Production Costs per Unit + Markup

Percentage Total Production Co

sts per Unit


Gross Margin Price on Per Unit Basis

Gross Margin-Based Price =

Direct materials + Direct labor + Variable overhead + Fixed overhead + Selling, general, and administrative expenses + Desired profit

Total Units Produced


Return on Assets Pricing

Earning a profit equal to a specified rate of return on assets employed in the operation

Balance sheet approach to pricing

Return on Assets-Based Price =

Total Costs and Expenses Per Unit + (Desired Rate of Return x Cost of Assets Employed per Unit)


Cost-Based Pricing


Pricing Services

Service businesses take a different approach to pricing

Time and materials pricing (also called parts and labor pricing)

• Direct labor • Materials and Parts

+ Markup percentage

= Price


Time and Materials Pricing IllustratedGil Marquis completed work on Lucinda Lowe’s Mercedes. The parts used to repair the vehicle cost $840. The company’s 40 percent markup rate on parts covers parts-related overhead costs and profit. The repairs required four hours of labor by a certified Mercedes specialist, whose wages are $35 per hour. The company’s overhead markup rate on labor is 80 percent.

Repair parts used $840Overhead charges ($840 x 40%) 336Total parts charges $1,176

Labor charges4 hours @ $35 $140Overhead charges ($140 x 80%) 112Total labor charges 252

Total billing $1,428

What amount will be billed to Lucinda Lowe?


Stop & Review

Q. What elements are included in the gross margin markup percentage?

A. Selling, general, and administrative expenses and the desired profit


Pricing Based on Target Costing

• Objective 4– Describe target costing, and use that

concept to analyze pricing decisions and evaluate a new product opportunity.


Designed to enhance a company’s ability to compete, especially in new or emerging product markets

Target Costing

Target costing: (1) Identifies the price at which a product will be

competitive in the marketplace (2) Defines the desired profit to be made on the product (3) Computes the target cost for the product by subtracting

the desired profit from the competitive market price

Target Price - Desired Profit = Target Cost


Advantages of Target Costing

• Gives managers the ability to control or dictate the costs of a new product beginning at the planning stage of the product’s life cycle

• Can analyze a product’s potential before they commit resources to its production


Traditional Costing Versus Target Pricing


Pricing Strategies Illustrated

Cost First Company• Enter planning, design, and

production as soon as possible

• Expects engineering changes

• Total unit cost cannot be computed until successful production

• Difficult to control costs from planning through production

Price First Company• Uses target costing approach

• Using market research and target costing formula, target cost equals $40

• Engineering begins with this cost restriction in mind

• Production did not begin until quality and cost were in line

Product price = $84 Product price = $48


Target Costing Illustrated

What is the target cost for each product?

Zephyr Company hopes to quote prices of $300 for a router and $725 for a computer. The company’s usual profit markup is 25 percent of total unit cost.

Router = $300 / 1.25 = $240Computer = $725 / 1.25 = $580


Target Costing Illustrated (cont’d)

What is the projected total unit cost for the router?

Zephyr Company hopes to quote prices of $300 for the router. Direct materials and parts will cost $40. One router will require 2.6 hours of manufacturing labor at $12/hour, 3.4 hours of assembly labor at $14. Materials handling will cost $52. Production will require 12.8 machine hours at $3.50/hour, and the product delivery cost is estimated to be $24.

Router = $40.00 + $31.20 + $47.60 + $52.00 +$44.80 + $24.00 = $239.60

Decision: The router can be produced below its target cost of $240.00, so it should be produced.


Stop & Review

Q. Does the target costing method or the traditional costing strategy result in more cost savings in the production stage?

A. Since cost and quality issues are worked out before going into production under the target costing method, this method results in more cost savings than the traditional method.


Pricing for InternalProviders of Goods and Services

• Objective 5– Describe how transfer pricing is used for

transferring goods and services and evaluating performance within a division or segment.


Transfer Pricing

• Not used for external pricing • Used to set prices for transfers within a

company’s departments, divisions, or segments

Transfer prices do not affect revenues and costs of

the company as a whole Transfer prices do affect revenues and costs of the

divisions involved.


Kinds of Transfer Prices

• Cost-plus transfer price

• Market transfer price• Negotiated transfer price


Cost-Plus Transfer Price

Based on either the full cost or the variable costs incurred by the producing division

plus an agreed-on profit percentage

• Fails to detect inefficient operating conditions

• Cost recovery is guaranteed to selling division


Market Transfer Price

Based on the price that could be charged if a

segment could buy from or sell to an external party

Forces the selling division to be competitive with market conditions

Does not penalize the buying division by charging a higher price than if the item were purchased on the open market

When market prices are used to develop transfer prices, they are usually used only as

a basis for negotiation


Negotiated Transfer Price

Arrived at through bargaining between the managers of the buying and selling

divisions or segments

Such a transfer price may be based on an agreement to use a cost plus a

profit percentage


Development of a Transfer Price

Pulp Division

Cardboard Division

May buy pulp from the pulp division or from outside sources

Simple Box Company


Development ofCost-Plus Transfer Price

Pulp Division

Cardboard Division

Cost-plus transfer price for pulp includes:• Variable costs ($3.30 + $0.70 + $1.60 + $2.40 +

$1.90 + $1.95)• Fixed cost of $1.05 related to the Pulp Division • The profit markup of 10 percent adds $1.29• Total cost-plus transfer price equals $14.19

$14.19


Development ofMarket Transfer Price

Outside source

Cardboard Division

• After the cost-plus transfer price is developed at $14.19/lb., the manager of the cardboard division might point out that pulp purchased from an outside source is only $13/lb.

• $13/lb. would be the ceiling price the cardboard division is willing to pay

• Managers of both divisions would likely enter into negotiations on the final transfer price

$13/lb.


Development ofNegotiated Transfer Price

Pulp Division

Cardboard Division

• Company does not want the Cardboard Division to buy pulp from another company

• Pulp Division should have an incentive to move toward the market price

• The negotiated transfer price also allows for the sharing between divisions of the final product’s company-wide profits when the boxes are sold on the outside market

Negotiated price


Using Transfer Pricesto Measure Performance

• When transfer prices are used, a division can be evaluated as a profit center

• While transfer prices are sometimes considered artificial, they create a valuable performance measure


Using Transfer Pricesto Measure Performance


Transfer Pricing inRetail and Service Organizations


Transfer Pricing inRetail and Service Organizations (cont’d) • Need for transfer prices in Auto Imports

– Used Car Department receives trades from New Car Department.

– Leasing Department obtains cars from both the New Car and the Used Car Departments

• If market prices are readily available, companies will use market prices for transfer pricing


Stop & Review

Q. What is a transfer price?

A. Used to set prices for transfers within a company’s departments, divisions, or segments


Chapter Review

1. Identify the objectives and rules used to establish prices of goods and services, and relate pricing issues to the management process.

2. Describe economic pricing concepts, including the auction-based pricing method used on the Internet.

3. Use cost-based pricing methods to develop prices.


Chapter Review (cont’d)

4. Describe target costing and use that concept to analyze pricing decisions and evaluate a new product opportunity.

5. Describe how transfer pricing is used for transferring goods and services and evaluating performance within a division or segment.

managerial accounting, chapter 11 by crosson, needles

Documents

pricing rules

transfer pricing

pricing decisions

pricing issues

pricing policy1

past pricing strategies

total cost curve costs

total revenue curve