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CHAPTER 24
Pricing Decisions, Including Target Costing
and Transfer Pricing
REVIEWING THE CHAPTER
Objective 1: Identify the objectives and rules used to establish prices of goods and services,
and relate pricing issues to the management process.
1.
A company’s long-term objectives should include a pricing policy. Possible pricing
objectives include (a) identifying and adhering to short-run and long-run pricing strategies,
(b) maximizing profits, (c) maintaining or gaining market share, (d) setting socially
responsible prices, (e) maintaining a minimum rate of return on investment, and (f) being
customer-focused.
2.
Pricing strategies depend on many factors and conditions. Identifying the market being
served and meeting the needs of that market are of primary importance. Companies that
make standard products for a competitive market have different pricing strategies from
firms that make products to customers’ specifications.
3.
For a company to stay in business, the selling price of its product or service must (a) be
competitive with the competition’s price, (b) be acceptable to the customer, (c) recover all
costs incurred in bringing the product or service to market, and (d) return a profit. If a
manager deviates from any of these four selling rules, there must be a specific short-run
objective that accounts for the change. Breaking these pricing rules for a long period will
force a company into bankruptcy.
4.
Pricing issues are addressed at each step of the management process. When managers plan,
they must decide how much to charge for each product or service. During the performing
step, the product or service is sold at the specified price or on the auction market. When
managers evaluate performance, they review sales to determine which pricing strategies
were successful and which failed. To communicate about performance inside the
organization, managers prepare analyses of actual and targeted prices and profits.
5.
When making and evaluating pricing decisions, managers must consider many factors, some
relating to the market and others to internal constraints. Factors related to the market include
the demand for the product, customer needs, competition, and the quantity and quality of
competing products or services. Internal constraints include the cost of the product or
service, the desired return on investment, the quality and quantity of materials and labor,
and the allocation of scarce resources.
Objective 2: Describe economic pricing concepts, including the auction-based pricing
method used on the Internet.
6.
The economic approach to pricing is based on microeconomic theory. A product’s total
revenue and total costs are plotted against units produced. Initially, because of fixed costs,
the cost line is above the revenue line, illustrating a loss. When enough products are
produced and sold to cover both variable and fixed costs, the lines cross, illustrating a profit.
However, the lines are destined to cross again. Price competition will eventually bend the
revenue line down; as more units are sold at a lower price, total revenue will decrease. The
cost line will eventually bend upward as production exceeds capacity, causing an increase in
fixed costs. Another way of stating this is that the marginal revenue (the change in total
revenue caused by a one-unit change in output) is decreasing as more units are produced,
while the marginal cost (the change in total cost caused by a one-unit change in output) is
increasing.
7.
The point at which the total revenue line and the total cost line are farthest apart (maximum
profit) is also the point at which marginal revenue equals marginal cost. Graphs of marginal
revenue and marginal cost would cross at this point. Projecting this point onto the product’s
demand curve indicates the optimal price the market will bring at that level of output and
the optimal number of units to produce. However, implementation is difficult and uncertain.
An analysis of this type is useful but should not be the only approach relied on when
establishing a price.
8.
In recent years due to the Internet and companies that host auction markets such as as eBay,
Yahoo, and Priceline.com, auction-based pricing has skyrocketed in popularity. The
Internet allows sellers and buyers to solicit bids and transact exchanges in an open market
environment. A willing buyer and seller set an auction-based price in a sales transaction.
Objective 3: Use cost-based pricing methods to develop prices.
9.
Managers may use any of several pricing methods to establish a selling price. Two methods
based on the cost of producing a product or service are gross margin pricing and return on
asset pricing.
10. Gross margin pricing (also known as the income statement method) is a cost-based pricing
method that establishes a selling price at a percentage above an item’s total production
costs. The following formulas are used:
Markup
Percentage
=
Gross
Margin–
Based
Price
=
Desired Profit + Total Selling, General,
and Administrative Expenses
Total Production Costs
Total Production Costs per Unit +
(Markup Percentage × Total Production
Costs per Unit)
11. Whereas gross margin pricing is based on a percentage above total costs, return on assets
pricing is based on a specific rate of return on assets employed in the generation of a
product or service. Assuming that a company has a specified minimum rate of return, the
following formulas are used to calculate the selling price:
Return on
Assets–
Based
Price
=
Total Costs and Expenses per Unit +
(Desired Rate of Return × Cost of
Assets Employed per Unit)
Return on
Assets–
Based
Price
=
[(Total Production Costs + Total
Selling, General, and Administrative
Expenses) ÷ Units to Be Produced] +
[Desired Rate of Return × (Total Cost
of Assets Employed ÷ Units to Be
Produced)]
12. Time and materials pricing is common practice in service businesses. The two primary
types of costs used in this method are the cost of actual materials and parts and the cost of
actual direct labor. An overhead rate, which includes a profit factor, is computed for each of
these cost categories. When preparing a billing, the two overhead percentages are added to
the two major cost categories.
13. Although managers may depend on traditional, objective, formula-driven pricing methods
to set prices, they must at times deviate from these approaches and rely on their own
experience.
Objective 4: Describe target costing, and use that concept to analyze pricing decisions and
evaluate a new product opportunity.
14. Target costing is a pricing method that (a) uses market research to identify the price at
which a new product will be competitive in the marketplace, (b) defines the desired profit to
be made on the product, and (c) computes the target cost for the product by subtracting the
desired profit from the competitive market price. The following formula is used to
determine the target cost:
Target Price – Desired Profit = Target Cost
The company’s engineers use the target cost as the maximum amount to be incurred in
designing and manufacturing the product. If this cost goal cannot be met, the product is not
manufactured.
15. Target costing gives managers the ability to control or dictate the costs of a new product in
the planning stage of the product’s life cycle. The pricing decision is made as soon as
market research has revealed the potential demand for the product and the maximum price
that customers would be willing to pay for it. In contrast, when traditional cost-based
pricing methods are used, the pricing decision must wait until production has taken place
and costs have been incurred and analyzed. At that point, a profit factor is added to the
product’s cost, and the product is ready to be offered to customers. Because target costing
enables managers to analyze a product’s potential before they commit resources to its
production, it enhances a company’s ability to compete, especially in new or emerging
markets. The philosophy underlying target costing is that a product should be designed and
built so that it produces a profit as soon as it is introduced to the marketplace.
16. Two types of cost patterns are involved as a new product moves through its life cycle.
Committed costs are design, development, engineering, testing, and production costs that
are engineered into a product or service at the design stage of development; these costs
should be incurred if all design specifications are followed. Incurred costs are the actual
costs of making the product. When cost-based pricing is used, controlling the costs of a new
product from the planning phase through the production phase is very difficult; management
has a hard time setting realistic targets because the product is being produced for the first
time. Because customers are expected to pay whatever amount cost-based pricing identifies,
the focus is on sales rather than on design and manufacture, and efforts at cost control focus
on costs incurred after the product has been introduced to the marketplace. With target
costing, committed costs are minimized because the product has been designed and built to
a specific cost goal. Target costing allows profitability to be built into the selling price from
the outset.
17. A company’s engineers sometimes determine that a product cannot be manufactured at or
below its target cost. In this case, the company should try to adjust the product’s design and
the approach to production. If those attempts fail, it should either invest in new equipment
and procedures or abandon its plans to market the product.
Objective 5: Describe how transfer pricing is used for transferring goods and services and
evaluating performance within a division or segment.
18. A decentralized organization has several divisions or operating segments. These divisions
or segments sell their goods and services both inside and outside the organization. The price
a division or segment charges for exchanging goods and services with another division or
segment is called a transfer price. This internal pricing mechanism enables an organization
to assess both the internal and external profitability of its products or services. There are
three basic kinds of transfer prices:
a.
A cost-plus transfer price is the sum of costs incurred by the producing division plus
an agreed-on profit percentage. The weakness of cost-plus pricing is that it guarantees
that the selling division will recover its costs. Guaranteed cost recovery does not take
into account any inefficiencies in a division’s operations or the incurrence of excessive
costs.
b.
A market transfer price is based on the price a product could command on the open
market. The danger in using market prices as transfer prices is that a decision to sell to
outside customers at the market price may cause an internal shortage of critical
materials; the selling division may realize a profit, but the overall profitability of the
company will suffer. Market prices are therefore usually used only as a basis for
negotiation.
c.
A negotiated transfer price is reached through bargaining between the managers of
the buying and selling divisions. This approach allows the selling division to recover
its costs and still earn a profit. To develop a negotiated transfer price, the managers
should compute the unit cost of the item being transferred and an appropriate profit
markup. If the item has an external market or if the buying division can purchase the
same item from an outside source, the market price should be included in the
negotiations. The transfer price on which the managers ultimately agree should be
beneficial to the company as a whole.
19. Because transfer prices include an estimated amount of profit, they can be used as a basis
for measuring performance. Even divisions that sell their products only within the company
can be evaluated as profit centers by using transfer prices to simulate revenues.