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Pricing
ASSIGNMENT CLASSIFICATION TABLE
A
Problems
B
Problems
3, 4, 5,
6, 7
1A, 2A
1B, 2B
8, 9, 10
3A
3B
7, 8, 9
4A, 5A, 6A
4B, 5B, 6B
10, 11
16, 17, 18
7A, 8A
7B, 8B
Study Objectives
Questions
Brief
Exercises
Exercises
*1.
1, 2
1, 2, 3
*2.
3, 4, 5, 6,
7, 8
2, 3, 4, 5
*3.
Use time-and-material
pricing to determine the
cost of services provided.
9, 10
*4.
*5.
18
*6.
19, 20
*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix
to the chapter.
8-1
Description
Difficulty
Level
Time
Allotted (min.)
1A
Simple
2030
2A
Simple
2030
3A
Simple
2030
4A
Moderate
2030
5A
Moderate
2030
6A
Moderate
2030
*7A*
Moderate
3040
*8A*
Complex
4050
1B
Simple
2030
2B
Simple
2030
3B
Simple
2030
4B
Moderate
2030
5B
Moderate
2030
6B
Moderate
2030
*7B*
Moderate
3040
*8B*
Complex
4050
8-2
8-3
Q8-19
Q8-20
BE8-10
BE8-11
E8-16
E8-17
BE8-6
E8-8
E8-9
E8-10
Q8-4
Q8-7
Q8-8
BE8-2
BE8-3
BE8-4
BE8-5
E8-3
E8-1
E8-2
E8-3
E8-18
P8-7A
P8-8A
P8-7B
P8-8B
P8-3A
P8-3B
E8-4
E8-5
E8-6
E8-7
P8-1A
P8-2A
P8-1B
P8-2B
Application
Q8-18
Q8-9
Q8-10
Q8-6
Q8-11
Q8-12
Q8-14
Q8-17
Q8-3
Q8-5
Q8-2
BE8-1
Comprehension
Q8-1
Knowledge
Study Objective
E8-15
P8-4A
P8-5A
P8-6A
P8-4B
P8-5B
P8-6B
Synthesis
BE8-7
BE8-8
BE8-9
E8-11
E8-12
E8-13
E8-14
Analysis
Decision Making
Across the
Organization
Real-World Focus
Communication
Ethics Case
Evaluation
Correlation Chart between Blooms Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems
STUDY OBJECTIVES
1. COMPUTE A TARGET COST WHEN THE MARKET
DETERMINES A PRODUCT PRICE.
2. COMPUTE A TARGET SELLING PRICE USING COSTPLUS PRICING.
3. USE TIME-AND-MATERIAL PRICING TO DETERMINE
THE COST OF SERVICES PROVIDED.
4. DETERMINE A TRANSFER PRICE USING THE
NEGOTIATED, COST-BASED, AND MARKET-BASED
APPROACHES.
5. EXPLAIN ISSUES INVOLVED IN TRANSFERRING GOODS
BETWEEN DIVISIONS IN DIFFERENT COUNTRIES.
*6. DETERMINE PRICES USING ABSORPTION-COST PRICING AND VARIABLE-COST PRICING.
8-4
CHAPTER REVIEW
External Sales
1.
(S.O. 1) Some of the many factors that can affect pricing decisions include:
a. Pricing Objectives
Gain market share
Achieve a target rate of return
b. Environment
Political reaction to prices
Patent or copyright protection
c. Demand
Price sensitivity
Demographics
d. Cost Considerations
Fixed and variable costs
Short-run or long-run
2.
In most cases, a company does not set prices. Instead the price is set by the competitive market
(laws of supply and demand). These companies are called price takers and price taking often
happens when the product is not easily differentiated from competing products, such as farm
products (corn or wheat) or minerals (coal or sand).
3.
Companies can set prices (1) where the product is specially made for a customer, (2) when there
are few or no other producers capable of manufacturing a similar item, or (3) when a company
can effectively differentiate its product or service from others.
Once a company has identified its segment of the market, it does market research to determine
the target price. The target price is the price that the company believes would place it in the
optimal position for its target audience. Once the company has determined the target price, it can
determine its target cost by setting a desired profit. The difference between the target price and
the desired profit is the target cost of the product. The target cost includes all product and period
costs necessary to make and market the product.
Cost-Plus Pricing
5.
(S.O. 2) When the price is set by the company, price is commonly a function of the product or
service. Cost-plus pricing involves establishing a cost base and adding to this cost base a
markup to determine a target selling price. The size of the markup (the plus) depends on the
desired operating income return on investment (ROI) for the product line, product, or service. The
cost-plus pricing formula is expressed as follows:
Target selling price = Cost + (Markup Percentage X Cost)
6.
The cost-plus approach has a major advantage: it is simple to compute. However, the cost model
does not give consideration to the demand sidethat is, will the customers pay the price. In
addition, sales volume plays a large role in determining per unit costs. The lower the sales
volume, the higher the price a company must charge to meet its desired ROI (because fixed costs
are spread over fewer units and therefore the fixed costs per unit increases).
8-5
7.
Instead of using both fixed and variable costs to set prices, some companies simply add a markup
to their variable costs. Using variable costing as the basis avoids the problem of using poor cost
information related to fixed cost per unit computations.
(S.O. 3) Under time and material pricing, the company sets two pricing ratesone for the labor
used on a job and another for the material. The labor rate includes direct labor time and other
employee costs. The material charge is based on the cost of direct parts and materials used and
a material loading charge for related overhead costs.
9.
Using time and material pricing involves three steps: (1) calculate the per-hour labor charge,
(2) calculate the charge for obtaining and holding materials, and (3) calculate the charges for a
particular job.
The per-hour labor charge typically includes the direct labor cost of an employee, selling,
administrative, and similar overhead costs, and an allowance for a desired profit of employee
time. The charge for materials typically includes the invoice price of any materials used on the job
plus a material loading charge. The charges for any particular job are then a result of (1) the labor
charge, (2) the direct charge for materials, and (3) the material loading charge.
10.
To illustrate a time and material pricing situation, assume the following data for Rancho Park Golf
Club Repair Service:
Rancho Park Golf Club Repair Service
Budgeted Costs for the Year 2009
Time
Charges
$26,000
1,950
Material
Charges
$ 5,000
1,000
4,940
$32,890
3,000
$ 9,000
Step 1: During 2009 Rancho Park budgets 1,300 of hours for repair time, and it desires a profit
margin of $6 per hour of labor. Computation of the hourly charges are as follows:
Per Hour
Hourly labor rate for repairs
Repair service employee
Overhead costs
Administrative assistant
Other overhead
Total Cost
Total Hours
Per Hour
Charge
$26,000
1,300
$20.00
1,950
4,940
$32,890
1,300
1,300
1,300
=
=
=
1.50
3.80
$25.30
6.00
Profit margin
Rate charged per hour
of labor
$31.30
8-6
Step 2: Rancho Park estimates that the total invoice cost of parts and materials used in 2009 will
be $30,000 and it desires a 10 percent profit margin markup on the invoice cost of parts and
materials. The computation of the material loading charge used by Rancho Park during 2009 is as
follows:
Material
Total Cost
Overhead costs
Parts manager salary
Administrative assistant
Other overhead
Total Invoice
Cost, Parts
and Materials
Material
Loading
Charge
$5,000
1,000
6,000
$30,000
20.00%
3,000
$9,000
30,000
30,000
=
=
10.00%
30.00%
10.00%
40.00%
Profit margin
Material loading charge
Step 3: Rancho Park prepares a price quotation to estimate the cost to fix a set of woods for a
patron. Rancho Park estimates the job will require a half hour of labor and $150 in parts and
materials. Rancho Parks price quotation is as follows:
Rancho Park Golf Club Repair Service
Time and Materials Price Quotation
Job: Arnold Palmer, repair of set of woods
Labor charges: half hour @ $31.30
$ 15.65
Material charges
Cost of parts and materials
Material loading charge (40% X 150)
Total price of labor and materials
$150.00
60.00
210.00
$225.65
Internal Sales
11.
(S.O. 4) Divisions within vertically integrated companies normally transfer goods or services to
other divisions within the same company, as well as to customers outside the company. When
goods are transferred internally, the price used to record the transfer between the two divisions
is called the transfer price. Three possible approaches for determining a transfer price are
(1) negotiated transfer prices, (2) cost-based transfer prices, and (3) market-based transfer prices.
The negotiated transfer price is determined through agreement of division managers. Using the
negotiated transfer pricing approach, a minimum transfer price is established by the selling
division, and a maximum transfer price is established by the purchasing division.
Calculating the minimum transfer price depends on whether the selling division has excess
capacity or not. If the selling division has no excess capacity, then the minimum transfer price is
the variable cost plus its lost contribution margin (also known as opportunity cost). If the selling
division has excess capacity, then the minimum transfer price is the variable cost.
8-7
Another method of determining transfer prices is to base the transfer price on the costs incurred
by the division providing the goods. If a transfer price is used, the transfer price may be based on
variable costs alone, or on variable costs plus fixed costs. A markup may be added to these cost
numbers. This method, however, may lead to a loss of profitability for the company and unfair
evaluations of division performance.
The market-based transfer price is based on existing market prices of competing goods or
services. A market-based system is often considered the best approach because it is objective
and generally provides the proper economic incentives. Unfortunately, however, there is often not
a well-defined market for the good or service being transferred and thus companies resort to a
cost-based system.
(S.O. 5) As more companies globalize their operations, an increasing number of transfers are
between divisions that are located in different countries. Companies must pay income tax in
the country where income is generated. In order to maximize income, and minimize income tax,
many companies prefer to report more income in countries with low tax rates, and less income in
countries with high tax rates. This is accomplished by adjusting the transfer prices they use on
internal transfers between divisions located in different countries. The division in the low-tax-rate
country is allocated more contribution margin, and the division in the high-tax-rate country is
allocated less.
Desired
ROIper unit
c.
Selling and
Adminstrative
Expenses Perr Unit
Markup
Percentage
X Manufacturing
Cost Per Unit
Manufacturing
Cost Per Unit
Markup
Percentage
8-8
Manufacturing
Cost Per Unit
Target
Selling Price
*Variable-Cost Pricing
*17. Under variable-cost pricing, the cost base consists of all of the variable costs associated with a
product, including variable selling and administrative costs. Because fixed costs are not included
in the base, the markup must provide for fixed costs (manufacturing and selling and
administrative) and the target ROI. The contribution approach is more useful for making short-run
decisions because it displays variable cost and fixed cost behavior patterns separately.
The steps in using the contribution approach are as follows:
a.
b.
= Markup Percentage X
Variable Costs
Per Unit
Variable
Cost Per Unit
Markup
Percentage
8-9
Variable
Cost Per Unit
Target
Selling Price
LECTURE OUTLINE
A.
External Sales.
1. Establishing the price for any good or service is affected by the following
factors: pricing objectives, environment, demand, and cost considerations.
TEACHING TIP
ILLUSTRATION 8-1 identifies the factors that can affect pricing decisions.
Emphasize that few management decisions are more important than setting
prices.
2. In the long run a company must price its product to cover its costs and
earn a reasonable profit. In most cases, a company does not set the
priceit is set by the competitive market (laws of supply and demand).
In this situation, companies are called price takers because the price of
the product is set by market forces.
3. In some situations the company does set the price. This occurs where
the product is specially made for a customer or when there are few or no
other producers capable of manufacturing a similar item. It also occurs
when a company can effectively differentiate its product from others.
B.
Target Costing.
1. In a competitive market, the price of a product is greatly affected by
supply and demand. No company in the market can affect the price to a
significant degree.
2. A company chooses the segment of the market it wants to compete in
(its market niche) in a competitive market.
8-10
3. Once the company has identified its market segment, it conducts market
research to determine the target price. The target price is the price
the company believes would place it in the best position for its target
audience.
4. Once the company determines the target selling price it determines its
target cost by setting a desired profit.
5. The difference between the target price and the desired profit is the
target cost of the product. The target cost includes all product and period
costs necessary to make and market the product.
C.
Cost-Plus Pricing.
1. In a noncompetitive environment, the company is faced with the task of
setting its own price, which is commonly a function of the cost of the
product.
2. The typical approach is to use cost-plus pricing which involves establishing a cost base and adding to this cost base a markup to determine a
target selling price.
3. The size of the markup depends on the desired return on investment
(ROI) for the product line or product.
4. The cost-plus pricing formula is expressed as follows: Target Selling
Price = Cost + (Markup Percentage X Cost). Markup Percentage is
computed by dividing Desired ROI Per Unit by Total Unit Cost.
TEACHING TIP
8-11
D.
Time-and-Material Pricing.
1. Under time-and-material pricing, the company sets two pricing rates
one for the labor used on a job and another for the material.
2. The labor rate includes direct labor time and other employee costs. The
material charge is based on the cost of direct parts and materials used
and a material loading charge for related overhead costs.
3. Using time-and-material pricing involves three steps:
a.
b.
c.
TEACHING TIP
8-12
4. The charge for labor time is expressed as a rate per labor hour which
includes:
a.
The direct labor cost of the employee (hourly rate or salary and
fringe benefits).
b.
c.
b.
c.
7. The charges for any particular job are the sum of the
E.
a.
Labor charge,
b.
c.
Internal Sales.
1. The transfer of goods between divisions of the same company is called
internal sales. Divisions within vertically integrated companies normally
sell goods to other company divisions as well as to outside customers.
8-13
2. When companies transfer goods internally, the price used to record the
transfer between the divisions is the transfer price.
3. Setting a transfer price is often complicated because of competing
interests among divisions within the company. A transfer price that is too
high will benefit the selling division, but hurt the purchasing division.
4. There are three possible approaches for determining a transfer price:
F.
a.
b.
c.
G.
a.
b.
c.
H.
TEACHING TIP
8-16
b.
c.
b.
c.
TEACHING TIP
ILLUSTRATION 8-5 compares the absorption-cost approach and the variablecost approach. Emphasize that the markup percentage provides for selling and
administrative costs plus target ROI under the absorption approach while it
covers fixed costs plus target ROI under the variable-cost approach.
Also available as teaching transparency.
*K. Variable-Cost Pricing.
1. Variable-cost pricing uses all of the variable costs, including selling and
administrative costs, as the cost base and provides for fixed costs and
target ROI through the markup.
2. Variable-cost pricing is more useful for making short-run decisions
because it considers variable cost and fixed cost behavior patterns
separately.
3. Variable-cost pricing involves the following steps:
a.
b.
c.
b.
This approach provides the type of data managers need for pricing
special orders.
c.
8-19
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Once a company has determined the target price, it can determine its target cost by
setting a desired profit.
True
False
False
3. Under cost-plus pricing, the markup percentage is computed by dividing desired ROI per
unit by variable cost per unit.
True
False
4. The labor charge includes the direct labor cost of employees, selling, administrative, and
similar overhead costs; and an allowance for a desired profit per hour.
True
False
5. The charges for any particular job are the sum of the labor charge, the materials charge,
and the material loading charge.
True
False
6. An appropriate transfer price should assist the company in making proper purchasing
decisions.
True
False
7. An advantage of the cost-based transfer price approach is that it can increase a division
managers control over the divisions performance.
True
False
8. The market-based transfer price approach provides a fairer allocation of the companys
contribution margin to each division than the cost-based approach.
True
False
9. In order to maximize income, and minimize income tax, companies can adjust the
transfer prices they use on transfers between divisions located in different countries.
True
False
*10. The absorption cost approach is more consistent with cost-volume-profit analysis used to
measure the profit implications of changes in price and volume.
True
False
8-20
Multiple Choice
1.
2.
In the cost-plus pricing approach, the markup percentage is computed by dividing the
a. desired ROI/unit by variable cost/unit.
b. desired ROI/unit by total unit cost.
c. total unit cost by desired ROI/unit.
d. selling price/unit by desired ROI/unit.
3.
All of the following are steps in the time-and-material pricing approach except calculating the
a. labor charge.
b. material loading charge.
c. manufacturing overhead charge.
d. charges for a particular job.
4.
The total contribution margin to a company in the market-based transfer price approach is
a. greater than in the cost-based approach.
b. less than in the cost-based approach.
c. the same as in the cost-based approach.
d. either greater than or less than in the cost-based approach.
*5.
8-21
ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.
True
False
False
True
True
6.
7.
8.
9.
*10.
True
False
True
True
False
Multiple Choice
1.
2.
3.
4.
*5.
c.
b.
c.
c.
d.
8-22
ILLUSTRATION 8-1
PRICING FACTORS
Environment
Political reaction to prices
Patent/copyright protection
Demand
Price sensitivity
Demographics
Cost Considerations
Fixed and variable costs
Short-run or long-run
8-23
ILLUSTRATION 8-2
COMPUTATION OF MARKUP PERCENTAGE AND TARGET
SELLING PRICE
Total
Markup
Unit Percentage
Cost
8-24
ILLUSTRATION 8-3
TIME AND MATERIAL PRICING STEPS
8-25
ILLUSTRATION 8-4
TRANSFER PRICING APPROACHES
8-26
ILLUSTRATION 8-5
ABSORPTION-COST APPROACH VS. VARIABLE-COST
APPROACH
1. Cost base
2. Markup
percentages
ABSORPTION
COST
Direct materials +
Direct labor +
Variable and fixed
manufacturing
overhead
Absorption:
VARIABLE
COST
Direct materials +
Direct labor +
Variable manufacturing
overhead and variable
selling/administrative
expenses
3. Target
selling
price
Absorption:
Manufacturing
Markup Manufacturing
+
Cost Per Unit
Percentage Cost Per Unit
Variable:
Variable
Markup Variable
+
Cost Per Unit
Percentage Cost Per Unit
(
(
8-27