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Unformatted text preview: Lecture 8 Lecture 8
Pricing – Chapter 9 Pricing Pricing Major influences on Pricing Competitive environment: company is a price taker and will not have much flexibility in making pricing decisions Cost based pricing: consider fix costs when setting longterm pricing decisions Customer demands Competitor’s actions Cost of the product Government policies Image Rationale: fixed costs are differential over the longrun (beware of variable costs) Less competitive market Less competitive market
Var Cost =21 Selling Price 25 27 30 32 35 Vol. 175,000 140,000 100,000 55,000 35,000 CM/unit 4 6 9 11 14 Total CM $700,000 $840,000 $900,000 $605,000 $490,000 Revenue Curve Revenue Curve
The total revenue curve increases throughout its range, but the range of increase declines as monthly sales quantity increases. The demand curve shows the relationship between sales price and the quantity of units demanded. Marginal revenue curve shows the change in total revenue that accompanies a change in the quantity sold. Cost Curve The total cost curve increases throughout its range. The rate of increase declines as quantity increases from 0 to c units; and then the rate increases as quantity increases from c units upward. The marginal cost curve shows the change in total costs that accompanies a change in quantity produced and sold. Marginal costs declines as quantity increases from 0 to c units, then it increases as quantity increases beyond c units Profit Maximizing Profit Maximizing Price and Quantity The profit maximizing sales quantity is determined by the intersection of the marginal cost and marginal revenues (q*). The profit maximizing price (p*) is determined from the demand curve for the quantity q*. Limitations of the Profit Maximizing Limitations of the Profit Maximizing model A firm’s demand and marginal revenue curves are difficult to discern with precision. The marginal revenue, marginal cost paradigm is not valid for all forms of markets. Marginal cost is difficult to measure. Cost and Benefits of Information Cost and Benefits of Information Cost Plus Pricing Cost Plus Pricing Price = Cost + (% Markup )* Cost
3 All Variable Cost (VarMan + VarS&A) 4 All Manufacturing Cost + All S&A 1 Variable Manufacturing Cost (VarMan) 2 Absorption Manufacturing Cost (VarMan + FixMan) AbsorptionCost Pricing Formulas AbsorptionCost Pricing Formulas
Disadvantage Fullabsorption unit price obscures the distinction between variable and fixed costs (is not consistent with CVP analysis). Price covers all costs. Perceived by consumers as equitable. Comparison with competitors. Absorption cost used for external reporting. VariableCost Pricing Formulas VariableCost Pricing Formulas Advantages Do not obscure cost behavior patterns. Do not require fixed cost allocations. More useful for managers. Disadvantage Fixed costs may be overlooked in pricing decisions, resulting in prices that are too low to cover total costs. Determining the markup Determining the markup
Step 1: Solve for the income that will result in an ROI of 20 percent. Income ROI = Invested Capital Income 20% = $300,000 Income = $60,000 Determining the markup Price = Cost + (%Markup )* Cost Price = Cost * (1 + Markup) Price = Cost * (1 + Markup) Price/Cost – 1 = Markup Price – Cost = Markup Cost If Cost = Total Cost then Profit = Markup Total Cost If Cost = Variable Cost then CM/unit = Markup Variable cost/unit Pricing New Products Pricing New Products Uncertainties make pricing difficult. Pricing Strategies: Production costs. Market acceptance. Skimming – initial price is high with intent to gradually lower the price to appeal to a broader market. Market Penetration – initial price is low with intent to quickly gain market share. Target Costing Target Costing Market research determines the price at which a new product will sell. Management computes a manufacturing cost that will provide an acceptable profit margin. Engineers and cost analysts design a product that can be made for the allowable cost. Target Cost = Target Price – Target profit Principles of Target Costing Price led costing Life-cycle costs Focus on process design Cross-functional teams Value-chain orientation Focus on product design Focus on the customer The Product Life Cycle and Cost The Product Life Cycle and Cost
% of Life Cycle Costs
100% 80% Committed Costs 50% Incurred Costs
0% Planning Design and Engineering Production Customer Service Value Engineering and Supply Value Engineering and Supply Chain Management Value Engineering: Examination of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance. Supply Chain Management: development of long term relationships between buyers and sellers Anchored in the concept of core competence: only produced something if you can do it better and/or at lower costs than anyone else; otherwise outsource it. Supplier that charges the lowest price is not necessarily the cheapest price. Concerns about target costing Concerns about target costing A source of conflicts: excessive pressure on suppliers to conform to schedule and reduce costs; design engineers upset that others parts of the organization are not cost conscious Employee burnout due to pressure to meet target costs (especially for design engineers) Sometimes repeated value engineering cycles are required to reduce costs which leads to increased development time, i.e. is it worth being 6 months late to avoid a small cost overrun Time and Material Pricing Time and Material Pricing
Used for services companies Time charges: $/hour hourly labour cost (inc. benefits) + annual overhead excluding material/billable hour + profit/hour Materials charges: materials cost incurred in the job + material loading charge (ordering handling and storage cost) (% of material cost or invoiced cost) Competitive bidding Competitive bidding Transfer Pricing Transfer Pricing The amount charged when one division sells goods or services to another division
A higher transfer price for batteries means . . . means Batteries
Battery Division lower profits greater greater for for profits the the auto division. battery division. Auto Division Goal Congruence Goal Congruence
ideal transfer price allows each division manager to make decisions that maximize the company’s profit, while attempting to maximize his/her own division’s profit.
The Scenario I: No Excess Capacity The Battery Division makes a standard 12volt battery. Production capacity 300,000 units Selling price per battery $40 (to outsiders) Variable costs per battery $18 Fixed costs per battery $7 (at 300,000 units) The Battery division is currently selling 300,000 batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X7 model. What is the appropriate transferprice? Scenario I: No Excess Capacity
Transfer Transfer price = Additional outlay cost per unit cost per incurred because goods are transferred $18 variable cost per battery $40 per battery + Opportunity cost per unit to the organization because of the transfer $22 Contribution lost if outside sales given up Transfer price Transfer price = = + Scenario I: No Excess Scenario I: No Excess Capacity
Auto division can purchase 100,000 batteries from an outside supplier for less than $40. than Transfer will not occur. $40 transfer price Auto division can purchase 100,000 batteries from an outside supplier for more than $40. than Transfer will occur. Scenario II: Excess Capacity The Battery Division makes a standard 12volt battery. Production capacity 300,000 units Selling price per battery $40 (to outsiders) Variable costs per battery $18 Fixed costs per battery $7 (at 300,000 units) The Battery division is currently selling 150,000 batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X7 model. It can purchase them for $38 from an outside supplier. What is the appropriate transfer price? Scenario II: Excess Capacity
Transfer Transfer price = Additional outlay cost per unit cost per incurred because goods are transferred $18 variable cost per battery $18 per battery + Opportunity cost per unit to the organization because of the transfer $0 Transfer price Transfer price = = + Scenario II: Excess Capacity
General Rule General Rule When the selling division is operating below capacity, the minimum transfer price is the variable cost per unit. So, the transfer price will be no lower than $18, and no higher than $38. Scenario II: Excess Capacity Scenario II: Excess Capacity
Transfer will not occur. Transfer will occur. Transfer will not occur. $18 transfer price $38 transfer price Goal Congruence Goal Congruence Conflicts may arise between the company’s interests and an individual manager’s interests when transfer pricebased performance measures are used. Setting Transfer Prices Conflicts may be resolved by . . . Direct intervention by top management. Centrally established transfer price policies. Negotiated transfer prices. Setting Transfer Prices
Top management may become swamped Top management may become swamped with pricing disputes causing division managers to lose autonomy.
You really You don’t have any don’t choice! just won’t Now, here is whatI the two to $65 of you are goingpaydo. for that part! Negotiated Transfer Price Negotiated Transfer Price Alberta Company – Example Sells hiking boots as well as soles for work & hiking boots Structured into two divisions: Boot and Sole Sole Division sells soles externally Boot Division makes leather uppers for hiking boots which are attached to purchased soles Each Division Manager compensated on division profitability Management now wants Sole Division to provide at least some soles to the Boot Division Alberta Company – Example: Continued
Divisional Contribution Margin Per Unit (Boot Division purchases soles from outsiders) Negotiated Transfer Price Negotiated Transfer Price What would be a fair transfer price if the Sole Division sold 10,000 soles to the Boot Division? Alberta Company – Example: Continued Negotiated Transfer Price Negotiated Transfer Price Sole Division has no excess capacity 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: Maximum Boot Division will pay what the sole would cost from an outside buyer Alberta Company – Example: Continued Negotiated Transfer Price Negotiated Transfer Price Sole Division has excess capacity Can produce 80,000 soles, but can sell only 70,000 Available capacity of 10,000 soles Contribution margin is not lost The minimum transfer price acceptable to Sole: Negotiate a transfer price between $11 (minimum acceptable to Sole) and $17 (maximum acceptable to Boot) Negotiated Transfer Price Negotiated Transfer Price Variable Costs In the minimum transfer price formula, variable cost is the variable cost of units sold internally May differ – higher or lower – for units sold internally versus those sold externally The minimum transfer pricing formula can still be used – just use the internal variable costs Negotiated Transfer Price Negotiated Transfer Price
Summary Transfer prices established: • Minimum by selling division • Maximum by the buying division Often not used because: • Market price information sometimes not available • Lack of trust between the two divisions • Different pricing strategies between divisions Therefore, companies often use cost or market based information to develop transfer prices CostBased Transfer Prices CostBased Transfer Prices Uses costs incurred by the division producing the goods as its foundation May be based on variable costs or variable costs plus fixed costs Markup may also be added Can result in improper transfer prices causing: • Loss of profitability for company • Unfair evaluation of division performance Alberta Company – Example: Continued CostBased Transfer Prices CostBased Transfer Prices Base transfer price on variable cost of sole and no excess capacity Bad deal for Sole Division – no profit on transfer of 10,000 soles and loses profit of $70,000 on external sales. Boot Division increases contribution margin by $6 per Alberta Company – Example: Continued CostBased Transfer Prices CostBased Transfer Prices Sole Division has excess capacity: Continues to report zero profit but does not lose the $7 per unit due to excess capacity Boot Division gains $6 Overall, company is better off by $60,000 (10,000 X 6) Does not reflect Sole Division’s true profitability CostBased Transfer Prices CostBased Transfer Prices Summary Disadvantages • Does not reflect a division’s true profitability • Does not provide an incentive to control costs which are passed on to the next division Advantages Simple to understand Easy to use due to availability of information Market information often not available Most common method MarketBased Transfer Prices MarketBased Transfer Prices Based on existing market prices of competing products Often considered best approach because: • Objective • Economic incentives 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 welldefined market price, companies use costbased systems Effect of Outsourcing on Transfer Effect of Outsourcing on Transfer Prices Contracting with an external party to provide a good or service, rather than doing the work internally Virtual Companies outsource all of their production As outsourcing increases, fewer components are transferred internally between divisions Use incremental analysis to determine if outsourcing is profitable Transfers between Divisions in Transfers between Divisions in Different Countries Going global increases transfers between divisions located in different countries 60% of trade between countries estimated to be transfers between divisions Different tax rates make determining appropriate transfer price more difficult Alberta Company – Example: Continued Transfers between Divisions in Transfers between Divisions in Different Countries Boot Division is in a country with 10% tax rate Sole Division is located in a country with a 30% rate The beforetax total contribution margin is $44 regardless of whether the transfer price is $18 or $11 The aftertax total is • $38.20 using the $18 transfer price, and • $39.60 using the $11 transfer price Why? More of the contribution margin is attributed to the division in the country with the lower tax rate. Alberta Company – Example: Continued Transfers between Divisions in Transfers between Divisions in Different Countries Transfer Pricing from Cost Transfer Pricing from Cost Centers Transfer cost should be the standard (budgeted) absorptive cost: If the transfer are made at actual, then the manager of the cost center has no incentive to be efficient Absorptive costs includes both variable and fixed costs since all costs should be transferred out. Transfer from Profit/ Investment Transfer from Profit/ Investment Centers Policy question: should divisions be able to source externally when goods are available? Operational question: at what price should transfers be made? Best transfer price is always the market price; however in the case of a large transfer the transfer price may be negotiated If the intermediate product can only be sold internally, the opportunity cost of providing the product should be the transfer price Transfer from Profit/ Investment Transfer from Profit/ Investment Centers Maximum (ceiling ) transfer price is the maximum price the purchasing division is willing to pay Minimum (floor) transfer price is the minimum acceptable price the selling division is willing to accept and is equal to the price that will make the division as well off before and after the transfer Maximum transfer price = external selling price – less any costs associated with the transfer Transfer from Profit/ Investment Transfer from Profit/ Investment Centers Minimum transfer price = variable cost of making the internal transfer + opportunity cost of making the transfer (lost of sales) +/ any other incremental cost/benefits If maximum > minimum, then a range of transfer prices exist and it can be shown that transfers will result in a differential profit to the company ...
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