Chapter 22
Pricing
Learning Objectives
After studying this chapter, you should be able to:
[1] Compute a target cost when the market determines a product price.
[2] Compute a target selling price using cost-plus 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.
22-1
Pricing Objectives
There are three main objectives to be considered in setting prices:
Cost & Profit:
Pricing must be set sufficient to cover costs and generate a
sufficient profit to support and grow the business.
22-2
There are three main objectives to be considered in setting prices:
Market Positioning:
Prices are a key signal to buyers of a products market
position. If a car sells for $90,000 while another sells for
$15,000, buyers have a certain image of what one car is
versus the other.
22-3
There are three main objectives to be considered in setting prices:
Market Share:
Pricing can affect the rate at which a product penetrates a
market. In general, cheaper pricing creates less buyer
resistance during the sale process and promotes faster
product adoption and share growth.
22-4
Pricing Strategies
The way in which it decides how to blend the tradeoffs between the
price objectives (cost & profit; market positioning; market
share). The most common price strategies are:
Predatory Pricing:
The company prices its product at very low margin, or
even at cost in order to gain entry into a new market.
Over time, it increases prices to be more in line with its
target brand position.
22-5
Pricing Strategies
The way in which it decides how to blend the tradeoffs between the
price objectives (cost & profit; market positioning; market
share). The most common price strategies are:
Skimming:
The company prices at a premium to capture the high end
segments first. Then as it saturates a buyer segment, it
drops prices to appeal to new buyer segments.
22-6
Pricing Strategies
Bundling:
The company groups together different products and
features in such a way that it can offer variations at
different prices.
Ex: auto industry … by bundling together desirable but
costly features (automatic trans) with less desirable but
more profitable features ("all weather" pkg), the overall
profitability of the car can be optimized.
22-7
Pricing Strategies
Multi-tier:
The company offers distinct product categories at different
price segments to appeal to different buyers.
Ex: auto industry … Toyota used to offer a mainstream
(Toyota) and luxury (Lexus) model under different brands
for substantially the same car (Camry vs. ES300).
22-8
Pricing Goods for External Sales
The price of a good or service is affected by many factors.

IF - products are not easily differentiated from
competitors … prices are not set by the company,
but rather by “supply and demand”.

IF - products are unique or clearly distinguishable
from competitors … prices are set by the company.
22-9
22-10
22-11
Pricing Goods for External Sales
Target Costing
22-12

Target cost: Cost that provides the desired profit
when the market determines a product’s price.

If a company can produce its product for the target cost or
less, it will meet its profit goal.
Pricing Goods for External Sales
Target Costing

1st, identify its *market niche where it wants to compete
(niche markets can be: left-handed users, stay-home dads, “tweens”, college
students, old folk, “foodies”, “techies”, gamers, shoe-aholics, “cat-people”).
22-13

2nd, determine the target selling price – the price where
company believes consumers will buy to maximize sales.

3rd, determines its target cost by: “target selling price the desired profit” = target cost.

Then, company assembles a team to develop a product to
meet the company’s goals. If not possible … NEXT !
• FL phones considering a fashion cover for its phones. Research
indicates that 200,000 units can be sold if price is $20 max.
• If FL makes items, it must invest $1,000,000 in new equipment.
• FL requires a 25% profit (return). What is “target cost” per unit.
The desired profit in $$ for this new product line is
$1,000,000 x 25% = $250,000
Each cover must result in profit of $250,000 ÷ 200,000 units = $1.25
Market price
$20
22-14
-
Desired profit
Target cost per unit
$1.25
$18.75 per unit
=
22-15
Pricing Goods for External Sales
Cost-Plus Pricing
22-16

When there is 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: cost-plus pricing.

Approach requires establishing a cost base and adding a
markup to determine a target selling price.
Illustration: JCo. is in the process of setting a selling price on its
new video pen. It will record up to 2 hours of audio-video. The per
unit variable cost estimates for the new pen are:
JCo also has fixed costs per unit at a sales of 10,000 units.
22-17
JCo needs to price its pen to earn a 20% return on its
investment (ROI) of $1,000,000.
Markup = 20% ROI of $1,000,000
Expected ROI = $200,000 ÷ 10,000 units = $20
Sales price per unit =
22-18
Use markup on cost to set a selling price:
22-19

Compute the markup percentage to achieve a desired ROI
of $20 per unit:

Compute the target selling price:
Limitations of Cost-Plus Pricing

Advantage of cost-plus pricing: Easy to compute.

Disadvantages:
►
Does not consider demand side:
o Will the customer pay the price?
►
Fixed cost per unit changes with in sales volume:
o At lower sales, company must charge higher price to meet
desired ROI.
22-20
Illustration: If budgeted sales volume for JCo was 8,000 and
not 10,000, JCo variable cost per unit would remain the same.
However, the fixed cost per unit would change as follows.
JCo 20% ROI now results in a $25 ROI per unit
[(20% x $1,000,000) / 8,000].
22-21
JCo computes the selling price at 8,000 units as follows.
At 8,000 units, how much would JCo mark up its total unit costs
to earn a desired ROI of $25 per unit.
22-22
Pricing Goods for External Sales
Variable-Cost Pricing
Alternative pricing approach:
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.
Major disadvantage is that managers may set the price too
low and fail to cover fixed costs.
22-23
KRC Air Corporation produces air purifiers. Using a 45% markup
percentage on total per unit cost, compute the target selling price.
22-24
Pricing Services
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, (auto repair) but especially
professional services like: public accounting, law etc.
22-25
Pricing Services
Illustration: Assume the following data for Lake Holiday
Marina, a boat and motor repair shop.
22-26
Pricing Services
Using time-and-material pricing involves three steps:
22-27
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.
Pricing Services
Step 1: Calculate the labor charge.


22-28
Express as a rate per hour of labor … to include:
►
Direct labor cost (includes fringe benefits).
►
Selling, administrative, and similar overhead costs.
►
Allowance for desired profit (ROI) per hour.
Labor rate for Lake Holiday Marina for 2011 based on:
►
5,000 hours of repair time.
►
Desired profit margin of $8 per hour.
Pricing Services
Step 1: Calculate the labor charge.
Multiply the rate of $38.20 x # labor hours used on a job to
determine the labor charges for the job.
22-29
Pricing Services
Step 2: Calculate the material loading charge.

Material loading charge added to invoice cost of
materials.

(
22-30
Covers the costs of purchasing, receiving, handling, storing +
desired profit margin on materials.
Estimated purchasing, receiving,
handling, storing costs
Estimated costs of parts & materials
)+
Desired profit
margin % on
materials
Pricing Services
Step 2: Calculate the material loading charge.
The marina estimates that the total invoice cost of parts and materials
used in 2011 will be $120,000. The marina desires a 20% profit margin
on the invoice cost of parts and materials.
22-31
Pricing Services
Step 3: Calculate charges for a particular job.
Labor charges
+ Material charges (often includes material loading charge)
+ Material loading charge (may be included in above)
Total Charge to customer *
for a particular, specific, job
* Often used as an “estimate” (or a bid) to get a job – such as:
building you a new fence, installing sink, car brake job, dental
work, new tires – balanced, installed with warranty,
22-32
Pricing Services
Step 3: Calculate charges for a particular job.
Lake Holiday Marina prepares a price quotation to estimate the cost to
refurbish a used 28-foot pontoon boat. Lake Holiday Marina estimates
the job will require 50 hours of labor and $3,600 in parts and materials.
22-33
Presented below are data for Harmon Electrical Repair Shop for
next year. The desired profit margin per labor hour is $10. The
material loading charge is 40% of invoice cost. Harmon estimates
that 8,000 labor hours will be worked next year. Compute the rate
charged per hour of labor.
22-34
If Harmon repairs a TV that takes 4 hours to repair and uses
parts of $50, compute the bill for this job.
22-35
Pricing Services
Review Question
Crescent Electrical Repair has decided to price its work on a time-andmaterial basis. It estimates the following costs for the year related to
labor.
Technician wages and benefits
Office employee’s salary/benefits
Other overhead
$100,000
$40,000
$80,000
Crescent desires a profit margin of $10 per labor hour and budgets 5,000
hours of repair time for the year. The office employee’s salary, benefits,
and other overhead costs should be divided evenly between time charges
and material loading charges. Crescent labor charge per hour would be:
a.
22-36
$42
b.
$34
c.
$32
d.
$30
22-37
22-38
Transfer Pricing for Internal Sales
Vertically integrated companies

Grow in either direction of its suppliers or its customers.

Frequently sells (transfers) goods to other divisions as well
as outside customers.
How do you
price goods
“sold” within the
company?
22-39
You are marketing manager for “Disney Cruises”
To offer a vacation package including:
• 7-day Disney cruise,
• 7-days at Disney-World with a
• 7-night stay in Disney-World hotel
you must:
Negotiate a transfer price (your “cost”) with
????
22-40
You are marketing manager for “Disney Cruises”
To offer a vacation package including:
• 7-day Disney cruise,
• 7-days at Disney-World with a
• 7-night stay in Disney-World hotel
you must:
Negotiate a transfer price (your “cost”) with
* Disney “Parks” Division (for 7-day park-hopper pass)
* Disney Hotel Division (for the 7 night hotel stay)
* Plus “others” (busses for transport from ship to hotel)
to offer the vacation package
22-41
Transfer Pricing for Internal Sales
Transfer price: price used to record the transfer between
two divisions of the same company or corporation.

Ways to determine a transfer price:
1. Negotiated transfer prices.
2. Cost-based transfer prices.
3. Market-based transfer prices.
22-42

Conceptually - a negotiated transfer price is best.

Due to practical considerations, companies often use the
other two methods.
Transfer Pricing for Internal Sales
Negotiated Transfer Prices
Illustration: Alberta Company makes rubber soles for work &
hiking boots.

22-43
Two Divisions:
►
Sole Division - sells soles externally.
►
Boot Division - makes leather uppers for hiking
boots which are attached to purchased soles.

Division managers compensated on division profitability.

Management now wants Sole Division to provide at least
some soles to the Boot Division.
Negotiated Transfer Prices
Computation of the contribution margin per unit for each division
when the Boot Division purchases soles from an outside supplier.
“What would be a fair transfer price if the Sole Division sold 10,000
soles to the Boot Division?”
22-44
Negotiated Transfer Prices
No Excess Capacity


22-45
If Sole sells to Boot,
►
payment must at least cover variable cost per unit
plus
►
its lost contribution margin per sole (opportunity cost).
The minimum transfer price acceptable to Sole is:
Negotiated Transfer Prices
Maximum Boot Division will pay is
what the sole would cost from an
outside buyer: $17
22-46
Negotiated Transfer Prices
Excess Capacity
22-47

Can produce 80,000 soles, but can sell only 70,000.

Available capacity of 10,000 soles.

Contribution margin of $7 per unit is not lost.

Minimum transfer price acceptable to Sole:
Negotiated Transfer Prices
Negotiate a transfer price between $11
(minimum acceptable to Sole) and $17
(maximum acceptable to Boot)
22-48
Negotiated Transfer Prices
Summary of Negotiated Transfer Pricing


22-49
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.
Transfer Pricing for Internal Sales
Market-Based Transfer Prices
22-50

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.

Why? No opportunity cost.

Where there is not a well-defined market price, companies
use cost-based systems.
Market-Based Transfer Prices
Review Question
The Plastics Division of Weston Company manufactures
plastic molds and then sells them for $70 per unit. Its variable
cost is $30 per unit, and its fixed cost per unit is $10.
Management would like the Plastics Division to transfer 10,000
of these molds to another division within the company at a
price of $40. The Plastics Division is operating at full capacity.
What is the minimum transfer price that the Plastics Division
should accept?
a.
b.
22-51
$10
$30
c.
d.
$40
$70
Transfer Pricing for Internal Sales
Effect of Outsourcing on Transfer Pricing
Outsourcing - Contracting with an external party to provide a
good or service, rather than doing the work internally.
22-52

Virtual companies outsource all of their production.

Use incremental analysis to determine if outsourcing is
profitable.

As companies increasingly rely on outsourcing, fewer
components are transferred internally thereby reducing the
need for transfer pricing.
Transfer Between Divisions in Different
Countries
Companies “globalize” their operations
22-53

Going global increases transfers between divisions
located in different countries.

60% of trade between countries is estimated to be
transfers between divisions.

Different tax rates make determining appropriate transfer
price more difficult.
22-54
• FL phones considering a fashion cover for its phones. Research
indicates that 200,000 units can be sold if price is $20 max.
• If FL makes items, it must invest $1,000,000 in new equipment.
• FL requires a 25% profit (return). What is “target cost” per unit.
The desired profit in $$ for this new product line is
$1,000,000 x 25% = $250,000
Each cover must result in profit of $250,000 ÷ 200,000 units = $1.25
Market price
$20
22-55
-
Desired profit
Target cost per unit
$1.25
$18.75 per unit
=
Illustration: JCo. is in the process of setting a selling price on its
new video pen. It will record up to 2 hours of audio-video. The per
unit variable cost estimates for the new pen are:
JCo also has fixed costs per unit at a sales of 10,000 units.
22-56
JCo needs to price its pen to earn a 20% return on its
investment (ROI) of $1,000,000.
Markup = 20% ROI of $1,000,000
Expected ROI = $200,000 ÷ 10,000 units = $20
Sales price per unit =
22-57
KRC Air Corporation produces air purifiers. Using a 45% markup
percentage on total per unit cost, compute the target selling price.
22-58
Presented below are data for Harmon Electrical Repair Shop for
next year. The desired profit margin per labor hour is $10. The
material loading charge is 40% of invoice cost. Harmon estimates
that 8,000 labor hours will be worked next year. Compute the rate
charged per hour of labor.
22-59
If Harmon repairs a TV that takes 4 hours to repair and uses
parts of $50, compute the bill for this job.
22-60