1. University of Louisiana at Lafayette
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

2. 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.

3. 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.

4. 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

5. 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

6. 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
STARBUCKS

7. 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

8. TARGET COSTING Steps Find market niche Determine target price
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

9. 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

10. 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)

11. 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)

12. COST-PLUS PRICING Example – Continued
Markup = 20% ROI of $1,000,000
Expected ROI = $200,000 ÷ 10,000 units
Sales price per unit = $132

13. 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:

14. 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

15. 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]

16. 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

17. 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

18. Let’s Review Cost-plus pricing means that:
Selling price = Variable cost + (Markup percentage + Variable cost)
Selling price = Cost + (Markup percentage X Cost)
Selling price = Manufacturing cost + (Markup percentage + Manufacturing cost)
Selling price = Fixed cost + (Markup percentage X Fixed cost)

19. Let’s Review Cost-plus pricing means that:
Selling price = Variable cost + (Markup percentage + Variable cost)
Selling price = Cost + (Markup percentage X Cost)
Selling price = Manufacturing cost + (Markup percentage + Manufacturing cost)
Selling price = Fixed cost + (Markup percentage X Fixed cost)

20. 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

21. TIME AND MATERIAL PRICING
Steps
Calculate the labor charge
Calculate the material loading charge
Calculate the charges for a job

22. TIME AND MATERIAL PRICING
Example – Lake Holiday Marina
Budgeted data:

23. 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

24. TIME AND MATERIAL PRICING
Example – Lake Holiday Marina (Continued)
Total ÷ Total = Per Hour
Per Hour Cost Hours Charge
Hourly labor rate for repairs
Mechanics wages/benefits $103, ÷ , = $20.70
Overhead Costs
Office employees salaries/benefits , ÷ , =
Office overhead , ÷ , =
Total hourly cost $151, ÷ , = $30.20
Profit Margin
Rate charged per hour of labor $38.20

25. 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

26. 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 $11,500
Office employees salary ,300
$13, ÷ $120, = %
Other overhead , ÷ , = % $28, ÷ 120, = %
Profit margin %
Material Loading Percentage %

27. TIME AND MATERIAL PRICING Example – Continued
Calculate Charges for a Particular Job =
Labor charges +
Material charges
Material loading charge

28. 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

29. How do you price goods when they are “sold” within the company?
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?

30. 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

31. NEGOTIATED TRANSFER PRICE
Determined by agreement of the division managers when no external market price is available

32. 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

33. 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?

34. 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:

35. NEGOTIATED TRANSFER PRICE Example – Alberta Company (Continued)
Maximum Boot Division will pay is
what the sole would cost from an outside buyer

36. 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:

37. NEGOTIATED TRANSFER PRICE Example – Alberta Company (Continued)
Negotiate a transfer price between $11 (minimum acceptable to Sole) and $17 (maximum acceptable to Boot)

38. 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

39. 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

40. 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

41. 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

42. COST-BASED TRANSFER PRICES Example – Alberta Company (Continued)
No Excess Capacity

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

49. TRANSFERS BETWEEN DIVISIONS IN DIFFERENT COUNTRIES Example – Alberta Company (Continued)

50. 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

51. APPENDIX: ABSORPTION COST APPROACH Example – Cleanmore Products, Inc
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

52. APPENDIX: ABSORPTION COST APPROACH Example – Cleanmore Products, Inc
APPENDIX: ABSORPTION COST APPROACH Example – Cleanmore Products, Inc. – Step 2
Compute markup percentage:
Percentage must cover desired ROI and
the selling and administrative expenses

53. APPENDIX: ABSORPTION COST APPROACH Example – Cleanmore Products, Inc
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

54. APPENDIX: ABSORPTION COST APPROACH Example – Cleanmore Products, Inc
A target price of $132 produces the desired 20% ROI

55. 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

56. 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

57. APPENDIX: CONTRIBUTION (VARIABLE COST) APPROACH
Steps
Compute unit variable cost
Compute markup percentage
Set target selling price

58. APPENDIX: CONTRIBUTION (VARIABLE COST) APPROACH Example – Cleanmore Products, Inc – Step 1
Compute the unit variable cost

59. APPENDIX: CONTRIBUTION (VARIABLE COST) APPROACH Example – Cleanmore Products, Inc – Step 2
Determine the markup percentage:

60. APPENDIX: CONTRIBUTION (VARIABLE COST) APPROACH Example – Cleanmore Products, Inc – Step 3
Set the target selling price:

61. APPENDIX: CONTRIBUTION (VARIABLE COST) APPROACH Example – Cleanmore Products, Inc
A target price of $132 produces the desired ROI of 20%

62. 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

63. 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
Variable cost per unit +
(Markup percentage X Variable cost per unit)

64. 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?
125% c /3%
75% d %

65. 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?
125% c /3%
75% d %

66. COPYRIGHT
Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.