Download Cost based transfer price

Pricing policy
What is price?
• Market value, or agreed exchange value, that will purchase
a definite quantity, weight, or other measure of a product or
service.
• The sum or amount of money at which a good or service is
valued.
• As the consideration given in exchange for transfer of
ownership, price forms the essential basis of commercial
transactions.
• Price denotes what
(1) a buyer is willing to pay,
(2) a seller is willing to accept, and
(3) the competition is allowing to be charged.
Price and marketing objectives
Some of the common broad based objectives
are:
• Increase market share
• Increase sales
• Increase profit
• Combat competition
• Project a particular image
Pricing objectives
(Focussed)
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Maximize long run profit
Maximize short run profit
Growth
Discourage new entrants
Enhance image of the firm and its products
Create interest and excitement about its product
Maintain price leadership
Discourage others from cutting prices
Desensitise customers to price
Be regarded as “fair” by customers
Major factors influencing price
• The price of a product or service is the outcome of
the interaction between the demand for the
product/service and its supply
• The three influencers on demand and supply are
• Customers
• Competitors
• Cost
Major factors influencing price
Customers influence prices through their
effect on demand.
Customers
•Perceive Quality from price.
•Have a rough estimate of price in their mind
Unexpectedly low price triggers fears that the
product may be of low quality
Unexpectedly high price make buyers doubt
the worth of the product
Major factors influencing price
Competitors influence prices through their
actions.
• Alternative or substitute products of a
competitor may affect demand and force a
business to lower its prices.
• Fluctuations in the exchange rates of
different countries’ currencies also affect
pricing decisions.
Major factors influencing price
Costs influence prices because they affect
supply.
• The lower the cost relative to the price, the
greater the quantity of product the company
is willing to supply.
Other factors influencing price
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Whether price should be based on
marketing or cost considerations
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Whether price should be based on
marketing or cost considerations
Relative importance of marketing
and cost considerations
Parameters
Marketing
considerations
Finance & Cost
considerations
Time-frame
Short and medium term
Medium and long term
Market condition Buyer’s market;
intense competition
Seller’s market;
competition not so intense
Primary
marketing
objective
profitability
Market share
Consumer
Impulsive, erratic,
buying behaviour irrational
Product
characteristics
Stable, predictable,
rational
When subjective features When objective features
are predominant
are predominant
(perceived attributes)
(physical attributes)
Pricing based on mktg considerations
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Penetration Pricing
Skimming pricing
Value pricing
Loss Leader
Psychological Pricing
Going Rate (Price Leadership)
Tender Pricing
Price Discrimination
Predatory Pricing
Penetration Pricing
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Price set to ‘penetrate the market’
‘Low’ price to secure high volumes.
Typical in mass market products
Suitable for products with long anticipated
life cycles
• May be useful if launching into a new
market
Example: Hotel Rooms, Promotional products – ‘Buy one and Get one free’
Skimming pricing
• High price, Low volumes
• Skim the profit from the market
• Suitable for products that have short life
cycles or which will face competition at
some point in the future
Example: New technology products – Televisions, Cameras, etc.,
Value pricing
• Price set in accordance with customer
perceptions about the value of the
product/service
• Examples include status products/exclusive
products
Example: Private Label products by retailers; Automobiles
Loss Leader
• Goods/services deliberately sold below cost to
encourage sales of some other product
• Typical in supermarkets
• Purchases of other items more than covers ‘loss’
on item sold
Example: Razor – with the intention that consumer will buy blades;
Insurance policy – The agent sacrifices part of his / her income by
way of paying premium for one or two months on behalf of
subscriber. Subsequently, subscriber chooses the agent in the future
Psychological Pricing
• Used to play on consumer perceptions
• Classic example – Rs. 99 or Rs. 990 instead
of Rs. 100 or Rs. 1000
• Linked with value pricing – high value
goods priced according to what consumers
THINK should be the price
Example: Bata pioneered pricing their foot-wear; Dollar stores
prices any product for a USD
Going Rate (Price Leadership)
• In case of price leader, rivals have difficulty in competing
on price – too high and they lose market share, too low and
the price leader would match price and force smaller rival
out of market
• May follow pricing leads of rivals especially where those
rivals have a clear dominance of market share
• Where competition is limited, ‘going rate’ pricing may be
applicable – banks, petrol, supermarkets, electrical goods –
find very similar prices in all outlets
Example: Pricing of cars by Maruti Suzuki: Suzuki Swift Dzire is
priced in such a manner competitors are moving away from the
product segment
Tender Pricing
• Firm (or firms) submit their price for
carrying out the work
• Purchaser then chooses which represents
best value
• Mostly done in secret
Example: Government Tenders: this is to ensure impartial
selection of vendors.
Price Discrimination
• Charging a different price for the same
good/service in different markets
• When each market to be impenetrable
• When different price elasticity of demand
exits in each market
Example: MNC’s chose to price their products in India / China to
gain initial market share. Air travel ticket price differs on the basis
of time/day of travel
Predatory Pricing
• Deliberate price cutting or offer of ‘free
gifts/products’ to force rivals (normally
smaller and weaker) out of business or
prevent new entrants
• Anti-competitive and illegal if it can be
proved
Example: Microsoft sold MS Windows along with Internet
Explorer. This made the customers to choose IE as their default
browser.
Pricing based on cost considerations
• Full cost/absorption pricing
• Marginal cost pricing
• Contribution pricing
Absorption/Full Cost Pricing
• Most conventional and popular method.
• Final price is determined after adding some mark
up to the full cost covering both fixed and variable
costs.
• Suitable
• when products are clearly differentiated between
companies
• custom made products
• New products where market is not established
Marginal cost pricing
• Marginal cost – the cost of producing an
additional unit of product
• Necessarily a short-run pricing strategy
• Existence of idle capacity is a necessary precondition.
• Particularly relevant in industries where where
fixed costs may be relatively high
• Allows variable pricing structure
• Suitable for export pricing, or one time special
order
Contribution pricing
• Contribution = Selling Price – Variable (direct
costs)
• Prices set to ensure coverage of variable
costs and a ‘contribution’ to the fixed costs
• Similar in principle to marginal cost pricing
• Break-even analysis might be useful in such
circumstances
Target pricing
• Target price is the estimated price for a product
(or service) that potential customers will be
willing to pay.
• The target price, calculated using customer and
competitors inputs, forms the basis for
calculating target costs.
• Setting price to ‘target’ a specified profit level
• Estimates of the cost and potential revenue at
different prices, and thus the break-even have to
be made, to determine the mark-up
• Mark-up = Profit/Cost x 100
Target costs
Target sales price per unit minus Target
operating income per unit
= Target cost per unit
Target Costing Characteristics
•Contradicts the traditional approach - design
product, determine cost, set price
•Intense customer focus
• What do they want?
• How much will they pay for it?
•Can we make a profit on it?
Want answers to these questions before
committing to the project
Target Costing Characteristics
• Cost control from the beginning- Focus on product
and process design to engineer out costs from the
beginning
• Product design, manufacturing process, delivery
process designed simultaneously
• Cost control at all phases of the product life cycle• Design, Production, Delivery/setup, service and repair,
Disposal and recycling
Steps in developing target prices
and target costs
Develop a product that satisfies the needs of
potential customers.
Choose a target price.
Derive a target cost per unit.
Perform value engineering to achieve target
costs.
Cost-Plus Pricing
• The general formula for setting a cost-based
price is to add a markup component to the
cost base.
• Cost base
Rs. X
Markup component
Rs. Y
Prospective selling price Rs.X + Y
What is the mark-up?
• It could be a percentage of the cost base
• It could be to earn a target rate of return on
investment.
Special pricing situations
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New product pricing
Pricing under recession
Pricing of joint products/by products
Export pricing
Transfer pricing
New product pricing
• If the product is only a new pack or line extension, price
can be based on marginal cost plus contribution approach.
Once it gets accepted , the price could be progressively
adjusted in line with the other products.
• If the product is new to the company but not new to the
country then extensive market survey should be conducted,
and pricing should be based on total cost/marginal cost and
competitor’s price.
• If the product is absolutely new to the customers then price
has to be fixed keeping in mind the recovery of research
and development costs and to encash on the brand image
of the company. Thus, the company may fix a relatively
high price initially.
Pricing under recession
• Under normal conditions, optimizing profits is the
guiding objective in pricing decision. Under
recessionary conditions minimizing losses should
be the guiding principle.
• Effort should be to get some contribution towards
recovery of fixed overheads.
• Marginal costing and contribution pricing is the
only relevant technique for determining pricing
strategy during recession.
Pricing of joint products
•Joint products are those products that emerge out of processing the
main products, but their importance as regards sale value or revenue
earning capacity is more or less same.
•When a joint product emerges from a main product, the joint cost
upto the split-off point are allocated to the joint products on the basis
of
 Relative weights/units
 Market value or sale value
 Net realisable value (market value less cost of further
processing)
Selling price acts as a determinant of costs instead of the
reverse.
Thus pricing of joint products tends to be based on the
overall profitability expectation, state of competition,
demand for the product and prevailing market prices of
the different products.
Export pricing
Factors to be considered in export pricing are:
• Factors which result in increase in costs
 special packing charges
 Freight, insurance, clearing and forwarding, shipping
agent’s commission and port charges etc.
 Cost of market exploration, such as special advt,
foreign representatives, exhibitions, fairs and other
sales promotion exps.
 Additional cost of maintaining export quality
• Factors which result in decrease in costs
 Subsidies received from Govt, duty drawback, market
development rebate, Income tax exemptions etc.
 Deduction of selling and distribution expenses from
export cost
Transfer pricing
• A transfer price is the price one sub-unit charges
for a product or service supplied to another subunit of the same organization.
• In decentralised organisations, much of the
decision making powers rests in the individual
sub-unit and each sub-unit is treated as a separate
responsibility centre, whose performance needs to
be evaluated.
• Transfer price is essentially a tool to evaluate the
sub-unit’s performance and to motivate their
managers.
Methods of determining transfer prices
• Market based transfer price
• Cost based transfer price
• Negotiated transfer price
Market based transfer price
• It is the price in the intermediate market
between independent buyers and sellers.
• This method works well when there is a
competitive external market for the
transferred product.
• Divisional performance is more likely to
depict the real economic contribution of the
division to the total company profit.
Limitations of market based
transfer price
• Cannot be used if a competitive market does not
exist for the intermediate product being
transferred.
• Internal selling expenses may be less than what
would be incurred, if the product were to be sold
to outsiders. Hence, the selling division would get
more benefit by transferring the product at the
market price.
• The buying division is unnecessarily penalised in
case the selling division is not working to full
capacity.
Cost based transfer price
• When external market does not exist for the
intermediate product being transferred, or
when information about the external market
price is not readily available, companies
may decide to use cost based transfer price.
• It could be based on variable cost, full cost,
full cost plus profit or standard cost.
Limitations of cost based
transfer price
• If variable cost method is used, the selling division
will be burdened with the un recovered fixed
costs.
• If full cost method is used then the selling division
does not realise any profit on the tranferred goods.
• If cost plus profit method is used then the basic
question is ‘what should be the mark up?
Negotiated transfer price
• This method is generally preferred as a middle
solution to market based price and cost based
price.
• Negotiated price provides an opportunity to
achieve the objective of goal congruence,
autonomy and accurate performance evaluation.
• It is also in line with the concept of decentralised
decision-making.
Limitations of negotiated transfer price
• A great deal of management effort, time and
resources can be consumed in the
negotiation process.
• The final emerging negotiated price may
depend more on the manager’s ability and
skill to negotiate than on other factors..
Transfer Pricing Law in India
• Arm’s length price: In accordance with internationally accepted
principles, any income arising from an international transaction or an
outgoing like expenses or interest from the international transaction
between associated enterprises shall be computed having regard to the
arm’s length price, which is the price that would be charged in the
transaction if it had been entered into by unrelated parties in similar
conditions.
• The arm’s length price shall be determined by one of the methods
specified in Section 92C in the manner prescribed in Rules 10A to 10C
that have been notified vide S.O. 808 E dated 21.8.2001.
• Specified methods are as follows:
a. Comparable uncontrolled price method;
b Resale price method;
c. Cost plus method;
d. Profit split method or
e. Transactional net margin method.