25 Pricing Decisions, Including Target Costing and Transfer Pricing C H A P T E R Financial and Managerial Accounting 10e Needles Powers Crosson ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. © human/iStockphoto

Concepts Underlying Pricing Decisions Establishing a product or service price depends on a manager’s ability to analyze the marketplace for customers’ price reactions and to know when to apply various cost-based or market-based approaches to pricing. Setting appropriate prices is one of the most difficult decisions that managers must make, and managers rely on managerial accounting information to make these decisions. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Revenue Recognition and Pricing Policies The prices managers set have a significant impact on business operations, both externally and internally, since revenue is computed by multiplying the product or service price by the quantity sold. Organizational goals, objectives, and strategic plans should include a pricing policy. A pricing policy is one way in which companies differentiate themselves from their competitors. They may also use pricing policies to differentiate among their own brands. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Pricing Policy Objectives Possible objectives of a pricing policy include: Identifying and adhering to both short-run and long-run pricing strategies Maximizing profits Maintaining or gaining market share Setting socially responsible prices Maintaining a minimum rate of return on investment Being customer focused ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

External and Internal Pricing Factors When making and evaluating pricing decisions, managers must consider many factors. The external factors include demand for the product, customer needs, competition, and quantity and quality of competing products or services. The internal factors include constraints caused by costs, desired return on investment, quality and quantity of materials and labor, and allocation of scarce resources. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Economic Pricing Concepts (slide 1 of 2) The economic approach to pricing is based on microeconomic theory, which states that profit will be greatest when the difference between total revenue and total cost is greatest. It may seem that if a company could produce an infinite number of products, it would realize the maximum profit, but this is not the case. Because of competition and other factors, price reductions will be necessary if the firm is to sell additional units. Total revenue will continue to increase, but the rate of increase will diminish as more units are sold. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Economic Pricing Concepts (slide 2 of 2) Costs react in an opposite way. Costs per unit will increase as more units are sold because fixed costs, such as supervision and depreciation, will increase. Competition causes marketing costs to rise. Repair and maintenance costs also increase. Thus, profits are maximized at the point where the difference between total revenue and total cost is greatest. In theory, if one additional unit is sold, profit per unit will drop because total cost is rising at a faster rate than total revenues. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Marginal Revenue and Marginal Cost Curves Economists use marginal revenue and marginal cost to help determine the optimal price for a product 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. Marginal revenue and marginal cost for each unit sold can be plotted on a graph. Profit will be maximized when the marginal revenue and marginal cost lines intersect. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Auction-Based Pricing Auction-based pricing occurs in one of two ways: Sellers post what they have to sell, ask for price bids, and accept a buyer’s offer to purchase at a certain price. Buyers post what they want, ask for prices, and accept a seller’s offer to sell at a certain price. Auction-based pricing will continue to grow in importance as a result of the escalating amount of business that is being conducted over the Internet. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Cost-Based Pricing Methods In a competitive environment, market prices and conditions influence price, but if prices do not cover a company’s costs, the company will eventually fail. Two pricing methods based on cost are gross margin pricing and return on assets pricing. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Gross Margin Pricing The gross margin pricing method (or the income statement method) emphasizes the use of income statement information to determine a selling price. Gross margin is the difference between sales and the total production costs of those sales. The price is computed using a markup percentage based on a product’s total production costs. This percentage is designed to include all costs other than those used in the computation of gross margin. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Gross Margin Calculations (slide 1 of 2) With gross margin pricing, there are three ways of determining a price. The first approach uses the formulas that follow: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Gross Margin Calculations (slide 2 of 2) The second approach is to state the formula in terms of a company’s desire to recover all of its costs and make a profit. The third way the gross margin-based price can be determined is on a per-unit basis. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Return on Assets Pricing The return on assets pricing method (or balance sheet method) focuses on earning a specified rate of return on the assets employed in the operation. This changes the objective of the price determination process from earning a return on the income statement to earning a return on the business’s resources on the balance sheet. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Return on Assets Calculations There are two formulas for finding the return on assets price. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Summary of Cost-Based Pricing Methods Companies select their pricing methods based on their degree of trust in a cost base. The cost bases from which they can choose are (1) total product costs per unit and (2) total costs and expenses per unit. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Pricing Services Most service organizations use a form of time and materials pricing (or parts and labor pricing) to arrive at the price of a service. Markup percentages are added to the cost of materials and labor to cover the cost of overhead and provide a profit factor. Services that do not require materials and parts use only direct labor costs in developing a price. The formula used in time and materials pricing follows: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Pricing Based on Target Costing (slide 1 of 3) Target costing (or target pricing) is a pricing method designed to enhance a company’s ability to compete, especially in markets for new or emerging products. Target costing: identifies the price at which a product will be competitive in the marketplace defines the desired profit to be made on the product computes the target cost for the product by subtracting the desired profit from the competitive market price ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Pricing Based on Target Costing (slide 2 of 3) The formula used in target costing follows: Once the target cost has been established, the company’s engineers and product designers use it as the maximum cost to be incurred for materials and other resources needed to design and manufacture the product. It is their responsibility to create the product at or below its target cost. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Pricing Based on Target Costing (slide 3 of 3) Advantages of target costing include the following: It gives managers the ability to control or dictate the costs of a new product at the planning stage of the product’s life cycle. In a competitive environment, it enables managers to analyze a product’s potential before they commit resources to its production. The pricing decision takes place immediately after the market research for a new product has been completed. The market research not only reveals the potential demand for the product but also identifies the maximum price that a customer would be willing to pay for it. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Differences Between Cost-Based Pricing and Target Costing With target costing, a company can focus on holding costs down while it plans and designs the product, before the costs are actually committed and incurred. Committed costs are the costs of design, development, engineering, testing, and production that are engineered into a product or service at the design stage of development. Incurred costs are the actual costs incurred in making the product. Under cost-based pricing, concern about reducing costs begins only after the product has been produced. This often leads to random efforts to cut costs, which can reduce product quality. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Pricing for Internal Providers of Goods and Services As a business grows, its day to day operations may be more manageable if it is organized into divisions or operating segments, with a separate manager assigned to control the operations of each segment. Such a business is called a decentralized organization. Each division or segment often sells its goods and services both inside and outside the organization. A transfer price is the price at which goods and services are charged and exchanged between a company’s divisions or segments. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Transfer Pricing The three basic kinds of transfer prices are: Cost-plus transfer prices—based on either the full cost or the variable costs incurred by the producing division plus an agreed-on profit percentage Market transfer prices—based on the price that could be charged if a segment could buy from or sell to an external party Negotiated transfer prices—arrived at through bargaining between the managers of the buying and selling divisions or segments ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Other Transfer Price Issues Additional issues may arise if a buying division chooses to purchase from outside suppliers. If the selling division has adequate capacity to fulfill the buying division’s demands, it should sell to that division at any price that recovers its incremental costs. The incremental costs of intracompany sales include all variable costs of production and distribution plus any avoidable fixed costs that are directly traceable to intracompany sales. If the buying division can acquire products from outside suppliers at an annual cost that is less than the selling division’s incremental costs, then purchases should be made from the outside suppliers because it will enhance the company’s overall profits. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Pricing and the Management Process For an organization to stay in business, its selling price must: be competitive with the competition’s price be acceptable to customers recover all costs incurred in bringing the product or service to market return a profit Breaking these pricing rules for a long period will lead to bankruptcy. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.