Pricing Study Notes

Chapter 21: Pricing

Chapter Outline

• Learning Objectives

  • LO 1: Compute a target cost when the market determines a product price.

  • LO 2: Compute a target selling price using cost-plus pricing.

  • LO 3: Use time-and-material pricing to determine the cost of services provided.

  • LO 4: Determine a transfer price using the negotiated, cost-based, and market-based approaches.

Learning Objective 1: Compute Target Cost

• Definition: Target costing is a pricing strategy in which the company determines the desired profit margin and subtracts it from the competitive market price to establish the maximum target cost.

Pricing Factors

• Companies must price products to cover costs and earn a reasonable profit in the long run.

• Understanding market forces is crucial.

  • Price Takers: Companies that cannot set their prices due to lack of product differentiation; prices are determined by supply and demand.

  • Price Makers: Companies that can set prices due to unique or distinguishable products.

Establishing a Target Cost

Key Steps:

1. Understand Market Segments: Identify the market segment where the company will compete.

2. Conduct Market Research: Assess desirable product features and optimal pricing.

3. Target Cost Calculation: Subtract desired profit from market price.

4. Product Development Team: Assemble a team to create the product aligned with the target cost and profit goals.

Target Cost Formula

• Target Cost Calculation:
  $ext{Target Cost} = ext{Market Price} - ext{Desired Profit}$

• If a company meets sales targets and produces at or below the target cost, it achieves its profit objectives.

Example: Target Costing for Fine Line Phones

• Market research predicts sales of 200,000 units at a price of $20 each.

• Investment: $1,000,000 in production equipment.

• Desired Profit: 25% of investment →
  $ext{Desired Profit} = 1,000,000 imes 0.25 = 250,000$

• Target Cost Per Unit: $ext{Target Cost Per Unit} = ext{Market Price} - ext{Desired Profit Per Unit}$

  • Desired profit per unit =
    $rac{250,000}{200,000} = 1.25$

  • Target cost =
    $20 - 1.25 = 18.75$

Learning Objective 2: Compute Target Selling Price Using Cost-Plus Pricing

• Definition: Cost-plus pricing adds a markup to the cost of a product to determine its selling price.

• Application: Typically used in low-competition environments.

Cost-Plus Pricing Calculation

1. Markup Formula: Selling Price - Cost = Markup

2. Total Cost Formula:
   $ext{Cost} + ext{Markup} = ext{Target Selling Price}$

Example of Unit Variable Cost for Thinkmore Products, Inc.

• Direct Materials: $23

• Direct Labor: $17

• Variable Manufacturing Overhead: $12

• Variable Selling and Administrative Expenses: $8

• Total Unit Variable Cost:
  $23 + 17 + 12 + 8 = 60$

• Selling price to earn a 20% ROI on an investment of $2,000,000:

  • Fixed Costs (at 10,000 units) = $65

  • Total Cost:
    $60 + 65 = 125$

  • Markup Calculation:
    $ext{Desired ROI} = 40$

  • Selling Price:
    $125 + 40 = 165$

Limitations of Cost-Plus Pricing

• Advantages: Simple to compute.

• Disadvantages:

  • Ignores demand and customer willingness to pay.

  • Variable costs change with sales volume affecting fixed cost allocation, leading to higher prices at lower volumes.

Learning Objective 3: Time-and-Material Pricing

• Definition: Pricing method using two rates: one for labor and another for materials, commonly used in service industries (law, consulting, construction).

Key Components:

1. Labor Rate: Includes direct labor cost with overhead and desired profit margin.

   • Example for Lake Holiday Marina:

   • Desired profit margin of $8 per hour based on 5,000 hours.

2. Material Loading Charge: Covers costs related to material procurement and desired profit margin.

   • Expressed as a percentage based on estimated annual costs.

Example Calculation - Labor Rate and Material Charge

• Labor Rate: $38.20/hr based on total estimated labor costs.

• Total part costs for materials were estimated at $120,000 with a 20% profit margin.

• Material Loading Charge Equation:
  $ext{Material Charge} = ext{Base Cost} + ( ext{Base Cost} imes ext{Profit Margin})$

Calculating Final Charges for a Job

• Total Cost:
  $ext{Labor Charges} + ext{Material Charges} + ext{Material Loading Charge}$

Learning Objective 4: Transfer Pricing Concepts

Importance of Transfer Pricing

• Relevant for vertically integrated companies, which transfer goods between divisions.

• Methods of Transfer Pricing:

  • Negotiated Prices: Based on negotiation between divisions.

  • Cost-based Pricing: Based on costs incurred by the transferor.

  • Market-based Pricing: Based on external market prices.

Examples and Calculations

• Negotiated Transfer Price Example: Alberta Company with Sole and Boot Divisions.

• Minimum Transfer Price Calculation:

  • Based on variable costs and opportunity costs.

  • Consideration of production capacity and market alternatives.

Summary Implications

• Minimizations of inter-division conflicts through clear pricing strategies are crucial for overall company efficiency.

Effects of Outsourcing on Pricing

• Definition: Contracting external providers impacting the internal pricing structure.

Transfers Between Different Countries

• Tax implications and income shifting strategies can influence transfer pricing decisions across international operations, ensuring compliance with local laws while optimizing consolidated profits.

Learning Objective 5: Absorption-Cost and Variable-Cost Pricing

Absorption-Cost Pricing

• Full-cost pricing utilizes total costs for markup decisions, despite practical complexities.

Variable-Cost Pricing

• Focuses on variable costs for short-term decision-making, ensuring fixed costs are adequately covered in pricing.

Examples to Illustrate Each Model: Thinkmore Products calculates using the defined methods and proves desired ROIs through practical financial statements, demonstrating strategies for profitability assessment.