Slide Set 8

Question 1

By which factors is a price affected?

Answer 1

• Environment (patents/politics)
• Demand (price sensitivity/demographics)
• Cost considerations (variable/fix, long/short run)
• Pricing objectives (market share/ROI)

Question 2

Target cost

Answer 2

Cost that provides the desired profit when the
market determines a product’s price.
Market price - Desired Profit =Target Cost

Question 3

If a company can produce its product for the target cost or less…

Answer 3

… it will meet its profit goal.

Question 4

Steps in Target Costing

Answer 4

• First, company should identify its market niche where it wants to compete.
• Second, company conducts market research to determine the target price – the price the company believes will place it in the optimal position for the target consumers.
• Third, company determines its target cost by setting a desired profit.
• Last, company assembles a team to develop a product to meet the company’s goals.

Question 5

cost-plus pricing
What are requirements in the market?
What is the Price then?

Answer 5

• In an environment with little or no competition, a company may have to set its own price.
• When a company sets price, the price is normally a function of product cost
• Approach requires establishing a cost base and adding a markup to determine a target selling price.

Question 6

Determine a mark up

Answer 6

• In determining the proper markup, a company must consider competitive and market conditions.
• Size of the markup (the “plus”) depends on the desired return on investment for the product:

Question 7

Calculate ROI

Answer 7

ROI = net income ÷ invested assets

Question 8

What areAdvantages and Disadvantages of Cost-Plus Pricing?

Answer 8

Advantage: Easy to compute.
Disadvantages:
► Does not consider demand side: Will the customer pay the price?
► Fixed cost per unit changes with change in sales volume: At lower sales volume, company must charge higher price to meet desired ROI.

Question 9

Variable-Cost Pricing

Answer 9

Advantage: Simply add a markup to variable costs.
- Avoids the problem of uncertain cost information related to fixed-cost-per-unit computations.
- Helpful in pricing special orders or when excess capacity exists.
Disadvantages
Major disadvantage is that managers may set the price too low and fail to cover fixed costs.

Question 10

Time-and-material pricing

Answer 10

Time-and-material pricing is an approach to cost-plus pricing in which the company uses two pricing rates:
- One for labor used on a job - includes direct labor time and other employee costs.
- One for material - includes cost of direct parts and materials and a material loading charge for related overhead.
Widely used in service industries, especially professional firms such as public accounting, law, and engineering.

Question 11

Steps in Time and Material Pricing

Answer 11

1. Calculate the labor rate (rate per hour of labor)
   Rate includes:
   ► Direct labor cost (includes fringe benefits).
   ► Selling, administrative, and similar overhead costs.
   ► Allowance for desired profit (ROI) per hour.
   Multiply the rate by the number of labor hours used on any particular job to determine the labor charges for the job.
2. Calculate the material loading charge
   - Material loading charge added to invoice price of materials
   - Covers the costs of purchasing, receiving, handling, storing+ desired profit margin on materials.
   - Expressed as a percentage of estimated costs of parts and materials for the year
3. Calculate charges for a particular job
   Labor charges+ material charges + material loading charges

Question 12

Transfer price

Answer 12

price used to record the transfer between two divisions of a company.

Question 13

Ways to determine a transfer price:

Answer 13

1. Negotiated transfer prices.
2. Cost-based transfer prices.
3. Market-based transfer prices.
   - Conceptually - a negotiated transfer price is best.
   - Due to practical considerations, companies often use the other two methods.

Question 14

Summary of Transfer pricing why is it not used more often?

Answer 14

Transfer prices established:
► Minimum by selling division.
► Maximum by the purchasing division.
Often not used because:
► Market price information sometimes not easily
obtainable.
► Lack of trust between the two divisions.
► Different pricing strategies between divisions.

Question 15

Cost-Based Transfer Prices

Answer 15

• Uses costs incurred by the division producing the goods as its foundation.
• May be based on variable costs alone or on variable costs plus fixed costs.
• Selling division may also add markup.
  Can result in improper transfer prices causing:
  ► Loss of profitability for company.
  ► Unfair evaluation of division performance.

Question 16

Market-Based Transfer Prices

Answer 16

• Based on existing market prices of competing goods.
• Often considered best approach because it is objective
  and generally provides the proper economic incentives.
• It is indifferent between selling internally and externally if can charge/pay market price.
• Can lead to bad decisions if have excess capacity.

Question 17

Market-Based Transfer Prices can lead to bad decisions if have excess capacity. Why?

Answer 17

Because Opportunity costs are not considered.

Question 18

Outsourcing

Answer 18

Contracting with an external party to provide a good or service, rather than doing the work internally.

Question 19

Effect of Outsourcing on Transfer Pricing

Answer 19

As companies increasingly rely on outsourcing, fewer components are transferred internally thereby reducing the need for transfer pricing.

Question 20

Absorption-Cost Pricing

Answer 20

• Consistent with GAAP: includes both variable and fixed manufacturing costs as product costs
• Both variable and fixed selling and administrative costs are excluded from product cost base

Question 21

Steps of Absorption-Cost Pricing

Answer 21

Steps in approach:

1. Compute the unit manufacturing cost.
2. Compute the markup percentage – must cover the desired ROI as well as selling/administrative expenses.
3. Set the target selling price

Question 22

What happens to ROI when units sold go up in Absorption-Cost Pricing?

Answer 22

Because of fixed costs, if more than the calculated units are sold, the ROI will be greater than assumed and vice versa.

Question 23

Most companies that use cost-plus pricing use either absorption cost or full cost as the basis. What are reasons?

Answer 23

Reasons:

1. Information readily available – cost effective.
2. Use of only variable costs may result in too low a price – suicidal price cutting.
3. Most defensible base for justifying prices.

Question 24

Variable-Cost Pricing

Answer 24

• 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 variable and fixed cost behaviors are considered separately.

Question 25

Steps of Variable-Cost Pricing

Answer 25

1. Compute the unit variable cost.
2. Compute markup percentage.
3. Set target selling price.

Question 26

Advantages of Variable-Cost Pricing?

Answer 26

1. More consistent with CVP analysis.
2. Provides data for pricing special orders by showing incremental cost of accepting one more order.
3. Avoids arbitrary allocation of common fixed costs to individual product lines.