ppt25[1]

Pricing Decisions, Including Target Costing

and Transfer Pricing

Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Chapter 25

Gail Mestas

Replace book cover with FM 2005e

25–2Copyright © Houghton Mifflin Company. All rights reserved.

Learning Objectives

1. Identify the objectives and rules used to establish prices of goods and services, and relate pricing issues to the management cycle.

2. Describe economic pricing concepts including the auction-based pricing method used on the Internet.

3. Use cost-based pricing methods to develop prices.


Learning Objectives (cont’d)

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.


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 cycle


The Pricing Decision and the Manager

• There are many approaches to setting prices– Each may produce a different price for the

same product or service– Is more of an art than a science

• Depends on the manager’s ability to– Analyze the marketplace– Anticipate customers’ reactions to a product or

service and its price


The Pricing Decision and the Manager (cont’d)

• Factors to consider when analyzing the market– Competitors’ price strategies– Economic environment– Legal, political, and niche issues

Managers perfect the art of price setting through experience in dealing with customers and products within their company’s industry


The Objectives of a Pricing Policy

• Setting appropriate prices– One of a manager’s most difficult day-to-

day decisions• Affects long-term survival of any profit-oriented

enterprise


The Objectives of a Pricing Policy (cont’d)

• Companies use pricing policies to differentiate– Themselves from their competitors– Among their own brands

• For each product brand, the company– Identifies the market segment it intends to serve– Develops pricing objectives to meet the needs of that

market



• Possible objectives of a pricing policy include1. 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



• Pricing strategies– Standard items or commodities for a

competitive market• Can reduce prices to win sales away from

competitors• Can continuously add value-enhancing features

and upgrades to products and services– Creates the impression that customers are receiving

more for their money

– Custom-designed items• Can be more conservative in pricing strategies



• Underlying objective of pricing policies– Maximizing profits– Key lead indicator of profit potential is

increasing market share• Maintaining or gaining market share is closely

related to pricing strategies• Market share is important only if sales are

profitable



• Socially responsible pricing– Enhances a company’s standing with the

public• Helps ensure long-term survival

• Social concerns include– Environmental factors– Influence of an aging population– Legal constraints– Ethical issues



• Maintain a minimum rate of return on investment– Organizations view each product or service

as an investment• Must provide a minimum return in order to

invest in making or providing the product or service

– When setting prices, a markup percentage is added to the cost of production

– Markup percentage is closely related to objective of profit maximization



• Important, when setting prices to– Take customers’ needs into consideration– Increase a product’s value to customers

• Sensitivity to customer needs is necessary to sustain growth

• Customers’ acceptance is crucial to success in a competitive market

• Prices should reflect the enhanced value the company adds (prices are customer driven)


Pricing and the Management Cycle

• To stay in business, an organization’s selling price must

1. Be competitive

2. Be acceptable to customers

3. Recover all costs incurred to bring the product or service to market

4. Return a profit



• Any deviation must be for a specific short-run objective that accounts for the change

• Breaking these rules for a long period will force a company into bankruptcy– Addressing pricing issues at each stage of

the management cycle helps prevent this from happening



Gail Mestas

Insert Figure 1, pricing and the management cycle, chapter 25, FM, 2005e



• Planning phase– Managers must

• Consider how much to charge for each product or service by identifying the

– Maximum price the market will accept– Minimum price the company can sustain

» Those prices form the foundation for budgets and projections of profitability



• Executing phase– Products’ or services’ pricing strategies are

followed– Products or services are sold either at

specified prices or on the auction market



• Reviewing phase– Managers evaluate sales to determine

which pricing strategies were successful and which failed• Important to determine reasons for success or

failure• Plan corrective action



• Reporting phase– Internal reports prepared

• Analyses of actual prices and profits versus targeted profits

• Used to assess past pricing strategies and plan future strategies



• When making and evaluating pricing decisions, managers must consider– The external market

• Demand for the product• Customer needs• Competition• Quantity and quality of competing products

– Internal factors• Constraints caused by costs• Desired return on investment• Quality and quantity of materials and labor• Allocation of scarce resources


Discussion

Q. What are the four rules for setting a selling price?

A. The selling price must1. Be competitive with the competition's price

2. Be acceptable to customers

3. Recover all costs incurred in bringing the product or service to market

4. Return a profit


Economic Pricing Concepts

• Objective 2– Describe economic pricing concepts

including the auction-based pricing method used on the Internet


Economic Pricing Concepts

• Economic approach to pricing– Based on microeconomic theory

• Profit will be maximized when the difference between total revenue and total costs is the greatest


Total Revenue and Total Cost Curves

• It may seem that if a company could produce an infinite number of products, it would realize the maximum profit– This is not the case– Microeconomic theory explains why


Microeconomic Pricing Theory:Total Revenue and Total Cost Curves

Gail Mestas

Insert Figure 3 A, microeconomic pricing theory, total revenue and total costs curves, chapter 25, FM, 2005e. Figure 3 B will be used in a different slide


Total Revenue and Total Cost Curves (cont’d)

• Total revenue curve– Curved line on economist’s breakeven

chart– Increases as more units are sold, but rate

of increase will diminish• Theory behind this

– As product is marketed, price reductions will be necessary to sell additional units because of competition and other factors



• Total cost curve– Costs react in opposite way– Total costs per unit rise at an accelerated

rate as more units are sold • Theory behind this

– As more units are sold, fixed costs will change» Supervision and depreciation increase» Marketing costs rise due to competition



• Breakeven point– Point where total revenue and total cost curves

intersect– Two breakeven points in microeconomic pricing

theory• Area between these two breakeven points represents

profit

• Maximizing profit– Occurs at point where the difference between total

revenue and total cost is the greatest• In Figure 3A, this point is 6,000 units of sales


Marginal Revenue and Marginal Cost Curves

• Marginal revenue– The change in total revenue caused by a one-unit

change in output

• Marginal cost– The change in total cost caused by a one-unit

change in output

• Marginal revenue and marginal cost are used by economists to help determine the optimal price for a good or service


Marginal Revenue and Marginal Cost Curves (cont’d)

• Graphic curves for marginal revenue and marginal cost– Created by measuring and plotting the rate

of change in total revenue and total cost at various activity levels

– Profit per unit greatest where marginal revenue and marginal cost curves intersect• Projecting this point onto the product’s demand

curve locates the optimal price


Microeconomic Pricing Theory:Marginal Revenue and Marginal Cost Curves

Gail Mestas

INsert Figure 3 B, microeconomic pricing theory, marginal revenue and marginal cost curves, chapter 25, FM, 2005e


Marginal Revenue and Marginal Cost Curves (cont’d)

• Information used in microeconomic theory analyses relies on projected amounts for unit sales, product costs, and revenues– But, usually highlights cost patterns and

the unanticipated influences of demand– Should also rely on other data when setting

product prices


Auction-Based Pricing

• Occurs two ways1. Seller auction-based price

– Sellers post what they have to sell, ask for price bids, and accept a buyer’s offer to purchase at a certain price

2. Buyer auction-based price– Buyers post what they want, ask for prices,

and accept a seller’s offer at a certain price


Auction-Based Pricing (cont’d)

• Seller auction-based price illustrated– Corporations such as Intel or Sun

Microsystems have excess silicon wafers from computer chip production

– Company posts message on Internet asking for quantity and price prospective buyers are willing to pay for the wafers

– Demand curve of all offers is prepared– Company accepts offer or bid that best fits

the quantity of wafers it has for sale


Auction-Based Pricing (cont’d)

• Buyer auction-based price illustrated– Individual wants to fly roundtrip to Europe

on certain dates– Posts needs on one of hosted auction

markets on the Internet– After receiving offers, selects the best

suited offer


Discussion

Q. Is a seller auction-based price set by the seller or does the seller accept offers or bids from buyers?

A. The seller requests offers from potential buyers and then accepts the best offer

A buyer auction-based price is set by the seller and the buyer accepts the best offer


Cost-Based Pricing Methods

• Objective 3– Use cost-based pricing methods to develop

prices


Cost-Based Pricing Methods

• Managers can develop a price based on the cost of producing the product or service– If prices do not cover costs, the company

will fail

• Two pricing methods based on cost– Gross margin pricing– Return on assets pricing


Cost-Based Pricing Methods (cont’d)The Energeez Company buys parts from outside vendors and assembles them into portable solar panels. In the previous period, the company produced 14,750 solar panels.

Total costs and unit costs incurred were as follows

No changes in unit costs are expected this period. Desired profit for the period is $110,625. The company uses assets totaling $921,875 in producing the panels and expects a 14% return on those assets

Total Costs Unit Costs Variable production costs Direct materials and parts $ 88,500 $ 6.00 Direct labor 66,365 4.50 Variable manufacturing overhead 44,250 3.00 Total variable production costs $199,125 $13.50 Fixed manufacturing overhead 154,875 10.50 Total production costs $354,000 $24.00 Selling, general, and administrative expenses Selling expenses $ 73,750 $ 5.00 General expenses 36,875 2.50 Administrative expenses 22,125 1.50 Total selling, general, and administrative expenses $132,750 $ 9.00 Total costs and expenses $486,750 $33.00


Gross Margin Pricing

• Gross margin– The difference between sales and the total

production costs of those sales

• Gross margin pricing– Cost-based pricing approach

• Price is computed using a markup percentage based on a product’s total production costs

• Markup percentage – Designed to include all costs other than those used in the

computation of gross margin– Composed of selling, general, and administrative expenses

and the desired profit

Emphasizes income statement information to determine a selling price


Gross Margin Pricing (cont’d)

• This method can be easily applied– An accounting system often provides

management with production cost data

Costs Production Total

Expenses tiveAdministra and General,

Selling, Total Profit Desired

Percentage Markup

per Unit Costs Production Total Price Based-Margin Gross Total Percentage (Markup

per Unit) Costs Production



Costs Production Total


Selling, Total Profit Desired

Percentage Markup

per Unit Costs Production Total Price Based-Margin Gross Total Percentage (Markup

per Unit) Costs Production

Compute markup percentage and selling price for Energeez Company

$354,000

$132,750 $110,625

68.75%

$24.00) (68.75% $24.00

$40.50



14,750

$110,625 $22,125 $36,875 $73,750

$154,875 $44,250 $66,375 500,88$

14,750 $597,375

• Alternate method– State the formula in terms of a company’s

desire to recover all of its costs and make a profit

Produced UnitsTotal

Profit Desired Expenses tiveAdministra and

General Selling, Total Costs Production Total

Price Based-Margin Gross

$40.50



• Gross margin-based pricing can also be detailed on a per unit basis

$40.50

$5.00 $10.50 $3.00 $4.50 $6.00 14,750) ($110,625 $1.50 $2.50

Variable Labor Direct MaterialsDirect Price Based-Margin Gross

per UnitProfit Desired Expenses

ingManufactur Fixed Overhead ingManufactur tiveAdministra and General, Selling, Overhead


Return on Assets Pricing

• Based on earning a profit equal to a specified rate of return on assets employed in the operation– Focuses on a desired minimum rate of

return on assets

• Also called the balance sheet approach to pricing


Return on Assets Pricing (cont’d)

per Unit Expenses and Costs Total Price BasedAssetson Return Cost Return of Rate (Desired

per Unit) Employed Assets of

The formula can also be expressed as follows

Selling, Total Costs Production [(Total Price BasedAssetson Return

Rate [Desired Produced] be to Units Assets ofCost (Total Return of

Produced)] be to Units Employed




Energeez Company has an asset base of $921,875. It plans to produce 14,750 units and it would like to earn a 14 percent return on assets

Calculate selling price per unit using return on assets pricing

$9.00 $24.00 Price BasedAssetson Return 14,750)] ($921,875 %14[

$41.75



Energeez Company has an asset base of $921,875. It plans to produce 14,750 units and it would like to earn a 14 percent return on assets

Or, alternatively

14,750] $132,750) [($354,000 Price BasedAssetson Return 14,750)] ($921,875 %14[

$8.75 $33.00 $41.75

The desired profit that is used in gross margin pricing is replaced by an overall company rate of return on assets

A unit profit factor of $8.75 is obtained by dividing cost of assets employed by projected units of output and multiplying the result by the desired minimum rate of return


Summary of Cost-Based Pricing Methods

• Companies select their pricing methods based on their degree of trust in a cost base

• For Energeez Company, a higher selling price is calculated using the return on assets pricing method

25–52

Cost-Based Pricing Methods: Energeez Company

Gail Mestas

Insert Figure 4, cost-based pricing methods: Energeez Company, chapter 25, FM, 2005e


Summary of Cost-Based Pricing Methods (cont’d)

• Can choose between two cost bases– Total product costs per unit

• Data readily available– Makes gross margin pricing a good way to compute

selling prices– Depends upon an accurate forecast of units– Fixed cost per unit portion of total production costs

will vary if actual and estimated number of units differ– Total costs and expenses per unit

• Good pricing method of assets used to manufacture a product can be identified and their cost determined– If not, the method yields inaccurate results


Pricing Services

• Most service organizations use a form of time and materials pricing– Also known as parts and labor pricing


Pricing Services (cont’d)

• Service companies such as appliance repair shops, home-remodeling specialists, pool cleaners, and automobile repair businesses– Use two computations

• Direct labor• Materials and parts

– Markup percentages are added to the costs of materials and labor• Covers cost of overhead and provides a profit factor



• Professionals, such as attorneys, accountants, and consultants– Use one computation

• Direct labor

– A markup percentage is added to the cost of labor• Covers cost of overhead and provides a profit

factor



Gil Marquiz completed work on Lucinda Lowe’s Mercedes. Parts for repairs cost $840. The company's 40 percent markup rate on parts covers parts-related overhead costs and profit. The repairs required four hours of labor by a Mercedes specialist, whose wages are $35 per hour. The company's overhead markup rate on labor is 80 percent

Compute Lucinda Lowe’s bill

Repair parts used $840 Overhead charges ($840 x 40%) 336 Total parts charges $1,176 Labor charges (4 hrs @ $35 per hour) $140 Overhead charges ($140 x 80%) 112 Total labor charges 252 Total billing $1,428


Final Notes on Cost-Based Pricing Methods

• Cost-based pricing is widely used in some areas of the economy, such as government contracts

• Once a cost-based price has been determined, the decision maker must consider– Competitor’s prices– Customers’ expectations– The cost of substitute products and services

Care must be taken when establishing prices—pricing is a risky part of operating a business


Discussion

Q. What are two pricing methods based on cost?

A. Gross margin pricing• Price is computed using a markup percentage

based on a product’s total production costs

Return on assets pricing• Price is computed to earn a specific rate of

return on assets used in the operation


Pricing Based on Target Costing

• Objective 4– Describe target costing and use that

concept to analyze pricing decisions and evaluate a new product opportunity


Pricing Based on Target Costing

• Target costing– A pricing method that

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• Desired profit is subtracted from the competitive

market price

CostTarget Profit Desired PriceTarget


Pricing Based on Target Costing (cont’d)

• The target cost is given to the engineers and product designers– Use it as a maximum cost to be incurred

for materials and resources needed to design and manufacture the product

– Must create the product at or below its target cost



• Target costing is strategically superior– Gives managers the ability to control or

dictate costs of a new product beginning at the planning stage of the product’s life cycle

– Enables managers to analyze a product's potential before committing resources to its production


Price Decision Timing Comparison

Gail Mestas

INsert Figure 5, price decision timing comparison, chapter 25, FM, 2005e



• Traditional cost-based pricing– Prices cannot be set 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

• Target costing– The pricing decision takes place immediately after

the market research for a new product• Reveals potential demand for product• Identifies the maximum price a customer will be willing to

pay for the product– Once the price is determined, engineers design the product

within a fixed maximum target cost



• Cost First Company– Strategy is to jump into the planning phase, design

the product, and get it into production ASAP– Prototype model tested during the production

phase– Assumed that flaws will be found, change orders

will be necessary, and the production process will have to be redesigned to fit the changes

– Total unit cost and price determined after product has been successfully produced



• Once the company decides to produce the new product, new costs are incurred at each stage in the product’s life cycle– Committed costs

• Costs of design, development, engineering, testing, and production that are engineered into a product or service at the design stage of development

• Should occur if all design specifications are followed during production

– Incurred costs• The actual costs to make the product


Traditional Cost-Based Approach to Pricing: Committed Versus Incurred Costs

To earn a profit of 20 percent of target cost, Cost First Company will need to price the product at about $84 [$70 cost + ($70 x .20)]

Gail Mestas

Insert Figure 6, traditional cost-based approach to pricing: committed versus incurred costs, chapter 25, FM, 2005e. Manipulate text box shape and placement to avoid covering important info in the figure



• When using cost-based pricing– Very difficult to control costs from the planning

phase through the production phase– Difficult for management to set realistic targets

• Because product is being made for the first time

– Focus is in sales, not on the design and manufacture of the product

– Cost control efforts will focus on incurred costs after the product has been introduced to the marketplace


• Price First Company– Market research indicated that the product would

be successful if priced at or below $48– Target cost is determined

– Engineers work on designing a product that will comply with the cost restriction

– Production efforts are not started until the prototype model meets the requirements for both cost and quality


CostTarget Cost Target of 20% $48 X .2X $48 $48 1.2X $40 X


Target Costing Approach to Pricing: Committed Versus Incurred Costs

Because a $40 maximum cost was engineered into the design of the product, committed costs are set at that amount (much lower than the $70 committed costs for Cost First Company)

Gail Mestas

Insert Figure 7, trtarget costing approach to pricing: committed versus incurred costs, chapter 25, FM, 2005e. Manipulate text box shape and placement to avoid covering important info in the figure



• If engineers determine product cannot be made at or below target cost– Company should examine product’s design

• Try to improve the approach to production

• If product still cannot be made at its target cost– Company must understand that its current facilities

prevent it from competing in that particular market• Should either

– Invest in new equipment or procedures– Abandon its plans to make and market the product



• Benefits of target costing– Ability to design and build a product to a

specific cost goal• A new product is designed only if its projected

costs are equal to or less than its target cost

– Product is expected to produce a profit as soon as it is marketed• Profitability is built into the selling price from the

beginning

Under the cost-based approach, concern about reducing costs begins only after the product has been produced


Illustrative Problem: Target Costing

A customer of Zephyr Company is seeking price quotations for two WiFi components: a special purpose router and a wireless palm-sized computer. Current market prices for the router and computer are $320-$380 and $750-$850 per unit, respectively. A salesperson feels that if Zephyr could quote prices of $300 for the router and $725 for the computer, the company would get the order and gain a significant share of the global market for those goods. Zephyr’s usual profit markup is 25 percent of total unit cost

• Required1. Compute the target cost for each product2. Compute the projected total unit cost of production and

delivery3. Use the target costing approach to determine if the

company should produce the products


Illustrative Problem: Target Costing (cont’d)

Activity-based cost rates Materials handling $ 1.30 per dollar of direct materials and

purchased parts cost Production $ 3.50 per machine hour Product delivery $24.00 per router $30.00 per computer

Company design engineers and accountants put together the following specifications and costs

Router Computer Projected unit demand 26,000 18,000 Per unit data: Direct materials cost $25.00 $65.00 Purchased parts cost $15.00 $45.00 Manufacturing labor Hours 2.6 4.8 Hourly labor rate $12.00 $15.00 Assembly labor Hours 3.4 8.2 Hourly labor rate $14.00 $16.00 Machine hours 12.8 28.4

Note that activity-based management can be used with target costing



*$240.00 1.25 $300.00 Router $580.00 1.25 $725.00 Computer

CostTarget Profit Desired PriceTarget * XX .25 $300.00

$240.00 1.25

$300.00 X

1. Compute the target cost for each product



Router Computer Direct materials cost $ 25.00 $ 65.00 Purchased parts cost 15.00 45.00 Total cost of direct materials and parts $ 40.00 $110.00 Manufacturing labor Router (2.6 hours x $12.00) 31.20 Computer (4.8 hours x $15.00) 72.00 Assembly labor Router (3.4 hours x $14.00) 47.60 Computer (8.2 hours x $16.00) 131.20 Activity-based costs Materials handling Router ($40.00 x $1.30) 52.00 Computer ($110.00 x $1.30) 143.00 Production Router (12.8 machine hours x $3.50) 44.80 Computer (28.4 machine hours x $3.50) 99.40 Product delivery Router 24.00 Computer 30.00 Projected total cost $239.60 $585.60

2. Compute the projected total unit cost of production and delivery



3. Use the target costing approach to determine if the company should produce the products

Router Computer Target unit cost $240.00 $580.00 Less projected unit cost 239.60 585.60 Difference $ .40 ($ 5.60)

The router can be produced below its target cost, so it should be produced

As currently designed, the computer cannot be produced at or below its target cost so the company should either redesign it or discontinue plans to produce it


Discussion

Q. How is a target cost per unit computed?

A. First, a target price per unit must be determined. Then, the target cost per unit is calculated by subtracting the desired profit from the target price

CostTarget Profit Desired PriceTarget


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


Pricing for Internal Providers of Goods and Services

• Decentralized organization– A large business organized into divisions or

operating segments– A separate manager controls the

operations of each segment– Each division or segment sells its goods or

services both inside and outside the organization

We will now focus inside an organization and how it prices its products and services for internal transfers between divisions or segments


Transfer Pricing

• Transfer price– Price at which goods and services are

charged and exchanged between a company’s divisions or segments


Transfer Pricing (cont’d)

• Is an internal pricing mechanism– Allows transactions between divisions or

segments of a business to be measured and accounted for

– Affects the revenues and costs of the divisions involved• Does not affect the revenues and costs of the company

as a whole• Shifts part of the profits from divisions that externally

charge for their goods and services to the divisions that do not bill externally for their services and products

Transfer pricing enables a business to assess both the internal and external profitability of its products or services


Transfer Pricing (cont’d)

• Three basic kinds of transfer prices– Cost-plus transfer prices– Market transfer prices– Negotiated transfer prices


Cost-Plus Transfer Price

• Based on either the full cost or variable costs incurred by the producing division plus an agreed-upon profit percentage– Weakness

• Cost recovery is guaranteed to the selling division

– Fails to detect inefficient operating conditions and the incurrence of excessive costs

– May inappropriately reward inefficient divisions that incur excessive costs

– This reduces overall company profitability and shareholder value


Market Transfer Price

• Based on the price that could be charged if a segment could buy from or sell to an external party

• Some experts believe this method is preferable to other transfer pricing methods


Market Transfer Price (cont’d)

• Advantages– Forces selling division to be competitive

with market conditions– Does not penalize buying division by

charging a price greater than it would have to pay on the market


Market Transfer Price (cont’d)

• Disadvantages– May lead selling division to ignore

negotiation attempts from buying division and sell directly to outside customers• Could cause an internal shortage of materials• Forces buying division to purchase materials

from the outside• Overall company profits may fall even though

selling division makes a profit

When market prices are used to develop transfer prices, they are usually used only as a basis for negotiation


Negotiated Transfer Price

• Is arrived at through bargaining between the managers of the buying and selling divisions or segments– May be based on an agreement to use a cost plus

a profit percentage– Will be between the negotiation floor and the

negotiation ceiling• Negotiation floor

– The selling division’s variable cost

• Negotiation ceiling– The market price

This approach allows for cost recovery while still allowing the selling division to return a profit


Developing a Transfer Price

Simple Box Company has two divisions: the Pulp Division and the Cardboard Division. The Pulp Division produces pulp for the Cardboard Division. The Cardboard Division may also purchase pulp from outside suppliers

Gail Mestas

Insert Figure 8, transfer price alternatives at simple box company, chapter 25, FM, 2005e. Place to fit below the text box


Transfer Price Computation

Gail Mestas

Insert exhibit 1, transfer price computation, chapter 25, FM, 2005e


Developing a Transfer Price (cont’d)

• Developing a cost-plus transfer price for the Pulp Division– Manager has developed a one-year budget based

on the expectation that the Cardboard Division will require 480,000 pounds of pulp

– Allocated corporate overhead is not included in computation of the transfer price• Only variable costs and fixed costs related to the Pulp

Division are included

– The final cost-plus transfer price is $14.19 per pound



• Two possible outcomes– Management can dictate that the $14.19

price be used– The manager of the Cardboard Division

can point out that an outside supplier is selling pulp for $13.00 per pound• Use of the $13.00 price represents a market

value approach



• The situation can be resolved by negotiating a transfer price between the floor and ceiling– Floor is equal to variable costs of $11.85– Ceiling is equal to the market price of $13.00

• The negotiation process will facilitate each manager’s role in maximizing company-wide profits and controlling his or her division’s costs



• Both managers brought their concerns to the attention of top management– Company did not want the Cardboard

Division to buy pulp from an outside source– The Pulp Division should have an incentive

to move toward the market price



• Negotiated price allows for the sharing between divisions of the final product’s company-wide profits when the boxes are sold on the outside market

• Approach is used to maintain harmony within an organization

• Allows top management to measure Pulp Division managers’ performance against a competitive price for pulp

• The price of the final product takes into account all operations of the business



• Cardboard Division– Should purchase pulp from outside source if the

overall annual cost is less than the Pulp Division’s incremental costs

• Pulp Division– Since it has adequate capacity to fulfill Cardboard

Division’s demands, it should sell to the Cardboard Division at any price that recovers incremental costs• Incremental costs include all variable costs of production

and distribution plus any avoidable fixed costs directly traceable to intracompany sales



• If the market price of pulp is below the Pulp Division’s incremental cost, and expected to remain so for an extended period of time– The Cardboard Division should buy from

an outside supplier– The Pulp Division should theoretically

cease operations, at least temporarily– A thorough analysis of the Pulp Division’s

operations should be conducted


Using Transfer Prices to Measure Performance

• Transfer prices– Contain an estimated amount of profit

• Therefore, a manager’s ability to meet a targeted profit can be measured

– Are often called artificial or created prices

• When transfer prices are used– A division can be evaluated as a profit center

• Using transfer prices to value a division’s output simulates revenues for the division

• Operating income calculated in this way is not based on real sales to outsiders, but is a valuable performance measure if transfer prices are realistic

25–100

Performance Report Using Transfer Prices

Gail Mestas

Insert Figure 4, cost-based pricing methods: Energeez Company, chapter 25, FM, 2005e


Using Transfer Prices to Measure Performance (cont’d)

• Pulp Division’s actual gross margin was ($1,725), whereas budgeted gross margin was $4,200– Difference of $5,925

• Stems from cost overages in various materials, labor, and variable overhead accounts

• Differences will need to be investigated

• Use of transfer prices to simulate income allows further evaluation– Return on investment

• Measures of operating income (loss) can be compared with amount of capital invested in the Pulp Division

– Impact of uncontrollable costs from corporate office can be assessed


Transfer Pricing in Retail and Service Companies

Auto Imports is an automobile dealership that sells and leases new and used cars and provides service through its Maintenance and Body Shop departments. There is a need for transfer prices in at least seven points of contact among its five departments. Because market prices are readily available, the company uses market prices for transfer pricing

Gail Mestas

Insert Figure 9, transfer pricinf for auto imports, chapter 25, FM, 2005e. Fit below text box


Discussion

Q. What is a transfer price?

A. A transfer price is an internal pricing mechanism that allows transactions between divisions or segments of a business to be measured and accounted for


Time for Review

1. Identify the objectives and rules used to establish prices of goods and services, and relate pricing issues to the management cycle

2. Describe economic pricing concepts including the auction-based pricing method used on the Internet

3. Use cost-based pricing methods to develop prices


And Finally…

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

ppt25[1]

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