Chapter 8-1

Chapter8-1

CHAPTER 8PricingManagerial Accounting, Fourth EditionChapter8-2

Study Objectives1.Compute a target cost when the marketdetermines a product price.2. Compute a target selling price using cost-pluspricing.3. Use timetime-andand--material pricing to determine thecost of services provided.4. Determine a transfer price using the negotiated,cost--based, and marketcostmarket-based approaches5. Explain issues involved in transferring goodsbetween divisions in different countries.Chapter8-3

Preview of ChapterFew management decisions are more important thansetting prices.Prices must be high enough to cover costs andensure a reasonable profit, but not so high that theproduct fails to sell.Two types of pricing are examined in this chapter:Pricing to sell to external partiesPricing to sell to other divisions within thesame companyChapter8-4

PricingExternal SalesTarget ter8-5Internal SalesNegotiated transferpricesCost--based transferCostpricesMarket--based transferMarketpricesEffect of outsourcing ontransfer pricingTransfers betweendivisions in differentcountries

External SalesThe price of a good or service is affected by manyfactors, such as those shown below.Regardless of the factors involved, the price must coverthe costs of the good or service as well as earn areasonable profit.Chapter8-6

External SalesTo determine an appropriate price, acompany must have a good understanding ofmarket forces.Where products are not easilydifferentiated from competitor goods,prices are not set by the company, butrather by the laws of supply and demand –such companies are called price takers.Where products are unique or clearlydistinguishable from competitor goods,prices are set by the company.Chapter8-7

Target CostingIn a highly competitive industry,the laws of supply and demandsignificantly affect productprice.No company can affect the priceto a significant extent so, to earna profit, companies must focus oncontrolling costs.This requires setting a targetcost that will provide thecompany’s desired profitChapter8-8LO 1: Compute a target cost when the market determines a product price.

Target CostingTarget cost: Cost that provides the desired profiton a product when the market determines aproduct’s priceIf a company can produce its product for the targetcost or less, it will meet its profit goalChapter8-9LO 1: Compute a target cost when the market determines a product price.

Target Costing - StepsFirst, a company should identify its market nichewhere it wants to compete.Second, the company conducts market researchto determine the target price – the price thecompany believes will place it in the optimalposition for the target consumers.Third, the company determines its target cost bysetting a desired profit.Last, the company assembles a team to develop aproduct to meet the company’s goals.Chapter8-10LO 1: Compute a target cost when the market determines a product price.

Let’s ReviewTarget cost related to price and profit means that:a.Cost and desired profit must be determinedbefore selling price.priceb. Cost and selling price must be determined beforedesired profit.c.Price and desired profit must be determinedbefore costs.d. Costs can be achieved only if the company is atfull capacity.Chapter8-11LO 1: Compute a target cost when the market determines aproduct price.

CostCost-Plus PricingIn an environment with little or no competition, acompany may have to set its own priceWhen a company sets price, the price is normally afunction of product cost: cost-plus pricingThis approach requires establishing a cost base andadding a markup to determine a target selling priceThe size of the markup (the “plus”) depends on thedesired return on investment for the product:ROI net income invested assetsChapter8-12LO 2: Compute a target selling price using costcost-plus pricing.

CostCost-Plus PricingIn determining the propermarkup, a company mustconsider competitive andmarket conditionsThe cost-plus formula isexpressed as:Chapter8-13LO 2: Compute a target selling price using costcost-plus pricing.

Cost––Plus PricingCostExample – Cleanmore ProductsManufactures wet/dry shop vacuumsPer unit variable cost estimates:Chapter8-14LO 2: Compute a target selling price using costcost-plus pricing.

Cost––Plus PricingCostExample – Cleanmore ProductsCleanmore also has the following fixed costs perunit at a budgeted sales volume of 10,000 unitsChapter8-15LO 2: Compute a target selling price using costcost-plus pricing.

Cost––Plus PricingCostExample – Cleanmore ProductsMarkup 20% ROI of 1,000,000Expected ROI 200,000 10,000 unitsSales price per unit 132Chapter8-16LO 2: Compute a target selling price using costcost-plus pricing.

Cost––Plus PricingCostExample – Cleanmore ProductsTo use markup on cost to set a selling price:1) Compute the markup percentage to achieve adesired ROI of 20 per unit:2)Chapter8-17Using this markup compute the target sellingprice:LO 2: Compute a target selling price using costcost-plus pricing.

Limitations of CostCost-Plus PricingMajor advantage of cost-plus pricing:Easy to computeDisadvantages:Does not consider demand side:Will the customer pay the price?Fixed cost per unit changes withchange in sales volume:At lower sales volume, company mustcharge higher price to meetdesired ROIChapter8-18LO 2: Compute a target selling price using costcost-plus pricing.

Limitations of CostCost-Plus PricingExample - Cleanmore ProductsReduce budgeted sales volume from 10,000 to8,000 unitsVariable costs per unit will remain the sameFixed cost per unit will increase to 65 per unitCleanmore’s 20% ROI now results in a 25 ROI perunit [(20% x 1,000,000) 8,000 units]Chapter8-19LO 2: Compute a target selling price using costcost-plus pricing.

Limitations of CostCost-Plus PricingExample - Cleanmore Products Cont’dCleanmore will now compute the new selling price as:The lower the budgeted volume, the higher the perunit priceFixed costs and ROI spread over fewer unitsFixed costs and ROI per unit increaseOpposite effect occurs if budgeted volume is higherChapter8-20LO 2: Compute a target selling price using costcost-plus pricing.

VariableVariable-Cost PricingAlternative pricing approach:Simply add a markup to variable costsAvoids the problem of uncertain cost informationrelated to fixed-cost-per-unit computationsHelpful in pricing special orders or when excesscapacity existsMajor disadvantage:Managers may set the price too low andfail to cover fixed costsChapter8-21LO 2: Compute a target selling price using costcost-plus pricing.

Let’s ReviewCost--plus pricing means that:Costa.Selling price variable cost (markup percentage variable cost).cost)b. Selling price cost (markup percentage X cost).c.Selling price manufacturing cost (markuppercentage manufacturing cost).d. Selling price fixed cost (markup percentage Xfixed cost).Chapter8-22LO 2: Compute a target selling price using costcost-plus pricing.

TimeTime-AndAnd-Material PricingAn approach to cost-plus pricing in which thecompany uses two pricing rates:One for the labor used on a jobIncludes direct labor time and other employee costsOne for the materialIncludes cost of direct parts and materials and amaterial loading charge for related overheadWidely used in service industries, especiallyprofessional firms such asPublic Accounting, Law,EngineeringChapter8-23LO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

TimeTime-AndAnd-Material PricingExample – Lake Holiday MarinaBudgeted data:Chapter8-24LO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

TimeTime-AndAnd-Material Pricing - ExampleStep 1: Calculate the labor chargeExpress as a rate per hour of laborRate includes:Direct labor cost (includes fringe benefits)Selling, administrative, and similar overhead costsAllowance for desired profit (ROI) per hourLabor rate for Lake Holiday Marina for 2008 based on:5,000 hours of repair timeDesired profit margin of 8 per hourChapter8-25LO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

TimeTime-AndAnd-Material Pricing – Example Cont.The marina multiplies the rate of 38.20 by the numberof labor hours used on any particular job to determinethe labor charges for the job.Chapter8-26LO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

TimeTime-AndAnd-Material Pricing – Example Cont.Step 2: Calculate the material loading chargeMaterial loading charge added to invoice price of materialsCovers the costs of purchasing, receiving, handling, storing desired profit margin on materialsExpressed as a percentage of estimated costs of parts andmaterials for the year:Estimated purchasing, receiving,handing, storing costsEstimated costs of parts/materialsChapter8-27 desiredprofit marginon materialsLO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

TimeTime-AndAnd-Material Pricing – Example Cont.Chapter8-28LO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

TimeTime-AndAnd-Material Pricing – Example Cont.Step 3: Calculate charges for a particular jobLabor charges Material charges Material loading chargeChapter8-29LO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

TimeTime-AndAnd-Material Pricing – Example Cont.A price quote to refurbish a pontoon boat:Estimated 50 hours of laborEstimated 3,600 parts and materialsChapter8-30LO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

Let’s ReviewCrescent Electrical Repair has decided to price its work on a timetimeand--material basis. It estimates the following costs for the yearandrelated to labor.Technician wages and benefitsOffice employee’s salary/benefitsOther overhead 100,000 40,000 80,000Crescent desires a profit margin of 10 per labor hour and budgets5,000 hours of repair time for the year. The office employee’ssalary, benefits, and other overhead costs should be divided evenlybetween time charges and material loading charges. Crescent laborcharge per hour would be:Chapter8-31a. 42c. 32b. 34d. 30LO 3: Use timetime-andand-material pricing to determinethe cost of services provided.

Internal SalesVertically integrated companies – grow in either direction ofits suppliers or its customersFrequently transfer goods to other divisions as well as outsidecustomersHow do you price goods “sold” with in the company?Chapter8-32LO 4: Determine a transfer price using the negotiated, costcost-based,and marketmarket-based approaches.

Internal SalesTransfer price - price used to record the transferbetween two divisions of a companyWays to determine a transfer price:Negotiated transfer pricesCost-based transfer pricesCostMarketMarket-based transfer pricesConceptually - a negotiated transfer price is bestDue to practical considerations,considerations, companies often usethe other two methodsChapter8-33LO 4: Determine a transfer price using the negotiated, costcost-based,and marketmarket-based approaches.

Negotiated Transfer PricesDetermined throughagreement of thedivision managerswhen no externalmarket price isavailableChapter8-34LO 4: Determine a transfer price using the negotiated, costcost-based,and marketmarket-based approaches.

Negotiated Transfer Price - ExampleAlberta Company now sells hiking boots as well assoles for work & hiking bootsStructured into two divisions: Boot and SoleSole Division - sells soles externallyBoot Division - makes leather uppers for hikingboots which are attached topurchased solesEach Division Manager compensated on divisionprofitabilityManagement now wants Sole Division to provide atleast some soles to the Boot DivisionChapter8-35LO 4: Determine a transfer price using the negotiated, costcost-based,and marketmarket-based approaches.