CHAPTER 6
PRICING
TARGET COSTING
Study Objective 1
In a highly competitive market:
Price is largely determined by supply and demand
Must control costs to earn a profit
Target cost - cost that provides the desired profit
on a product when the seller does not have control
over the product’s price
TARGET COSTING
Steps
Find market niche
Select segment to compete in
For example, luxury goods or economy goods
Determine target price
Price that company believes would place it in the
optimal position for its target audience
Use market research
TARGET COSTING
Steps - Continued
Determine target cost
Difference between target price
and desired profit
Includes all product and period
costs necessary to make and
market the product
Assemble expert team
Includes production, operations,
marketing, finance
Design and develop a product
that meets quality specifications
while not exceeding target cost
COST-PLUS PRICING
Study Objective 2
May have to set own price where there is little or
no competition
Price typically a function of product cost
Steps:
Establish a cost base
Add a markup (based on desired operating income or
return on investment)
COST-PLUS PRICING - Continued
Example – Cleanmore Products
Manufactures wet/dry shop vacuums
Per unit variable cost estimates:
Fixed cost per unit $52 = $28 fixed manufacturing overhead
+ $24 fixed selling and administrative expenses (based on a
budgeted volume of 10,000 units)
COST-PLUS PRICING
Example – Continued
Markup = 20% ROI of $1,000,000
Expected ROI = $200,000 ÷ 10,000 units
Sales price per unit = $132
COST-PLUS PRICING
Example – Continued
Steps for using a markup on cost to set selling price:
Compute markup percentage for desired ROI:
Compute target selling price using markup percentage:
COST-PLUS PRICING
LIMITATIONS
Advantage - Easy to compute
Disadvantages:
Does not consider demand side
Will the customer pay the price?
Fixed cost per unit changes with
change in volume
At lower sales volume, company must
charge higher price to meet
desired ROI
COST-PLUS PRICING – LIMITATIONS
Example – Continued
Reduce budgeted sales volume to 8,000 units:
Variable cost per unit remain the same,
Fixed cost per unit increases from $52 per unit to:
Desired 20% ROI now results in a per unit ROI of
$25 [(20% X 1,000,000) ÷ 8,000]
COST-PLUS PRICING – LIMITATIONS
Example – Continued
New selling price:
The lower the budgeted volume, the higher the per
unit price
Fixed costs and ROI spread over fewer units
Fixed costs and ROI per unit increase
Opposite effect occurs if budgeted volume is higher
VARIABLE COST PRICING
Alternative pricing approach:
Simply add a markup to variable costs
Avoids using poor cost information related to
fixed costs per unit
Useful in pricing special orders or when excess
capacity exists
Major disadvantage:
Prices set too low to cover fixed costs
INTERNAL SALES
Vertically integrated companies – grow in direction of
customers or supplies
Frequently transfer goods to other divisions as well as outside
customers
How do you price goods when they are “sold” within the company?
INTERNAL SALES
Study Objective 4
Transfer price - price used to record the transfer
between two divisions of a company
Ways to determine a transfer price:
Negotiated transfer prices
Cost-based transfer prices
Market-based transfer prices
Conceptually - a negotiated transfer price is best
Due to practical considerations, other two methods
are more widely used
NEGOTIATED TRANSFER PRICE
Determined by
agreement of the
division managers
when no external
market price is
available
NEGOTIATED TRANSFER PRICE
Example – Alberta Company
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
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
Divisional Contribution Margin Per Unit
(Boot Division purchases soles from outsiders)
What would be a fair transfer price if the Sole Division sold
10,000 soles to the Boot Division?
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
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:
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
Maximum Boot Division will pay is
what the sole would cost from an outside buyer
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
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:
NEGOTIATED TRANSFER PRICE
Example – Alberta Company (Continued)
Negotiate a transfer price between $11 (minimum acceptable to
Sole) and $17 (maximum acceptable to Boot)
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
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
COST-BASED 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
COST-BASED TRANSFER PRICES
Example – Alberta Company
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 sole
COST-BASED TRANSFER PRICES
Example – Alberta Company (Continued)
No Excess Capacity
COST-BASED TRANSFER PRICES
Example – Alberta Company (Continued)
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
COST-BASED 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
MARKET-BASED 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 well-defined market price,
companies use cost-based systems