Chapter 5 Pricing calculations

Question 1

1.1 Practical point

Answer 1

The sales price must be low enough to encourage the purchases to buy, yet high enough to allow the producer to make a profit. This can be achieved using a mark-up or a margin.

Question 2

2.1 Cost-plus pricing

Answer 2

Cost plus profit gives sales price.
Full costs are production cost and nonproduction cost. Marginal costs are variable production costs and variable nonproduction costs.
To achieve the same sales price, and therefore ensure all costs are recovered, the percentage must be different under each cost option. The business must decide whether to include anticipated inflation in costs.

Question 3

3.1 Full cost-plus pricing

Answer 3

There are 2 options. Unit sales price (total production plus mark-up) and unit sales price (total production cost plus total other costs plus mark-up). Both of these are acceptable.
The advantage of full cost-plus pricing is that the price is easy to calculate, they can justify price increases if costs rise, pricing decisions can be delegated and in a normal working capacity profit will be made. The disadvantages are that profit maximisation may not be achieved as the relationship between price and demand is ignored, no incentive to control costs and an arbitrary absorption of overhead into product costs.

Question 4

4.1 Marginal cost plus pricing

Answer 4

There are 2 options:
- Unit sales price: total variable production cost plus mark-up
- Unit sales price: total variable cost-plus mark-up
The advantages are it is simple, avoids the arbitrary appointment and absorption of fixed costs and it is useful for short-term decisions concerning the use of excess capacity or one-off contracts. The disadvantages are it may make losses in the long term if sales price does not cover fixed costs, may not be relevant to businesses with heavy fixed cost base and profit maximisation may not be achieved as the relationship between price and demand is ignored.

Question 5

5.1 Determining the mark-up percentage

Answer 5

The mark-up does not have to be fixed across all products. A different mark-up could be applied to each range of productions. The mark-up could vary according to the nature of the customer, or the strategy being pursued and achieve target return on investment

Question 6

5.2 Mark-up v margin

Answer 6

There is a difference between a mark-up and a margin:
- A mark-up is the profit expressed as a percentage of cost
- A margin is the profit expressed as a percentage of the sales price

Question 7

6.1 Transfer pricing

Answer 7

A transfer price is the amount charged by one part of an organisation for the provision of goods or services to another part of the same organisation.
- If division A only gives its product to division B (who sells to the customer). Division A must be a cost centre
- To make division A a profit centre (so profit related bonuses can be paid to managers of division A) it needs a revenue from a TP
- To make division B realise that division A does not make the goods for free, division B needs a cost from a TP
- The TP is a signalling mechanism, to encourage divisional managers to act in a way to maximise shareholder wealth
Aims of transfer pricing:
- Measure divisional profits
- Measure costs and revenues
- Autonomy to managers
- Encourage goal congruence
- Profit maximisation

Question 8

6.2 How much should the TP be?

Answer 8

There are 4 practical methods which can be used to determine a TP:
- Market price: In a perfectly competitive market, the optimum TP is the market price providing the supplying division is operating at full capacity. This should be reduced for cost savings from internal transfers. This includes packaging, advertising, distribution and irrecoverable debts.
- Cost-plus price: TP works in the same way as cost-plus pricing. The issues with this is that a predetermined standard cost should be used rather than actual cost. This prevents divisional profit being distorted due to inefficiencies being transferred between divisions. The TP should be based on total cost to ensure overheads are recovered by the supplying division. However, the supplying divisions fixed costs will be perceived as variable by the receiving division. The supplying division may also over recover its fixed costs. This may lead the recovering division to outsource purchases when this is suboptimal for the overall business
- Two-part transfer price: the transfer is accounted for in two parts. The standard variable cost and the periodic fixed charge. This ensures the recovering division is aware of the cost behaviour patterns of the supplying division
- Dual pricing: each division records the TP at a different amount to encourage optimal decision making. The supplying division records revenue at market price or total cost-plus. The receiving division records purchases at the supplying divisions standard variable cost only.