Slide Set 8 Flashcards
By which factors is a price affected?
- Environment (patents/politics)
- Demand (price sensitivity/demographics)
- Cost considerations (variable/fix, long/short run)
- Pricing objectives (market share/ROI)
Target cost
Cost that provides the desired profit when the
market determines a product’s price.
Market price - Desired Profit =Target Cost
If a company can produce its product for the target cost or less…
… it will meet its profit goal.
Steps in Target Costing
- 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.
cost-plus pricing
What are requirements in the market?
What is the Price then?
- 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.
Determine a mark up
- 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:
Calculate ROI
ROI = net income ÷ invested assets
What areAdvantages and Disadvantages of Cost-Plus Pricing?
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.
Variable-Cost Pricing
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.
Time-and-material pricing
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.
Steps in Time and Material Pricing
- 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. - 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 - Calculate charges for a particular job
Labor charges+ material charges + material loading charges
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, companies often use the other two methods.
Summary of Transfer pricing why is it not used more often?
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.
Cost-Based Transfer Prices
- 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.
Market-Based Transfer Prices
- 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.
Market-Based Transfer Prices can lead to bad decisions if have excess capacity. Why?
Because Opportunity costs are not considered.
Outsourcing
Contracting with an external party to provide a good or service, rather than doing the work internally.
Effect of Outsourcing on Transfer Pricing
As companies increasingly rely on outsourcing, fewer components are transferred internally thereby reducing the need for transfer pricing.
Absorption-Cost Pricing
- 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
Steps of Absorption-Cost Pricing
Steps in approach:
- Compute the unit manufacturing cost.
- Compute the markup percentage – must cover the desired ROI as well as selling/administrative expenses.
- Set the target selling price
What happens to ROI when units sold go up in Absorption-Cost Pricing?
Because of fixed costs, if more than the calculated units are sold, the ROI will be greater than assumed and vice versa.
Most companies that use cost-plus pricing use either absorption cost or full cost as the basis. What are reasons?
Reasons:
- Information readily available – cost effective.
- Use of only variable costs may result in too low a price – suicidal price cutting.
- Most defensible base for justifying prices.
Variable-Cost Pricing
- 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.
Steps of Variable-Cost Pricing
- Compute the unit variable cost.
- Compute markup percentage.
- Set target selling price.
Advantages of Variable-Cost Pricing?
- 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.
