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LECTURE OUTLINE - Chapter 22
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.
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 price—it 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.
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 = Desired ROI Per Unit ÷ Total Unit Cost.
5. The cost-plus pricing approach’s major advantage is that it is simple to compute. However, it does not
give consideration to the demand side. In addition, sales volume plays a large role in determining per
unit costs which in turn affect selling price.
6. The lower the sales volume, the higher the selling price the company must charge to meet its desired
ROI. This occurs because fixed costs are spread over fewer units and the fixed cost per unit increase.
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. Calculate the per hour labor charge.
b. Calculate the charge for obtaining and holding materials.
c. Calculate the charges for a particular job.
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. Selling, administrative, and similar overhead costs.
c. An allowance for a desired profit or ROI per hour of employee time.
5. The charge for materials typically includes a material loading charge which covers the costs of
purchasing, receiving, handling, and storing materials, plus any desired profit margin on the materials
themselves.
6. The material loading charge is expressed as a percentage of the total estimated costs of parts and
materials for the year. The company determines this percentage by doing the following:
a. Estimating the total annual costs for purchasing, receiving, handling, and storing materials.
b. Dividing the amount in a. by the total estimated cost of parts and materials.
c. Adding a desired profit margin on the materials themselves.
7. The charges for any particular job are the sum of the
a. Labor charge,
b. Charge for materials, and
c. Material loading charge.
E. 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.
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:
a. Negotiated transfer prices.
b. Cost-based transfer prices.
c. Market-based transfer prices.
F. Negotiated Transfer Prices.
1. The negotiated transfer price is determined through agreement of division managers. It will range
between the external purchase price per unit and the sum of the unit variable cost plus unit opportunity
cost.
2. Opportunity cost is the contribution margin per unit of goods sold externally.
3. The minimum transfer price equals variable cost plus opportunity cost whether the seller is at full
capacity or has excess capacity. However, opportunity cost will vary depending on whether a division is
at full capacity or has excess capacity.
4. Given excess capacity (zero opportunity cost) to the selling division, it would be in the company’s best
interest for the buying division to purchase goods internally as long as the selling division’s variable cost is
less than the outside price.
5. When the selling division has excess capacity, it will receive a positive contribution margin from any
transfer price above its variable cost while the buying division will benefit from any price below the
outside price.
6. In the minimum transfer price formula, variable cost is defined as the variable cost of units sold internally
which will differ from the variable cost of units sold externally in some instances (i.e. reduced variable
selling expenses for internal sales).
7. Under negotiated transfer pricing, the selling division establishes a minimum transfer price and the
purchasing division establishes a maximum transfer price.
8. Companies often do not use negotiated transfer pricing because:
a. Market price information is sometimes not easily obtainable.
b. A lack of trust between the two negotiating divisions may lead to a breakdown in negotiations.
c. Negotiations often lead to different pricing strategies from division to division which is sometimes
costly to implement.
G. Cost-Based Transfer Prices.
1. One method of determining transfer prices is to base the transfer price on the costs incurred by the
division producing the goods.
2. A cost-based transfer price may be based on full cost, variable cost, or some modification including a
markup.
3. The cost-based approach often leads to poor performance evaluations and purchasing decisions. Under
this approach, divisions sometimes use improper transfer prices which leads to a loss of profitability and
unfair evaluations of division performance.
4. The cost-based approach does not provide the selling division with proper incentive. In addition, this
approach does not reflect the selling division’s true profitability, and doesn’t even provide adequate
incentive for the selling division to control costs since the division’s costs are passed on to the buying
division.
H. Market-Based Transfer Prices.
1. The market-based transfer price is based on existing market prices of competing goods. This system is
often considered the best approach because it is objective and generally provides the proper economic
incentives.
2. When the selling division has no excess capacity, it receives market price and the purchasing division
pays market price.
3. If the selling division has excess capacity, the market-based system can lead to actions that are not in
the best interest of the company.
4. In many cases, there is not a well-defined market for the good being transferred. As a result, a reasonable
market value cannot be developed, and companies must resort to a cost-based system.
I. Transfers Between Divisions in Different Countries.
1. An increasing number of transfers are between divisions that are located in different countries.
Differences in tax rates across countries can complicate the determination of the appropriate transfer
price.
2. Companies must pay income tax in the country where they generate the income. Many companies
prefer to report more income in countries with low tax rates in order to maximize income, and minimize
income tax.
3. Companies maximize income by adjusting the transfer prices they use on internal transfers between
divisions located in different countries. They allocate more contribution margin to the division in the low-taxrate country while they allocate less to the division in the high-tax-rate country.
4. Adjusting the transfer prices to maximize income can result in inappropriate purchasing decisions and
unfair evaluations. In addition, a company must consider whether it is legal and ethical to use a lower
transfer price when the market price is clearly higher.
*J. Absorption-Cost Pricing.
1. Absorption-cost pricing uses total manufacturing cost as the cost base and provides for selling /
administrative costs plus the target ROI through the markup.
2. Absorption-cost pricing involves three steps:
a. Compute the unit manufacturing cost.
b. Compute the markup percentage (the percentage must cover both the desired ROI and selling and
administrative expenses).
c. Set the target selling price.
3. The markup percentage is computed by dividing the sum of the desired ROI per unit and selling and
administrative expenses per unit by the manufacturing cost per unit.
4. The target selling price is computed as: Manufacturing cost per unit + (Markup percentage X
Manufacturing cost per unit).
5. Most companies that use cost-plus pricing use either absorption cost or full cost as the basis because:
a. Absorption-cost information is most readily provided by a company’s cost accounting system.
b. Basing the cost-plus formula on only variable costs could encourage managers to set too low a price to
boost sales.
c. Absorption-cost or full-cost pricing provides the most defensible base for justifying prices to managers,
customers, and government.
*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. Compute the unit variable cost.
b. Compute the markup percentage.
c. Set the target selling price.
4. The markup percentage is computed by dividing the sum of the desired ROI per unit and fixed costs per
unit by the variable cost per unit.
5. The target selling price is computed as: Variable cost per unit + (Markup percentage X Variable cost per
unit).
6. The specific reasons for using variable-cost pricing are:
a. It is more consistent with cost-volume-profit analysis used to measure the profit implications of changes
in price and volume.
b. This approach provides the type of data managers need for pricing special orders.
c. It avoids arbitrary allocation of common fixed costs to individual product lines.