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Pricing Chapter Decisions,
Including Target Costing
and Transfer Pricing
The Pricing
Decision and the Manager
Objective 1
Identify the objectives and rules used to
establish prices of goods and services, and
relate pricing issues to the management
process.
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The Objectives of a Pricing Policy
1. Identifying and adhering to both short-run
and long-run pricing strategies
2. Maximizing profits
3. Maintaining or gaining market share
4. Setting socially responsible prices
5. Maintaining a minimum rate of return on
investment
6. Being customer focused
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Pricing Rules
Must be competitive
Should be acceptable to customers
Seek to recover all costs in bringing the
product or service to market
Should return a profit
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Planning
Managers consider how much to charge
for products or services
Identify the maximum price the market will
accept and the minimum price the company
can sustain
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Performing
Pricing strategies for products and services
are followed
Products or services are sold either at the
specified prices or on the auction market
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Evaluating
Review
sales
Determine which
pricing strategies were
successful or which
failed
Recommend changes
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Communicating
Analyses of
actual prices
and profits
versus
targeted ones
are prepared
Used to assess past pricing
strategies and plan future
strategies
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Stop & Review
Q. In which management stage do managers
determine which pricing strategies were
successful and which failed?
A. Evaluating stage
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Economic Pricing Concepts
Objective 2
Describe economic pricing concepts
including the auction-based pricing
method used on the Internet.
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Economic Approach to Pricing
Based on microeconomic theory
Microeconomic theory states that profit will
be maximized when the difference between
total revenue and total cost is the greatest
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Total Revenue Curve
As a product is marketed, price reductions
will be necessary to sell additional units
because of competition and other factors
Total revenue will continue to increase, but
the rate of increase will diminish as more
units are sold
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Total Cost Curve
Costs per unit will increase as more units
are sold because fixed costs will change
Variable and fixed costs are fairly
predictable, with fixed costs remaining
constant and variable costs being the same
per unit
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Profit
Profit is maximized
At the point where the difference between total revenue
and total cost is the greatest
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Marginal Revenue
and Marginal Cost Curves
Marginal revenue
is the change in
total revenue
caused by a oneunit change in
output.
Marginal cost is the
change in total cost
caused by a oneunit change in
output.
Help determine the optimal price for a
good or service
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Auction-Based Pricing
Companies like eBay, Yahoo, and
Priceline.com use auction-based pricing
Sellers auction-based price
Buyers auction-based price
Company posts a message on
the Internet asking for the
quantity and price that
prospective buyers are willing
to pay, then selects the best
price
Company or individual posts
need for product or service,
receives offers, accepts the
best offer
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Stop & Review
Q. According to microeconomic theory, do
costs per unit increase or decrease as more
units are sold?
A. The costs per unit will increase as more units
are sold because fixed costs will change.
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Cost-Based Pricing Methods
Objective 3
Use cost-based pricing methods to
develop prices.
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Pricing Methods Based on Cost
Gross Margin Pricing (also known as
the income statement method)
Return on Assets Pricing
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Gross Margin Pricing
A cost-based pricing approach in which the price is computed
using a markup percentage based on a products total
production costs
Gross margin markup percentage is
composed of selling, general, and
administrative expenses and the desired
profit
Desired Profit + Total Selling,
General, and Administrative Expenses
Markup Percentage =
Total Production Costs
Gross Margin-Based Price = Total Production Costs per Unit + ( Markup
Percentage Total Production Costs per Unit )
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Gross Margin Price on Per Unit Basis
Gross Margin-Based Price =
Direct materials + Direct labor + Variable
overhead + Fixed overhead + Selling,
general, and administrative expenses +
Desired profit
Total Units Produced
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Return on Assets Pricing
Earning a profit equal to a specified rate of return on
assets employed in the operation
Balance sheet approach to pricing
Return on Assets-Based Price =
Total Costs and Expenses Per Unit + (Desired Rate
of Return x Cost of Assets Employed per Unit)
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Cost-Based Pricing
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Pricing Services
Service businesses take a different approach to pricing
Time and materials pricing
(also called parts and labor pricing)
Direct labor
+
Materials and Parts
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Markup
=
percentage
Price
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Time and Materials Pricing Illustrated
Gil Marquis completed work on Lucinda Lowes Mercedes.
The parts used to repair the vehicle cost $840. The companys
40 percent markup rate on parts covers parts-related overhead
costs and profit. The repairs required four hours of labor by a
certified Mercedes specialist, whose wages are $35 per hour.
The companys overhead markup rate on labor is 80 percent.
What amount
will be billed to
Lucinda Lowe?
Repair parts used
Overhead charges ($840 x 40%)
Total parts charges
Labor charges
4 hours @ $35
Overhead charges ($140 x 80%)
Total labor charges
Total billing
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$840
336
$1,176
$140
112
252
$1,428
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Stop & Review
Q. What elements are included in the gross
margin markup percentage?
A. Selling, general, and administrative expenses
and the desired profit
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Pricing Based on Target Costing
Objective 4
Describe target costing, and use that
concept to analyze pricing decisions and
evaluate a new product opportunity.
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Target Costing
Designed to enhance a companys ability to compete,
especially in new or emerging product markets
Target costing:
(1) Identifies the price at which a product will be
competitive in the marketplace
(2) Defines the desired profit to be made on the product
(3) Computes the target cost for the product by subtracting
the desired profit from the competitive market price
Target Price - Desired Profit = Target Cost
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Advantages of Target Costing
Gives managers the ability to control or
dictate the costs of a new product
beginning at the planning stage of the
products life cycle
Can analyze a products potential before
they commit resources to its production
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Traditional Costing
Versus Target Pricing
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Pricing Strategies Illustrated
Cost First Company
Enter planning, design, and
production as soon as
possible
Expects engineering changes
Total unit cost cannot be
computed until successful
production
Difficult to control costs from
planning through production
Product price = $84
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Price First Company
Uses target costing approach
Using market research and target
costing formula, target cost
equals $40
Engineering begins with this cost
restriction in mind
Production did not begin until
quality and cost were in line
Product price = $48
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Target Costing Illustrated
Zephyr Company hopes to quote prices of $300 for a router
and $725 for a computer. The companys usual profit markup
is 25 percent of total unit cost.
What is the target cost for each product?
Router = $300 / 1.25 = $240
Computer = $725 / 1.25 = $580
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Target Costing Illustrated (contd)
Zephyr Company hopes to quote prices of $300 for the router.
Direct materials and parts will cost $40. One router will require
2.6 hours of manufacturing labor at $12/hour, 3.4 hours of
assembly labor at $14. Materials handling will cost $52.
Production will require 12.8 machine hours at $3.50/hour, and
the product delivery cost is estimated to be $24.
What is the projected total unit cost for the router?
Router = $40.00 + $31.20 + $47.60 + $52.00 +$44.80 + $24.00
= $239.60
Decision: The router can be produced below its target
cost of $240.00, so it should be produced.
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Stop & Review
Q. Does the target costing method or the
traditional costing strategy result in more
cost savings in the production stage?
A. Since cost and quality issues are worked out
before going into production under the target
costing method, this method results in more
cost savings than the traditional method.
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Pricing for Internal
Providers of Goods and Services
Objective 5
Describe how transfer pricing is used for
transferring goods and services and
evaluating performance within a division
or segment.
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Transfer Pricing
Not used for external pricing
Used to set prices for transfers within a
companys departments, divisions, or segments
Transfer prices do not
affect revenues and costs of
the company as a whole
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Transfer prices do affect
revenues and costs of the
divisions involved.
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Kinds of Transfer Prices
Cost-plus transfer price
Market transfer price
Negotiated transfer price
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Cost-Plus Transfer Price
Based on either the full cost or the variable
costs incurred by the producing division
plus an agreed-on profit percentage
Fails to detect inefficient operating
conditions
Cost recovery is guaranteed to selling
division
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Market Transfer Price
Based on the price that
could be charged if a
segment could buy from or
sell to an external party
Forces the selling division to
be competitive with market
conditions
Does not penalize the buying
division by charging a higher
price than if the item were
purchased on the open market
When market prices are used to develop
transfer prices, they are usually used only as
a basis for negotiation
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Negotiated Transfer Price
Arrived at through bargaining between the
managers of the buying and selling
divisions or segments
Such a transfer price may be based
on an agreement to use a cost plus a
profit percentage
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Development of a Transfer Price
Simple Box Company
Pulp
Division
Cardboard
Division
May buy pulp from the
pulp division or from
outside sources
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Development of
Cost-Plus Transfer Price
Cost-plus transfer price for pulp includes:
Variable costs ($3.30 + $0.70 + $1.60 + $2.40 +
$1.90 + $1.95)
Fixed cost of $1.05 related to the Pulp Division
The profit markup of 10 percent adds $1.29
Total cost-plus transfer price equals $14.19
Pulp
Division
$14.19
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Cardboard
Division
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Development of
Market Transfer Price
After the cost-plus transfer price is developed at
$14.19/lb., the manager of the cardboard division
might point out that pulp purchased from an
outside source is only $13/lb.
$13/lb. would be the ceiling price the cardboard
division is willing to pay
Managers of both divisions would likely enter
into negotiations on the final transfer price
Outside
source
$13/lb.
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Cardboard
Division
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Development of
Negotiated Transfer Price
Company does not want the Cardboard Division
to buy pulp from another company
Pulp Division should have an incentive to move
toward the market price
The negotiated transfer price also allows for the
sharing between divisions of the final products
company-wide profits when the boxes are sold on
the outside market
Pulp
Division
Negotiated price
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Cardboard
Division
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Using Transfer Prices
to Measure Performance
When transfer prices are used, a division can
be evaluated as a profit center
While transfer prices are sometimes considered
artificial, they create a valuable performance
measure
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Using Transfer Prices
to Measure Performance
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Transfer Pricing in
Retail and Service Organizations
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Transfer Pricing in
Retail and Service Organizations (contd)
Need for transfer prices in Auto Imports
Used Car Department receives trades from New
Car Department.
Leasing Department obtains cars from both the
New Car and the Used Car Departments
If market prices are readily available,
companies will use market prices for transfer
pricing
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Stop & Review
Q. What is a transfer price?
A. Used to set prices for transfers within
a companys departments, divisions,
or segments
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Chapter Review
1. Identify the objectives and rules used to
establish prices of goods and services, and
relate pricing issues to the management
process.
2. Describe economic pricing concepts,
including the auction-based pricing method
used on the Internet.
3. Use cost-based pricing methods to develop
prices.
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Chapter Review (contd)
4. Describe target costing and use that concept
to analyze pricing decisions and evaluate a
new product opportunity.
5. Describe how transfer pricing is used for
transferring goods and services and
evaluating performance within a division or
segment.
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