Pricing Decision

By Ghanendra Fago (Ph. D Scholar, M. Phil, MBA)For MBA, Ace Institute of Management

Pricing Decision

Price is the value of goods and services. Setting price for goods or services Pricing is always determined for making profit. Factors of pricing decision are cost of goods and

services, demand of the customers and pricing of the competitors

Pricing Methods

Pricing for external sales. Pricing for internal transfers.

External Pricing

Under this system, a certain percentage mark up is added to

estimated cost for determination of selling price of goods and

services.

Cost plus pricing system maintains a certain percentage of

profit on cost, so that there is rare chance for making loss in

the organization.

Cost plus pricing technique is based on the following formula.

Price = Cost + (Mark up percentage Cost price)

External Pricing Systems

Full cost pricing system. Variable cost pricing system. Activity Based Costing (ABC) pricing system. Target cost pricing system. Return on Investment (ROI) pricing system.

Target Pricing

Target pricing is based on the target costing. Target costing is a method of determining the cost of product

based on target price that customers are willing to pay. A target price is determined by the marketing department before

designing and introducing a new product. Target Cost = Anticipated selling price – Desired profit Under this method, product cost is calculated by deducting

anticipated profit from anticipated selling price. If the product cost is above the target cost, then the product

designer focuses on modification of design of the product so that it reduces the cost of product to target cost.

A company is going to produce hair dye product. The marketing manager of the company estimates the following costs for production and sale of the hair dye into market.

Direct materials Rs. 40

Direct labor 30Overheads 20Estimated Total Cost 90Add mark up 40% 36Expected selling price 126

The market research department reveals that the similar types of hair dye is selling at Rs. 100 by the competitors in to market. Required:1. Should the company produce hair dye, if it is using target pricing?2. Should the company expand this product line, if standard mark up 40% is applied with decreasing of Rs. 6 and Rs. 7 on materials and labour respectively?

Computation of Target Cost

Particulars Amount (Rs.)

Direct materials 40

Direct labour 30

Overheads 20

Estimated total cost 90

Target selling price 100

Target profit 10

Decision: If company uses target pricing, it can earn profit at Rs.10 per unit.

Computation of Target cost and price with change in cost

Particulars Amount (Rs.)

Direct materials (40 – 6) 34

Direct labour (30 – 7) 23

Overheads 20

Estimated Total Cost 77

Target profit 30.8

Estimated price 107.8

Target price 100

Difference in profit 7.8

Decision: If 40% standard mark up is applied under given condition, the estimated price will be higher than target price. Thus, the company should not expand its product line.

The management of a company present you the following estimates of cost for sales of one unit of its proposed product X.

Direct materials Rs. 50

Direct labour (4 hrs. @ Rs. 10) 40

Overheads (50% of DL) 20

Estimated Total Cost 110

Add: Mark up 30% 33

Selling price 143

The sales agent and middlemen have reported that similar type of product is selling into market by the competitors at Rs. 125.Required:a.Should the product be expanded by the company if it used target pricing?b.What would be the selling price if it charges 15% profit on cost?c.Should the company expand the product at 15% margin on cost?

The company’s market research department has discovered a market for such a part. The market research department has indicated that the new part would likely sell for Rs. 450. A similar part currently being produced has the following manufacturing cost:

Particular Per unit (Rs.)

Variable manufacturing cost 280

Variable selling and administrative cost 20

Fixed manufacturing cost (based on 10,000 units) 70

Fixed Selling and Administrative Cost (based on 10,000 units)

20

Required: 1. Should the company manufacture the part, if it is using Target Pricing?2. What price would the company charge for the product if the company

wants 20% profit on cost?

Transfer Pricing

Transfer prices represent the value of goods or services transfer to other division.

When one division of an organization provides goods and services to another division it charges price to the division.

Transfer prices are the amounts charged by one division of an organization for goods and services that is supplied to another division of the same organization.

Transfer pricing is also known as Intra Company pricing. The transfer pricing is a revenue to one division on the return of

providing goods and services where as it is a cost to another division for acquiring of goods

and services.

Transfer Pricing Methods

(a) Market based transfer pricing

(b) Cost based transfer pricing

i. Full cost transfer pricing

ii. Variable cost transfer pricing

(c) Negotiated transfer pricing

(d) General formula approach

Market Based Transfer Pricing

Transfer price based on market value of the product or services is known as market based transfer pricing.

Generally, market price is used for determination of transfer pricing of the product.

Market based transfer pricing is appropriate when both buying and selling divisions are operating at full capacity.

Both the buying and selling divisions can buy and sell at market price. The internal transfer price may be then external market price less marketing cost.

Transfer price = Market price – Selling and distribution expenses

Cost Based Transfer Pricing

Most of the companies transfer its price based on cost.

Cost based transfer pricing is used when Market price is not available like for semi–finished

goods It is difficulty for determining the market price Product manufactured is of secret nature There are many possible definitions of cost. Some company use only variable cost, others use

full cost and still others use full cost plus profit.

Variable Cost Based Transfer Pricing

When the market price is not applicable at that condition variable cost transfer pricing also can be used in practice.

In this method, only the variable costs, i.e. direct material, direct labour and variable factory overhead are taken into consideration as the transfer price.

General Formula Approach To Transfer Pricing

There is no any hard and fast rule for transfer pricing which would lead to optimal decisions for an organization as a whole. According to general rule, the transfer price is set in that point which helps to recover the variable costs plus opportunity cost.

Transfer price = Outlay cost (Variable cost) per unit + Opportunity cost per unit

Opportunity Cost

Opportunity cot is the amount or revenue foregone by the company as a whole when the product or services is transferred internally.

The selling divisions opportunity cost depends upon its operating capacity.

If the selling division is operating at full capacity, external demand can not satisfy.

At this situation, the opportunity cost will be the contribution margin foregone from the sales cost but opportunity cot may be zero if the division has idle capacity and can satisfy to the external demand

CASE 1 Transfer Pricing

Division X of a company produces parts. The division transfers some of its products to the division Y and sells some of its products to other companies in the external market under different levels. The following valuable costs are incurred to produce part and transport it to a buyer:

Production:

Standard variable cost per unit (including packaging) Rs. 400

Transportation: Standard variable cost per unit Rs. 15

Division X can sell its product to outside buyer at a market price of Rs. 655 per unit.

Required: What transfer price does the general rule yield, if there is:

(i) No excess capacity?

(ii) Excess capacity?

Outlay cost per unit:

Rs.

Standard variable cost 400

Standard variable transportation cost 15

415

Opportunity cost per unit:

Selling price per unit in external market 655

Outlay cost per unit 415

Opportunity cost (foregone contribution margin) 240

General–Transfer–Pricing Rules:(i) Transfer Price = Outlay cost + Opportunity cost = Rs.415 + Rs.240 = Rs. 655(ii) Transfer Price under excess capacity = Outlay cost + Opportunity cost =Rs. 415 + 0 = Rs. 415

CASE 2

A company has there divisions ; X, Y and Z. Division X can buy a part from division Y or from external company , which will meet Y’s market price of Rs. 20 per unit. If X buys from A co., A co. in terms buys a component from division Z for Rs. 4 per unit. The outlay costs to division Z of supplying their component are Rs. 2 per unit. In filling X’s order, Y would incur, outlay costs of Rs. 16.5 per unit. Assume that division Y is working at full capacity and can provide to an outside buyer (i.e. company A) at the same market price of Rs. 20 per unit and with the same outlay costs of Rs. 16.5 per unit.

Required:

(i) What alternative would be the best for company as a whole buying from company A or division Y? Show supporting calculations.

(ii) What transfer price should be used to guide the manger of division X and Y so as to maximize overall net income (cash flow)?

(iii) Suppose that division Y has enough extra capacity to supply to both division X and the outside buyer at the same time. How would this change your answer in part (i) and (ii) ? show supporting calculation.

The optimal action from the standpoint of company as a whole can be analyzed as follows:

Particulars Buy from division Y

Buy from Co. A

Outflow to the company as a whole (16.5) (20)

Cash in flows:

Division Z (4 – 2) - 2

Division Y (20 – 16.5) - 3.5

Net cash outflow to the company as a whole (16.5) (14.5)

Since a net outflow of Rs. 14.5 is less than a net outflow of Rs. 16.5, division X should buy from Co. A. (ii) Transfer Price = Variable cost + Opportunity cost