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Pricing Decisions EMBA 5411 Budgeting and Pricing.

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Presentation on theme: "Pricing Decisions EMBA 5411 Budgeting and Pricing."— Presentation transcript:

1 Pricing Decisions EMBA 5411 Budgeting and Pricing

2 2/30 Pricing  External sales- outside Target costing Cost plus pricing Variable cost pricing Time and material pricing  Internal-within the company among divisions Negotiated transfer prices Cost based transfer prices Market based transfer prices Effect of outsourcing on transfer prices Transfers between divisions in different countries

3 3/30 Profit Maximization Economic Theory 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

4 4/30 Quantity made and sold per month Determining the Profit- Maximizing Price and Quantity Dollars per unit Demand Marginal revenue q* p* Marginal cost Profit is maximized where marginal cost equals marginal revenue, resulting in price p* and quantity q*.

5 5/30 Determining the Profit-Maximizing Price and Quantity Total revenue Dollars Total cost Total profit at the profit-maximizing quantity and price, q* and p*. Quantity made and sold per month q*

6 6/30 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.

7 7/30 Who determines the price?  Price takers- when there is a competitive market and the company has no influence on price 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.

8 8/30 Influences on Price  Customer demand  Competitors’ behavior/prices/actions  Costs  Regulatory environment – legal, political and image related

9 9/30 Pricing approaches  Cost plus mark-up 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

10 10/30 Product Life Cycle http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

11 11/30 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).

12 12/30

13 13/30 Cost-plus Pricing  Cost + mark-up = price  Mark-up = cost x desired % return

14 14/30 Which cost?  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

15 15/30 Which costs?  Total variable costs Variable manufacturing and selling costs Price= variable costs + markup %* variable costs

16 16/30 Which costs?  Absorption – manufacturing costs  Unit manufacturing costs – both variable and fixed Price= unit manuf. cost + markup %* unit manufacturing cost

17 17/30 Which costs?  Absorption – total costs Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs) Price= unit cost + markup %* unit cost

18 18/30 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

19 19/30 Cost Plus Pricing Versions

20 20/30 Cost Plus Pricing Versions

21 21/30 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

22 22/30 Example

23 23/30 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 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 4% of material costs

24 24/30 Example con’t

25 25/30 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

26 26/30 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

27 27/30 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

28 28/30 Transfer Pricing Methods  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

29 29/30 Transfer Pricing Implementation  Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers  Internal accounting data are often used to set transfer prices, even when external market prices are available  Classifying costs as fixed or variable can influence transfer prices determined by internal accounting data  To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms

30 30/30 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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