Pricing decisions Learning outcomes

CHAPTER 11 Pricing decisions Learning outcomes In Chapter 11 we look at: ● fundamental export pricing strategies and relationships to domestic price policies ● factors that must be considered in determining an export price: costs, competition, legal/political considerations, company policies ● the effects of the Internet and World Wide Web, and other advances in communications, on pricing as: — a threat to prices and brands — an opportunity for balancing demand over time, and — a means of improving economic growth and social welfare ● problems from changing exchange rates, the choice of currency to be used, and hedging possibilities ● price quotations, terms, and calculations ● transfer pricing Three cases are provided at the end of the chapter. Case 11.1, RAP Engineering and Equipment Company, requires the student to develop two different price calculations and to explain the implications regarding responsibilities for arrangements and liabilities for each. Case 11.2, Capitool Company, explores the issue of transfer pricing policies. Case 11.3, Strato Designs, involves questions regarding the possible use of hedging. Introduction The management of prices and price policies in export marketing is somewhat more complex than in domestic marketing. Due to increasing complexity of markets, price decisions are becoming more critical than ever. All markets are becoming more segmented, which results in firms having to broaden their product lines with different products aimed at different types of customer. Gone are the days when Coca-Cola could offer a single brand to 483 Chapter 11 Pricing decisions everyone; today it has Coke, Diet Coke, Caffeine Free Coke, Cherry Coke, etc. Successful B2B marketing is similarly shifting from commodity selling to speciality products. Of concern to the export marketing manager are the following: ● pricing decisions for products that are produced wholly or in part in one country and marketed in another (exports); ● pricing decisions that are made on products produced or marketed locally but with some centralized influence, from outside the country in which the products are produced or marketed; ● the effect of pricing decisions in one market on the company’s operations in other countries. The philosophy and practice of establishing an export price is fundamentally no different to establishing a price for the domestic market. The customer must feel that he or she has received full value for their money. At the same time the export marketing manager must seek profits, either short-run or long-run, depending upon the company’s overall objectives and the specific decision situation at hand. Broadly speaking, pricing decisions include setting the initial price as well as changing the established price of products from time to time. Changing a price may involve a discount or allowance or anything that represents a deviation from the so-called base price. Price decisions must be made for different classes of purchasers, that is, prices must be set for sales to the following: ● consumers or industrial users; ● wholesalers, distributors, or other importing agencies; ● partners in strategic alliances; ● licensees (when parts or components are exported); ● one’s own subsidiaries or joint ventures, whether minority or majority interest or wholly owned subsidiaries. Pricing for the last type of purchaser involves the use of transfer prices. Other pricing decisions include the following: ● determining the relationships between prices of individual products in a product line and between products in the product mix; ● whether to offer bundle pricing or price by individual product or component; ● deciding, in larger companies, on the type and amount of central control to be exercised to ensure that the price to ultimate consumers and users is maintained at a certain level; ● establishing a geographic pricing policy, for example whether or not to quote uniform delivered prices, or free on board (FOB) factory prices. The issue of differential pricing is important with regard to most of these decisions, especially the differential between export prices and domestic prices. Decisions must be made on the relationships between the prices of products sold in multiple national markets, that is, whether the price to customers in one foreign market should be the same, lower, or higher than in other foreign markets or in the domestic market. 484 Fundamental export pricing objectives and strategies There are five distinct facets to the pricing problem facing the export manager, at least three of which are unique to exporting. These five facets, each of which will be discussed in the following pages, are as follows: ● fundamental pricing strategy; ● relation of foreign price policy to domestic policy; ● currency issues; ● elements in the price quotation; ● transfer pricing. We will now discuss the fundamental export pricing objectives and strategies. Fundamental export pricing objectives and strategies All too frequently export marketing managers rely entirely on costs as a basis for establishing foreign market price policy. In some instances they attempt to cover full costs at all times even though such a policy may result in substantially less than optimum sales volume or may encourage competitors to enter and steal the market. In other instances a rough approximation of marginal (direct) cost pricing is utilized. In this situation the price is based primarily on the variable, or direct, costs of production with only a minimum part of fixed costs added. Such a technique assumes that profits will be made on domestic sales and that they will be larger than otherwise because of the utilization of fixed equipment and labor for a larger volume of production, thus reducing fixed costs per unit. Foreign markets may be used to dispose of surplus production (or use excess capacity) priced at no more than the direct costs. Unfortunately, such strategy may prove short sighted since it gives rise to the frequent international complaint of dumping, which may result in foreign governments imposing arbitrary restrictions on the import of the commodity. In addition, there is a chance that the strategy may be viewed as predatory pricing, which might be a violation of the foreign country’s antitrust law. The relationship between cost and volume is critical to an approach to pricing known as experience-curve pricing. Based on the Boston Consulting Group’s work, unit costs are expected to decline as accumulated volume (i.e., total units produced of a product) increases. The decline in costs is attributed to changes in production efficiency. Initially, prices are set below unit cost so as to gain a price advantage over competitors. Efficiency increases through market share increase, leading to a reduction in cost, and these lower costs then exceed price reductions. The essence of the cyclical nature of experience-curve pricing is illustrated in Figure 11.1. Strategies of basing prices on costs, whether full cost or marginal cost, oversimplify the pricing process in export marketing. There are a number of different pricing strategies that may be used effectively in export markets. Pricing is not the simple problem of establishing a selling price somewhere between cost and the maximum that the traffic (market, customers, or consumers) will bear. It is not one of mathematical precision, but one of statistical probabilities. The problem of the pricing executive is much like that of the player in a card game. His or her play is determined by the moves and countermoves of opponents. This anticipating and reacting to opponents or competitors is known as strategy and is as important in pricing as in card games. 485 Chapter 11 Pricing decisions Start Price advantage Gain in market share and volume Reduced unit cost Increase in efficiency Price set below cost Figure 11.1 Experience-curve pricing It is the gap between cost and value that makes it possible to have a pricing strategy. Which strategy is appropriate for a company depends upon the objective underlying strategy choice. That is, just what is it that export management wants to achieve by using price as a marketing tool? There are many objectives in pricing (see Table 11.1) and as many strategies. For example, in a recent study of international pricing practice that was based on a series of 45 qualitative interviews with seasoned international business executives from five different countries, the author concludes that the respondent exporting firms did not employ separate objectives for pricing decisions. Interestingly, the responding firms stated either financial or nonfinancial goals as key objectives for their international business. More explicitly, maintaining market share or increasing international market coverage ranked first. Only onethird of the firms in the sample were using financial goals to measure performance. What seemed in particular to influence the price goals were the company’s experience in exporting and the distribution system in which the company was operating internationally. The following sections present the two main export price strategies (skimming and penetration) as well as several alternative price strategies that can be used effectively in export markets. Skimming the market A simple objective might be to make the largest profit possible. This involves the strategy of getting the highest possible price out of a product’s distinctiveness. A high price is set until the small market at that price is exhausted. The price may then be lowered to tap a second successive market or income level. This strategy may be used either because the company Table 11.1 Alternative pricing objectives ● ● ● ● ● ● ● ● ● ● 486 Satisfactory return on investment Maintaining market share Meeting a specified profit goal Largest possible market share Meeting a specific sales goal Profit maximization Pricing at the high end of the price range Highest return on investment Prices are set at a high level and then lowered after a certain period has elapsed Meeting competition Fundamental export pricing objectives and strategies feels that there is no permanent future for the product in a foreign market; that its costs are high and a competitor may come in and take the market away; or because production capacity is limited; or because it enjoys a temporary and erodible competitive advantage. Penetration pricing This strategy involves establishing a price sufficiently low to rapidly create a mass market. Emphasis is placed on value rather than cost in setting the price. Penetration pricing involves the assumption that if the price is set to bring in a mass market, the effect of this volume will be to lower costs sufficiently to make the price yield a profit. In an industry of rapidly decreasing costs, penetration pricing can accelerate the process. The strategy also involves the assumption that demand is highly elastic or that foreign purchasers buy primarily on a price basis. This strategy may be more appropriate than skimming for multinational companies facing the demand conditions of the less-developed countries. An extreme form of penetration pricing is expansionistic pricing. This is the same as penetration pricing except that it goes much lower in order to get a larger percentage of the customers who are potential buyers at very low prices. This strategy assumes: (1) a high degree of price elasticity of demand and (2) costs extremely susceptible to reduction with volume output. This may be based on experience-curve pricing. Sliding down the demand curve This strategy is a variation of the skimming strategy and in this case the company reduces prices faster and further than it would be forced to do in view of potential competition. A company pursuing this strategy has the objective to become established in foreign markets as an efficient producer at optimum volume before foreign or domestic competitors can get entrenched. This is primarily used by companies introducing product innovations. Here the strategy involves starting out with almost the entire emphasis on pricing on the basis of what the market will bear and moving from this point toward cost pricing at a measured pace. The pace must be slow enough to pick up profits but fast enough to discourage competitors from entering the market. Companies following this strategy are seeking to recover development costs as they become an established entity in the market. Preemptive pricing Setting prices so low as to discourage competition is the objective of preemptive pricing. The price will be close to total unit costs for this reason. As lower costs result from increased volume, still lower prices will be quoted to buyers. If necessary to discourage potential competition prices may even be set temporarily below total cost. The assumption is that profits will be made in the long run through market dominance. This approach, too, may utilize experience curves. Extinction pricing The purpose of extinction pricing is to eliminate existing competitors from international markets. It may be adopted by large, low-cost producers as a conscious means of driving weaker, marginal producers out of the industry. Since it may prove highly demoralizing, especially for small firms and those in newly developing countries, it can slow down economic advancement and thus retard the development of otherwise potentially substantial markets. 487 Chapter 11 Pricing decisions Preemptive and extinction pricing strategies are both closely associated with ‘dumping’ in international markets. Actually, they are merely variations of the dumping process, depending upon the domestic or ‘home’ market price. Although they may serve to capture initially a foreign market and may keep out, or drive out, competitors, they should be used only with extreme caution. There is the ever-present danger that foreign governments will impose arbitrary restrictions on the import and sales of the product, consequently closing the market completely to the producer. More important, once customers have become used to buying at low prices it may prove difficult, if not impossible, to raise them subsequently to profitable levels. Exhibit 11.1 provides examples of some pricing strategies used, and the results achieved. Exhibit 11.1 Some pricing strategies and results achieved 488 ● Successfully using premium prices. Louis Vuitton has opened its 46th store in Japan, where the combination of its status-symbol name and high prices appeal to a growing market segment of young, educated single women still living with their parents. They splurge on products with cachet while cutting costs on other items. Louis Vuitton sells more than twice as many handbags in Japan as in all of Europe. Maintaining high prices that support their positions as status symbols Vuitton, Chanel and Hermes do well while the overall market for luxury goods in Japan has been falling since 1996 (Katz, 2003). ● Pricing to capture an additional market segment. An ongoing recession in 2009 caused a 17% drop in worldwide sales of Rolls-Royce automobiles, one of BMW’s brands. In December of 2009, the company launched a new smaller Rolls-Royce model, the Ghost, selling for about $250,000. BMW hopes it will broaden its appeal to a younger clientele than the four models of its existing Phantom model, which sell for about $380,000 to $450,000 each. In the first five months of 2010, the company sold 678 cars, a rise of 146% from 2009. The number Rolls-Royce sold has been steadily increasing since 2005. ● A problem in failing to meet price competition. In the mid-2000s with the weak dollar failing to adequately cover high euro prices for labor and parts in Germany, Volkswagen AG adopted a strategy of reducing discounts on cars being sold in the United States. Their US sales fell 30% in the first two months of 2004, and VW then resumed offering competitive discounts (White, 2004). In recent years, the dollar has been much stronger and European producers are benefiting. In 2015, however, VW was faced with a major problem after it was discovered that software had been installed to make it seem in tests like the cars were more environmentally friendly than they actually are. ● Two successes in using low-price strategies. (1) Southwest Airlines of the United States has been very successful providing low-cost scheduled air services at prices below those charged by major airlines. They have done this by maintaining substantially lower cost structures for personnel (made easier by cutbacks in service by many major carriers) and lower overhead than traditional international airlines. They also avoid routes on which they cannot attain high load factors for the aircraft they use, while major carriers need to provide service on some of these routes. (2) Walmart has been highly successful in some countries, such as the United States, using very low prices to attract a large number of customers. It was able to do this by developing a very efficient distribution system, operating large stores attracting a high volume of customers, and obtaining low prices from suppliers. It is notable that it was not successful with this strategy in Germany where competitive conditions and customer preferences were different. ➨ Fundamental export pricing objectives and strategies ● Pricing to prevent piracy. Microsoft was frustrated that 95% of the installations of its Office software in China were pirated. In a 10-month trial in China it lowered its price to $29. Sales increased more than 800%. ● An experiment in pricing. Procter & Gamble has traditionally focused on in-house development of new products, setting initial prices at a high level to cover development costs and advertising, and then cutting prices as competitors move in. But in January 2001 they took a new approach in acquiring a low-cost battery-powered toothbrush from outside entrepreneurs, who they also hired to assist in marketing. Focus groups and the prior experience of the entrepreneurs in selling the electric toothbrush to selected retailers indicated that, with a toothbrush design that would appeal to children and with proper packaging, advertising would not be necessary for the product launch. The price was set at $5, far below the prices of $50 or more for most electric toothbrushes and one-fourth the cost of a recently introduced low-priced electric toothbrush. The SpinBrush was a great success and, in P&G’s quickest global rollout ever, posted global sales of over $200 million in 2001 (Berner, 2002). Over time, competitors such as Colgate developed their own low-priced battery-powered toothbrushes, taking away P&G’s initial advantage. ● Changing competition, changing strategies. Toys ‘Я’ Us grew rapidly in the United States and overseas based on a low-price strategy. It was able to do this through high volume that allowed them to obtain low prices from manufacturers. Now, faced with growing competition from Walmart in the United States, they are closing US stores, emphasizing some different product lines including video games, and increasing their operations in smaller overseas markets that do not have extremely large competitors such as Walmart. ● Changing type of payments accepted, and services provided. Costco is a chain originally designed to provide small business owners, particularly restaurants and food service organizations, with groceries and other products. It charges a membership fee and is able to offer very low prices because it sells in bulk in wholesale or near-wholesale quantities, and accepts payment only by debit cards or cash. It expanded to include selling to individuals willing to buy in large quantities, customers generally economically ‘upscale’ from those buying at Walmart. It continued to do well in the recession, but decided to see if additional customers could be attracted by accepting government-provided food stamps in payment for goods. These ‘stamps,’ now available to recipients as a value on a card that can be used like a bank debit card at a checkout stand, are given to lower-income families and individuals in the United States (Costco, 2009). The change substantially increased sales, with 13% of new members indicating that this change had caused them to join. In one overseas market it was not successful until it offered a ‘refund with no questions asked’ policy. This was an innovation in the country which, after seeing that the company really did this, resulted in the attraction of many new customers. ● A disaster in pricing. In 1997 McDonald’s Holdings Co. (Japan) was the market leader in hamburger chains, a position it had held since entering the market. The chairman of the company came up with a plan to increase that share by offering a burger for the extraordinarily low price of ¥59, far below that of any competitor. He was able to do this because he had contracted for a large amount of beef priced in dollars shortly before a substantial increase in the value of the yen. He expected to be able to continue to get beef at a very low price. The company enjoyed initial success as greatly increased volume raised profits in spite of the drop in prices. However, the temporary advantages gained from lower prices disappeared under a combination of price cuts by competitors, a drop-off in customers as the novelty wore off, and an inability to gain long-term cost advantages in using forward purchases of foreign exchange. McDonald’s subsequently raised prices to a point part-way between the original prices and the lowest prices, but profits suffered. In 2003 McDonald’s Japan had its first loss in 30 years and the chairman resigned (Tanaka, 2003). 489 ➨ Chapter 11 Pricing decisions ● Success in using an incentive. In the US market, Toyota has been able to increase its market share for automobiles and small pickups without using the large incentives frequently offered by GM, Ford and Chrysler. In 2006, Toyota began manufacturing the Tundra full-size pickup truck in a large new facility in Texas, hoping to gain a sizeable share of the market for this type of vehicle (Kurasawa, 2007). American buyers of full-size pickup trucks are very brand-loyal, and sales of the Tundra were initially substantially lower than desired. In June 2007, Toyota began offering incentives, including no-interest loans, valued at $5,083 per vehicle. Sales for the Tundra more than doubled in June, putting sales back on track, while sales of trucks by GM, Ford and Chrysler all fell sharply (Tierney, 2007). ● Different prices for different sharks. When the entrepreneurs in 2014 on the popular TV-show ‘Shark tank’ were presented with the idea of “Elephant chat’ they did not agree on the optimal pricing strategy. After hearing the Adams family pitch the idea, sharks seemed to agree that the price of $69.00 was way too high for a stuffed elephant that would otherwise be bought for a couple of dollars. Each shark explained the necessity of starting low in order to achieve sales. Mark Cuban, however, disagreed with the other sharks, and proposed that the product was too inexpensive and should be specifically targeted to marriage counsellors. In the end, none of the sharks invested in the Adams family and their product. Summary In the final analysis there are different approaches to pricing strategy; and there is no one master policy or procedure that should be used under all circumstances or in all foreign markets. Pricing strategy is a matter of having as much information as possible about costs and the value of a product to various classes of consumers in different markets. With this information and intelligent application the danger of an exporting company pricing itself out of potentially profitable markets is considerably reduced. Given the importance firms attach to international pricing, however, it is a wonder that most exporting companies do not apply more systematic approaches to price-related issues. In a study on international price practices the overall impression of how industrial exporters deal with international pricing issues was as follows: anchored around the strategic price position, managers set a certain, implicit price level. This price level serves as a guideline and overall benchmark. For setting prices, firms choose either a fixed or a flexible cost-plus approach. The calculation approach and the goals that are set are a matter of international experience. The size and the design of the firms’ international distribution systems will mediate the final solution. The price decision is most likely taken centrally under the supervision of top management. Furthermore, the study concludes that the importance of pricing compared with other marketing decisions was at least highlighted by the responding exporting firms. Determinants of an export price No other marketing tool has such a powerful and immediate effect on a firm’s sales and profitability record as pricing. The consequences of price changes are more direct and immediate than those of any other of the elements of the marketing mix, as they result in subsequent customer and, in most cases, competitor reactions. Given their power, pricing 490 Determinants of an export price issues have attracted surprisingly little research interest compared with other marketing tools. What applies to a single market-setting holds even more true for the global marketplace, because additional context factors increase complexity. In order to understand the structure of a price we need first to examine those basic factors that influence the setting of an export price. These factors include the following: ● costs; ● market conditions and customer behavior (demand or value); ● competition; ● legal and political issues; ● general company policies, including policies on financial matters, production, organization structure; and on marketing activities such as the planning and development of products, the product mix, marketing channels, sales promotion, advertising, and selling. Costs Costs are often a major factor in price determination and there are a number of reasons to have detailed information on costs. Costs are useful in setting a price floor. In the short run, when a company has excess capacity, the price floor may be out-of-pocket costs, that is, such direct costs as labor, raw materials, and shipping. However, in the long run full costs for all products must be recovered, although not necessarily full costs for each individual product. The actual cost floor, therefore, may often be somewhere between direct cost and full cost. Some years ago a large chemical company sometimes sold products abroad on an incremental cost basis whenever excess domestic capacity existed. The company’s price floor was direct cost, since every unit sold at a price in excess of direct cost would contribute to net profit. This company illustrates a technique known as marginal pricing, based on the accounting concept of contribution margin. Direct costs are those that are incurred by the decision that is made. When used in export pricing, this technique suggests that only those costs that are necessary to produce export revenues are relevant and should be matched against export revenues when assessing profitability. In addition to excess capacity, marginal or incremental pricing may be used for the purposes of entering an export market on a competitive level, or retaining an existing competitive position. Other reasons for pricing exports at less than full costs include: to assist dealer organization growth; to keep a group of employees working together; to sell a special product outside the usual export line; to supply a manufacturing prototype to a subsidiary or licensee; orders for large volumes; the product sold in the domestic market at less than full cost; the export customer provides his or her own installation and services; and significant incremental sales may result. Costs are also helpful in estimating how rivals will react to setting a specific price, assuming that knowledge of one’s own costs helps to assess the reactions of one’s competitors. Costs may help in estimating a price that will keep out or discourage new competitors from entering an industry. Internationally, however, costs are often somewhat less helpful for this purpose than in the domestic market, since they may vary over a wider range from country to country. The developments of e-commerce, e-trade, etc. seem to lower the price differentials between countries. Economic theory might suggest the Internet would reduce price competition. Prices becoming more transparent, consumers and competitors having fuller information at a very low cost are all factors conducive to industry cooperation. 491 Chapter 11 Pricing decisions However, what makes price competition rather more than less likely is the lowering of barriers to entry. New entrants do not need to invest in expensive stores or international channels of distribution. This could increase the number of firms and the differences among them, making high prices more difficult to sustain. New entrants with no brand name will find it necessary to compete on price to get a toehold in the market. Further, the reduction in search costs and the ease with which consumers can compare prices on the Internet will encourage consumers to switch to lower price suppliers. Search and switching costs may be so low that negotiated prices become the norm. It may be much easier for customers to play suppliers off against each other, obtaining price quotes through e-mail and making offers and counteroffers among a large number of sellers. The Internet challenges price quotations and strategies for most exporting companies due to what economists call price and cost transparency, a situation made possible by the abundance of free, easily obtained information on the Internet. All that information has a way of making a seller’s prices and costs more transparent to buyers – in other words, it lets them see through those costs and determine whether they are in line with the prices being charged (see Exhibit 11.2). Exhibit 11.2 The Net’s threat to prices and brands The most prevalent form of information available on the Internet is about prices. Consumers know that they can often find lower prices for books, CDs, computers, and airfares by clicking online rather than by standing offline. But they can do much more than compare the prices of an Internet store against those of a traditional retailer. They can log on to price-comparison sites such as Pricescan.com and shopping agents such as Bottomdollar. com to compare the prices and features of more than 10,000 products available on the Web. Every time a customer takes advantage of a cheaper price from an online discounter such as Buy.com or Onsale.com, she unlearns her long-held rules of thumb about how price and cost are related for the product she has just purchased. Therefore, the Internet represents a threat thus far to a company’s ability to extract price premiums from buyers, to brand its products, and generate high profit margins. Everyone knows that the Web makes price comparisons much easier. The Web is increasing price and cost transparency in several ways: 492 ● The Internet makes a buyer’s search much more efficient. Anyone can use Web-based shopping agents or bots to research products quickly. With a few clicks of the mouse a consumer can find out, say, who’s selling washing machines, at what prices, with what features, and what kind of warranty. Thus an online shopper can know in a matter of minutes what the best deal is. ● The Internet encourages highly rational shopping. The Internet presents a very different shopping experience, one that appeals to people’s cognitive facilities instead of affective behavior. It encourages dispassionate comparisons of prices and features. It also puts shoppers in control – it is up to them to consciously navigate through the net’s maze of pages and links. The information-rich nature of Web shopping will encourage people to make decisions based on reason rather than emotion. ● The Internet encourages buyer-led pricing and reverse auctions. Buyer-led pricing and reverse auctions allow consumers to see the ‘price floor’ more easily than they can with traditional shopping. Thanks to sites such as Priceline._com and eBay, consumers have started to believe that the prices of even the best-known brands are open to negotiation. ➨ Determinants of an export price Priceline requires that buyers name the price they are willing to pay for hotel rooms, air tickets, home financing, cars, etc. It then lets companies decide if they want to meet the quoted price. A buyer whose price is accepted may be motivated to bid even lower the next time. Sooner or later, she will come to know the price floor – the lowest price for which the company is willing to sell a product or service. ● The Internet erodes ‘risk premiums’ experienced by the buyers. Through the Web people can, in effect, always find an expert to provide information about a product or service. In the past, buyers had relatively few sources of information about a brand’s quality or about variations in quality from brand to brand vis-à-vis the price of the product. A growing number of sites maintained by individuals and organizations offer reliable and independent information about products and services, as well as stories about them from consumers around the world. For example, people who need medical treatment can research their ailments on the Internet. Moreover, health care consumers can even find out if the charges being levied by their health maintenance organization are in line with prevailing rates. Such easy access to information helps prospective buyers – whether of digital cameras or surgery – to see through a risk premium and make better decisions about the premium’s justification. Source: Adapted by permission of Harvard Business Review from ‘Cost transparency; The Net’s real threat to prices and brands’ by I. Sinha in Harvard Business Review, March–April 2000. Copyright © 2000 by the Harvard Business School Publishing Corporation; all rights reserved. In the new reality of price and cost transparency the seller or manufacturer can take several steps to mitigate the effects brought about by the Internet’s trove of information; however, companies won’t be able to avoid it. First, companies can pursue price options that go beyond just cutting their prices. One strategy involves ‘price lining.’ This is a well-known practice of offering different products or services at various price points to meet different customers’ need. For example, the US telephone operator ANC offers many plans at different prices and rates for its customers worldwide according to the level of subscriber usage. Second, companies may implement dynamic pricing, in which the prices they charge vary from one market to another, depending on the market conditions, differences in costs, and variations in the way consumers value the offering. By forcing the customers to enter their zip codes before they can view prices, companies can earn higher profits than those that have only one price for every market they serve. However, the companies should tread carefully when thinking about dynamic pricing. Because the Internet allows customers to share information with one another easily, dynamic pricing is likely to create widespread perceptions of unfairness that may prove devastating to business in the long run. Consumers will be unhappy if they believe they have paid more for a product than someone who was more persistent, more adept at bargaining, or just plain lucky. As a third and better solution, companies should look toward innovating and improving the benefits that their products or services offer. Bundling – packaging a product with other goods and services – can make it difficult for buyers to see through the costs of any single item within the bundle. It focuses buyers on the benefits of the overall package rather than the cost of each piece. Also consumers will reward makers of new and distinctive products that improve their lives. The Internet and World Wide Web do not only provide problems for exporters/suppliers. They give them a tool that can help them in smoothing out demand over time. Increased 493 Chapter 11 Pricing decisions communications capabilities can also be advantageous to companies in responding to shifts in purchasers’ preferences between models and other characteristics of products, colors, for example (see Exhibit 11.3). The basic categories of cost incurred to serve domestic and export customers are the same, for example labor, raw materials, component parts, selling, shipping, overheads. But their relative importance as a determinant of price may differ greatly. For example, the cost of marketing a product in a thin market thousands of miles from the production plant may be relatively high. Such items as the cost of sales people, ocean freight, marine insurance, modified packaging, specially adapted advertising, and so forth may raise the price floor. Also, the location of foreign customers affects either the time needed to ship products or the need for maintaining local inventories, thus influencing either the cost of transportation – for example relatively expensive shipments by air cargo – or the costs of carrying and financing local inventories. Special legal requirements may influence production costs; for Exhibit 11.3 Using the Internet to smooth out demand The Internet and the World Wide Web, coupled with appropriate software programs, provide suppliers/sellers in some industries with a tool to deal effectively with short-run as well as longer-range fluctuations in demand. All components of the travel industry, including airlines, hotels, restaurants, etc., experience periods of low demand and excess demand from both domestic and international customers. Airlines and hotels in particular attempt to smooth out longer-range fluctuations by having different prices for low, mid-, and high seasons, and may even have exceptionally high rates for periods of peak demand (New Years’ Eve, Mardi Gras, national or international events). Airlines and restaurants often have different prices for different times of the day (e.g., for airlines in some countries, the lowest-cost flights are early in the morning when they have business travelers going on short flights from one city to another, but still have difficulty filling all of the seats). Some airlines have set up Web pages on which it is very easy to find the lowest price combinations of days and times for flights between cities. With the increasing number of customers who are making purchases online, airlines can now make real-time determinations of demand by dates and times, and adjust prices in real time accordingly. Hotels may do the same by date. The authors have observed a price increase of over $100 for an e-ticket purchase, for a given flight on a given date and time, during a five minute interval. Independent companies that offer discount online bookings, such as Expedia, Hotels.com, and Priceline, will search for the lowest price among all (or most) hotels and airlines for potential customers. Making purchases through these companies will often provide lower prices. However, offered prices may vary between booking companies, may not actually turn out to be the lowest, and may sometimes not include certain add-on prices (fuel surcharges, hold baggage, etc.). With the improved communications and logistics now available, and advanced software for tracking sales to final customers, importers and their suppliers can use quick response time as a competitive weapon. A modified version of just-in-time can be applied, particularly where air freight is justified by the mix of value, transportation cost, and importance of timing to sales. Examples would include changes in demand for clothing of a new design or in new colors, and for different versions of electronic components or final products that can be produced by the same factory. While only 2% of world trade by volume goes by air, 40% of the value of trade moves by air (Byrnes, 2007). 494 Determinants of an export price example automobile safety requirements or legislation affecting food and drugs. To illustrate, in 2000 a right-hand drive model of a Jeep Cherokee vehicle produced in the United States and destined for Japan needed to have adjustments made to adapt it to Japanese regulations. Chrysler, the manufacturer, needed to show compliance with 238 regulations. It is no wonder that costs can easily mount up. Any consideration of costs requires knowledge of volume. The allocation of nonescapable costs on a per unit basis varies in accordance with the number of units sold. Thus if volume is increased in a situation where nonescapable costs are a substantial proportion of total costs, the cost floor will drop relatively rapidly. On the other hand, if direct costs are high, say 80% or 85% of total costs – a realistic figure for a broad range of products – a substantial increase in volume is necessary before the amount of nonescapable cost allocated to each unit will be reduced appreciably. Thus, since for most products a high percentage of costs are direct, the cost floor is often influenced primarily by direct costs. Mobile phones have also been used to improve market efficiency in areas where Internet access is limited by availability, cost, or the capabilities of prospective users. Exhibit 11.4 Exhibit 11.4 Using mobile phones to improve market efficiency and economic growth While the primary emphasis in this text is on individuals and companies that are or can be involved in international activities, improved communications can also help both sellers and buyers in local markets. This can eventually lead to an improvement in their economic conditions and/or organization that allows participation in wider markets. An article in The Economist (Economic focus, 2010) cites a study showing that access to mobile phones by fishermen and local markets in southern India resulted in fishermen increasing their profits while consumer prices fell. This resulted from the fishermen being able to take their catches to the local markets that were short on fish that day and avoid markets where there was a surplus. This allowed them to avoid wasting their catches while increasing the supply and decreasing the prices for consumers in the local markets where there was a shortage that day. It also cites another study involving a large Indian company that established Internet kiosks to improve its purchasing from intermediaries who purchased from farmers. The kiosks posted minimum and maximum prices being paid at each. The result was that the profits of farmers increased by one-third, while output also increased as production became more attractive. Studies by others, including an author of this text, showed that Japan in much earlier years had been able to greatly increase rice production and provide more equal income distribution by providing stable and higher prices to farmers. This enabled them to purchase more fertilizer and gave them an incentive to bring more land under cultivation. The number of mobile phones in use in Africa has expanded dramatically. With backing from Britain’s Department for International Development, Vodafone and a local partner developed M-Pesa, a mobile banking and savings system that now has over 6.5 million customers. Other groups and banks are entering the market (Lapper, 2010). Some estimates indicate that improvements in communications in Africa are contributing a percentage point growth to GDP each year, and changing attitudes toward business (Wallis and Burgis, 2010). The article in The Economist also notes that an advantage in using mobile phones, at least initially, is that they are cheaper and easier to obtain and use than access to the Internet may be in some areas. Many international organizations, and a number of international companies interested in social responsibility issues, actively support efforts to improve opportunities and assist local companies. 495 Chapter 11 Pricing decisions provides an example of using mobile phones as well as the Internet to improve market efficiency and welfare in underdeveloped areas. Market conditions (demand) The nature of the market determines the upper limit for prices. The utility, or value, placed on the product by purchasers sets the price ceiling. When a manager attempts to establish the value of a product in an export market, the manager in essence is attempting to establish a demand schedule for the product. Values should be measured in terms of product utility, translated into monetary terms. Thus pricing can be viewed as a continuous process of adjusting the price of the export product to the fluctuating utility of the last prospective buyer so as to make him a customer. In June 1988 Isuzu Motors Limited of Japan increased its base price in the United States for its sports utility vehicles and pickup trucks. Although the company claimed that the price increase was due to the currency exchange situation caused by continuing pressure of the Japanese yen on the US dollar, the facts were that the dollar/yen exchange rate was the same as it had been six months earlier and the trend seemed to be for the dollar putting pressure on the yen. What did justify higher prices was a higher demand. Purchases of Isuzu vehicles were more than 6% above those a year earlier, while purchases of Japanese-produced competing products all declined. Since US consumers seemed to prefer Isuzu over competitors’ products, it can be argued that the company made a good decision in raising the price to take advantage of that preference. In effect this amounted to assessing customers’ price sensitivity or price elasticity. Although techniques such as conjoint analysis can be used to estimate elasticities, it has been suggested that a simple starting point is to examine the important factors that affect sensitivity, as shown in Table 11.2. When estimating a demand schedule the market can be stratified, which involves estimating the number of customers who will buy at several levels of price. The exporter can then select the strata of interest, which gives the last prospect an amount of utility equal to the price charged while all other buyers will have surplus utility in that they would be willing to pay a higher price. Value may be determined by asking people, by some type of barter experiment, by test market pricing, by comparison to substitute products, or by statistical analysis of historical price/volume relationships. A special type of market is discussed in Exhibit 11.5. Table 11.2 Factors affecting price sensitivity Customer economics: Will the decision maker pay for the product himself? Is the cost of the item a substantial percentage of the total expenditure? Is the buyer the end user? If not, will the buyer be competing on price in the end-user market? In this market, does a higher price signal higher quality? ● ● ● ● Customer search and usage: Is it costly for the buyer to shop around? Is the time of the purchase or the delivery significant to the buyer? Is the buyer able to compare the price and performance of alternatives? Is the buyer free to switch suppliers without incurring substantive costs? ● ● ● ● Competition: ● How is the offering different from competitors’ offerings? ● Is the company’s reputation a consideration? Are there other intangibles affecting the buyer’s decision? Source: Adapted from Dolan, 1995, p. 178. 496 Determinants of an export price Exhibit 11.5 A special case: Comics and heroes Ever since the first Superman comics, kids around the world have been fascinated with the heroic deeds of super-heroes. As these kids have grown up, the super-hero comics have become bearers of social, cultural, and personal meaning. Today, super-hero comics is one of the most internationally liquid collectible markets. Other examples include coins, sports memorabilia, and stamps. Action Comics no. 1 – sold for $3,207,852 in 2014 In 2014, a copy of the first appearance of Superman, Action Comics 1, was put for sale on eBay. As the auction progressed over several days thousands of users were following the price as the bids came in. Another copy of Action Comics no. 1 was owned by actor Nicolas Cage, but was sold when he had to sell most of his belongings after a tax issue. But how was the price of more than $3 million determined? What determines the price of a superhero comic? The price of a comic book reflects the significance of the event that takes place in the issue, as well as the state of preservation of the comics. The latter is graded on an incremental scale from ‘poor’ to ‘mint.’ In between there are further grades such as fair, good, very good, fine, very fine, and near mint. At times these increments are put on a scale from 0 to 10 with 10 being ‘mint.’ A further price determinant is the significance of the comic book. Action Comics 1 is the most expensive comic book (in equal grade) because it is the first appearance of arguably the most important super-hero in the world. Apart from the first appearance, comics with the first origin, and comics with the first appearance in own title are the three most sought after events by comic book collectors (in order of importance). This trinity of events can be identified for each super-hero or super-hero team or group. However, at times more than one of these events happens in the same issue. For example, the first appearance of Spawn was in the first appearance in own title, Spawn 1. The trinity events (appearance, origin, and title) for 20 selected super-heroes are as follows: First Appearance First Origin First in own title Superman Action Comics 1 Action Comics 1 Superman 1 Batman Detective Comics 27 Batman 47 Batman 1 Spider-man Amazing Fantasy 15 Amazing Fantasy 15 Amazing Spiderman 1 Wolverine The Incredible Hulk 181 X-men 98 Wolverine 1 Captain America Captain America Comics 1 Captain America Comics 11 Captain America Comics 1 Thor Journey into Mystery 83 Thor 159 Thor 126 The Hulk The Incredible Hulk 1 The Incredible Hulk 1 The Incredible Hulk 1 Fantastic Four Fantastic Four 1 Fantastic Four 1 Fantastic Four 1 Justice League of America Brave and the Bold 28 Justice League of America 9 Justice League of America 1 Iron-man Tales of Suspense 39 Tales of Suspense 39 Iron-man 1 The Flash Flash Comics 1 Flash Comics 1 Flash Comics 1 Wonder Woman All Star Comics 8 All Star Comics 8 Wonder Woman 1 ➨ 497 Chapter 11 Pricing decisions First Appearance First Origin First in own title Green Lantern All American Comics 16 Ail-American Comics 16 Green Lantern 1 (1941) Deadpool New Mutants 98 Deadpool 1 Deadpool 1 The Thing Fantastic Four 1 Fantastic Four 1 The Thing 1 Doctor Strange Strange Tales 110 Strange Tales 115 Doctor Strange 169 Punisher Amazing Spider-man 129 Marvel Preview 2 Punisher 1 (miniseries) Atom Showcase 34 Showcase 34 Atom 1 Spawn Spawn 1 Spawn 1 Spawn 1 Sometimes the creators of the stories allow for interpretation in regards to which issue the trinity event actually took place. For example, the origin of the Wolverine is not completely clear-cut. Wolverine is a mutant and not half wolverine and half human or some other being. Therefore, discovering his mutant origin in X-men 98 is crucial to our understanding of Wolverine. X-men 98 is also the first time we learn that Wolverine’s claws are not merely gloves, and it is arguably the first time we see Wolverine without his mask on. Marvel comics presents 72 on the other hand reveals how adamantium was later inserted into his body. Another example relates to the first origin and first appearance of the Teen Titans. The first time we hear about a group of teenage super-heroes called the Teen Titans is in The Brave and the Bold no. 60. In this issue we learn that the group had four founding members, and was founded after the bout with Mr Twister. Seemingly, the team was founded before no. 60, and first appeared in no. 60 as the Teen Titans. The prequel to this appearance takes place in Brave and the Bold no. 54. In no. 54 three teenage friends join forces to battle Mr Twister. As such, we learn how at least three of the teens who would later form the Teen Titans met. However, contrary to real life, it is rare in comics that the origin takes place before the first appearance, and thus there is still no real agreement among comic book collectors on whether no. 54 is not only the origin, but also the first appearance of the team. First appearance of the origin is defined as the first time we learn who the super-hero really is (for teams/groups: who the members are and how they meet) and the origin of his/her super-powers. In the early Thor stories we were told that Thor was an earthling who found Thor’s hammer in a cave. This, however, turned out to be a false origin story, and we first learned of Thor’s actual origin in Thor 159. Both super-heroes and groups are represented in Table 11.3. However, also super-hero teams (sustained team-up of two super-heroes) have trinity events. For example, the first appearance and origin of ‘Atom and Hawkman’ takes place in Atom no. 7, and their first appearance in own title is Atom and Hawkman no. 1. First appearance is usually more attractive and commands higher prices than first origin, and first in own title. A separate collecting category relates to the cross-over event. A cross-over is an important event in comics. A cross-over event may become the origin of a future team or group of super-heroes, or it may be the beginning of a recurring rivalry. Among the most important cross-overs in comic book history are Superman no. 76, Top Notch Comics no. 5, and Marvel Mystery Comics 8. Apart from trinity events, cross-overs events, and grade, the popularity of the super-hero, team, or group also influences the value of the comic. The supply of each issue is also a very important price determinant, and one of the reasons why Action Comics no. 1 fetched more than $3 million in grade 9.0 (near mint). 498 Determinants of an export price Table 11.3 Cost figures of a consumer product Domestic market Factory price Domestic freight Export market $10.00 1.00 1.00 $11.00 $11.00 Export documentation 0.75 $11.75 Ocean freight and insurance 2.25 $14.00 1.40 Import duty (10% of landed cost) $15.40 Wholesaler markup (15% on cost) 1.65 $12.65 Importer/distributor markup (25% on cost) 3.85 $19.25 Retail markup (50% on cost) Final consumer price 6.32 9.62 $18.97 $28.87 Source: Terpstra 1988. The basic factors that determine how the market will evaluate a product in foreign markets include demographic factors, customs and traditions, and economic considerations, all of which are related to customer acceptance and use of a product. However, the nature of demand as expressed in terms of price elasticity, income elasticity, and so forth, often varies widely from country to country. Diverse religions, differences in the cost of borrowing, varying attitudes on family formation and living habits, to mention just a few factors, create wide differences in the willingness and ability of customers to pay a given price. Often a critical determinant to estimating demand is the availability of information. The obtaining of such information can be extremely difficult and costly in many countries, particularly developing countries. The lack of published statistics and the lack of competent local marketing research agencies in some countries, added to the cost of conducting marketing research in distant markets, may make it relatively difficult to determine how the market will respond to different levels of export pricing. Competition While costs and demand conditions circumscribe the price floor and ceiling, competitive conditions help to determine where within the two extremes the actual price should be set. Reaction of competitors is often the crucial consideration imposing practical limitations on export pricing alternatives. Prices of competitive products (‘substitute’ products) have an impact on the sales volume attainable by an exporter. The decision is whether to price above, at the same level as, or below competition. In addition to present competitors, potential competitors must be considered. Of relevance is the extent and importance of the barriers to entry and competition – how easy and cheap it is to get into the business and compete effectively. Barriers that an exporter can use 499 Chapter 11 Pricing decisions to provide ‘shelter’ from competition include having a product distinctiveness, a brand prominence with high brand equity, and a well-established channel of distribution both between countries and within a country that can provide greater dealer strength. Obviously, the more significant the barriers, the more pricing freedom there is. Under conditions approximating pure competition, price is set in the marketplace. Price tends to be just enough above costs to keep marginal producers in business. Thus, from the point of view of the price setter, the most important factor is costs. If a producer’s cost floor is below the prevailing market price, the product will be produced and sold. Since the exporter in such a market has little discretion over price, the pricing problem is essentially whether or not to sell at the market price. Under conditions of monopolistic or imperfect competition the seller has some discretion to vary the product quality, promotional efforts, and channel policies in order to adapt the price of the ‘total product’ to serve preselected market segments. For most branded products and even for some commodities (when the export marketer and its reputation for service, dependability, and delivery are known) exporters have some range of discretion over price. Nevertheless, they are still limited by what their competitors charge; any price differentials from competitors must be justified in the minds of customers on the basis of differential utility, that is, perceived value. The closer the substitutability of products, the more nearly identical the prices must be, and the greater the influence of costs in determining prices (assuming a large enough number of buyers and sellers so that conditions of oligopoly do not exist). There are times when an exporter in such a competitive structure ignores competitive prices. To illustrate, a few years ago one manufacturer of capital equipment for mining and earth-moving operations sold primarily on a cost-plus ‘fair profit’ basis. The company sold in foreign markets at domestic factory list prices plus costs of exporting. The company paid little attention to the utility of the equipment and to competitors’ prices, mainly because foreign products were not good substitutes. However, many branded industrial products must also be priced competitively (e.g., electronic data processing equipment, machine tools, and road-building equipment) since purchasers are often keenly aware of the comparative cost/value relationship among feasible product alternatives. Under conditions of oligopoly, without sufficient product differentiation to give a seller a monopoly position, the point between the cost floor and price ceiling at which products will be priced depends upon the assessment of each oligopolist of the others’ reactions to his decisions. If there is price leadership, conscious parallel action, or collusion, the price will probably be somewhat above the cost floor, and competition is likely to be based to a great extent on product variations, quality, services, and promotional activities. A good illustration of the effect of competition on prices is the reaction of Eastman Kodak to competition by Japan’s Fuji in the US film market. In 1994 Fuji was priced such that Kodak’s main product, Kodak Gold, was priced at 17% above Fuji. Since Fuji could easily, and would, match any price cut, Kodak chose to introduce a new low-priced product, Funtime Film, in larger package sizes and limited quantities. On a per-roll basis Kodak was priced lower than Fuji. Fuji continued using price as a competitive tool, but in 1997 it cut prices in the United States by as much as 50% on multiple-roll packs of color film. Kodak lost market share. Kodak’s problems were aggravated by the loss of exclusive rights to parts of Walmart’s photo-developing business and problems with its film-developing agreements with Walgreen Co., the US’s largest drugstore chain (Bandler, 2004). Kodak’s film sales through these outlets has been hurt by its diminished visibility. In 2004 Kodak announced that it would cease selling traditional film-using cameras in its move into digital cameras, and the effect that 500 Determinants of an export price this may have on its film sales is unknown. Sales of all brands of film have been declining for several years, but it is still a major market that Kodak cannot afford to lose. Within the limits of costs, market conditions, and competition, there are still alternative ways of pricing related products. Some companies are challenging traditional models. For a number of international giants, new software products are being used to determine more optimal prices, to determine when and where to have sales, and to enable them to respond more rapidly to requests for quotations (see Exhibit 11.6). Exhibit 11.6 New approaches to pricing: alternative strategies and Web-based systems An alternative strategy The model of ‘companion pricing,’ in which a basic device is sold cheaply and money made by selling replacement or complimentary parts, is being challenged. Rolls-Royce and General Electric both sell jet engines worldwide at low prices, and then make much of their profits by selling spare parts and services at high prices. Pratt & Whitney is challenging this marketing model by selling parts for the GE/Snecma engine, used on the Boeing 737, at a lower price than GE/Snecma itself does. Hewlett-Packard, and several other producers of printers, sell their printers at low prices and replacement ink cartridges at a high price. Kodak is now offering a relatively high-priced Kodak Easyshare printer for which the replacement cartridges cost relatively little (Gapper, 2007). Software for improving pricing SAP AG and Oracle Corp., as well as startups such as DemandTec Inc., ProfitLogic and others, have developed programs that can analyze massive amounts of data for the purposes of determining more optimum pricing for products, timing of sales and discounts, and speeding up quotations. Two very simple examples will give an idea of what the systems do. For one company, an analysis of customer buying decisions indicated that cutting the price on a mid-priced model of a drill, while leaving the prices of the least expensive and most expensive models the same, would result in greater sales overall and greater profits. It did (Bergstein, 2007). A major electronics retailer found that there was a greater sensitivity to the price of its batteries in Boston than in Dallas. Prices were adjusted accordingly with a resulting increase in total sales and profits (San Francisco Chronicle, 2007). The systems being used by giant internationals are sometimes referred to as Web-based since they depend upon the analysis of vast amounts of data fed in, usually on a real-time basis, from multiple locations. Companies using these systems include GE Lighting, DHL, Hewlett-Packard, 7-Eleven Inc., Walmart, and approximately 150 retailers worldwide (Keenan, 2003; Bergstein, 2007). A new system for providing computing services Cloud computing is the Internet-based provision of computing services to companies that no longer need to have all of their own physical infrastructure. Covered services, such as for computing, data storage, etc. are provided on-demand as needed by contracting organizations, paid for based on usage, and provided by outside organizations (‘servers’) such as Amazon, Google and Microsoft and others that operate worldwide. The model is somewhat analogous to that of the electricity grid with power companies providing the electricity when needed by their customers, and charging their customers based on usage. The customers thus do not have to have physical facilities designed for maximum need with the attendant higher costs for plant and maintenance. 501 Chapter 11 Pricing decisions Legal/political influence The manager charged with determining prices must consider the legal and political situations as they exist and as they differ from country to country. Legal and political factors act primarily to restrict the freedom of a company to set prices strictly on the basis of economic considerations. Today it is widely recognized that sovereign nations have the right and obligation to take action that protects and fosters the prosperity and wellbeing of their citizens. Although there is often disagreement as to whether specific types of governmental actions are proper (whether or not they advance the long-run interests of their citizens), managers with pricing responsibility nevertheless must usually accept the situation as it exists, taking account of antidumping legislation, tariffs, import restrictions, and so forth. Officials of some countries will not issue import licenses if they feel that the price is too high or too low. One company in Brazil needed a product that Brazilian manufacturers were unable to supply due to lack of capacity. Brazilian authorities, presumably to foster local production, would not permit importation of the product from Japan or the United States because it was available from these countries at a lower price than ordinarily charged by Brazilian manufacturers. Sometimes foreign officials use pricing guidelines as a criterion for granting foreign exchange to the buyer of foreign merchandise. In some countries the government is concerned with the relationship between the amount paid and the social benefits of the purchase. Even though the customer may be willing to pay a high price, the government may refuse to grant adequate foreign exchange for what it considers to be nonessential imports. Most industrialized countries have antidumping legislation. Dumping is the practice of selling in foreign markets at prices below those in the domestic market. Antidumping legislation is ordinarily enacted in nations that wish to protect certain industries from temporary or abnormal price fluctuations that would disrupt local production. Thus, antidumping legislation sets a price floor. It should be noted that antidumping legislation is particularly relevant for firms from less-developed countries wherein a Catch-22 situation often arises. Competitive advantage for firms from less-developed countries centers on their low-cost base; firms run the risk of being reported in export markets for ‘unfair’ pricing and dumping. While promoting exports is essential to less-developed countries improving their economic performance, in some cases they may be prevented from utilizing their competitive advantages in the most effective way. The fact that sales are made at lower prices for export does not mean that antidumping action will be initiated in a foreign market. Under the laws of most countries, no dumping occurs if the exporter’s price is above that of the country’s current market price, even if the exporter’s price to that country is lower than its selling price in its domestic market. Exhibit 11.7 gives some recent examples of antidumping actions. Exhibit 11.7 Examples of antidumping actions The United States, European nations, and Canada have a long history of imposing antidumping penalties on products from both developing nations and other industrialized nations. More recently, India and China have become active in levying antidumping duties on both the United States and members of the EU. The steel industries and chemicals industries in various countries often charge their counterparts in other nations with dumping. This is due to their typically high fixed costs and low marginal (variable, direct) costs that enable them 502 ➨ Determinants of an export price to make additional profits by selling below total costs when they have unused capacity. However, companies from many industries file actions. While the duties are usually imposed immediately on imports when the importer’s country finds the prices charged by exporters constitute dumping, the government of the exporter’s country may appeal the decision to the government of the importers country, and if that fails, appeal to the World Trade Organization. The WTO rules state that the legitimacy of charges of dumping must be determined on the basis of conclusions drawn from fair comparisons of the export price and the domestic price in the exporting country. While the WTO has no means of enforcing its decisions, it provides a moral/legal basis for the imposition of retaliatory tariffs by the exporter’s country on products from the importer’s country. In 2005, the WTO ruled on a complaint by Brazil that US subsidies to cotton farmers violated fair trade rules by depressing world prices and breaching WTO subsidy limits. The ruling was a moral victory for millions of farmers in less-developed countries. Though Brazil initiated action to impose offsetting high duties on a number of American products, it eventually backed down. This was probably due to the realization that the United States was politically unable to reduce the subsidies and Brazil did not want to enter into a possible series of trade disputes. Examples of some of the many antidumping duty cases in recent years are: ● The EU in 2010 extended duties on footwear from China and Vietnam: 16% and 10% respectively. The duties caused some of the countries that just buy shoes to oppose those that make shoes within the EU (Chaffin, 2009). ● Russia has proposed imposing duties of 28.9% to 39.1% on Chinese nickel-containing stainless steel from different companies ● China, which is involved in a number of trade disputes with the United States, has proposed duties on US chicken exports, with different rates for different parts of the chicken (chicken feet are an item of particular interest: they are virtually worthless in the United States but bring good prices in China, where they are a delicacy) ● In 2010 the US imposed new duties on steel pipes used in oil and gas wells, with rates of 29.94% to 99.14% depending upon the company exporting. (The executive director of the US Consuming Industries Trade Action Coalition has complained that this will hurt United States industries by raising their costs and making supplies uncertain.) ● The EU has put duties on screws and bolts made in China A very small sample of earlier actions includes the following. In 2003 the United States imposed antidumping duties ranging from 44.66% to 63.88% on catfish from Vietnam, and tariffs of up to 44.71% on computer chips from South Korea (the amount varying according to the particular company producing the chips) (The Japan Times, 2003). In 2004 antidumping investigations were being held on shrimp exported from Vietnam. In some earlier examples, Canada imposed antidumping tariffs on carbon steel plate suppliers in seven European countries and Brazil. Canada also imposed antidumping duties on US exporters of cold-rolled steel in retaliation for the filing of antidumping petitions by US steel producers against Canadian steel exporters (and exporters in 18 other countries) (Mercado et al., 2001). Another area of potential concern is how to handle rebates, discounts, allowances, and even price escalation or guarantee against price decline clauses in contracts. An importer may ask for, and the exporter may give, one of these price concessions. By themselves such concessions are not illegal, but they may become so in the exporter’s and/or the importer’s country if they are not disclosed to the appropriate governmental agency (Johnson, 1994, p. 82). 503 Chapter 11 Pricing decisions Since tariff levels vary from country to country there is an incentive for exporters to vary the price somewhat from country to country. The incentive changes, depending on the nature of demand in each market and how much customers are willing to pay (i.e., the price elasticity of demand). Thus, in some countries with high Customs duties and high price elasticity, the base price may have to be lower than in other countries if the product is to achieve satisfactory volume in these markets. Consequently the profitability of the product will be reduced. On the other hand, if demand is quite inelastic, the price may be set at a high level, with little loss of volume, unless competitors are selling at lower prices. Import tariffs can influence decisions on sourcing, thereby influencing costs and prices. If import duties in a country are high on finished products, relative to duties on materials or component parts, from a total cost standpoint it may be desirable to import materials or components for local manufacturing or assembly. When the government intervenes in currency markets the competitive situation may change. If a government devalues its currency, exporters to that market might have to lower prices in order to compete with domestic producers. At the same time the country’s exporters would find themselves able to do better in export markets as their prices become lower. An exporter in such a situation might find itself able to improve its competitive position in selected foreign markets. Company policies and marketing mix Export pricing is influenced by past and current corporate philosophy, organization, and managerial policies. Ideally, all long-run and short-run decisions should be recognized as interrelated and interdependent, but as a practical matter some decisions must be made first and must serve as a basis for making subsequent decisions. For example, the company organizational structure must be established and maintained for a period of time. During this period other activities must be conducted within the constraints of the structure. Pricing cannot be divorced from product considerations. Management must take the customer’s point of view and evaluate a product in terms of its quality and other characteristics relative to its price. Decisions on the nature of the product, package, quality, varieties or styles available, and so forth influence not only the cost, but what customers are willing to pay, as well as the degree to which competitors’ products are considered acceptable substitutes. For example, there are numerous manufacturers of such products as industrial machines, tools, and equipment, which are able to export at higher prices than foreign competitors because of a design advantage. So-called national stereotypes and buyer attitudes toward particular countries of origin (as discussed in Chapter 10) can affect the way in which export prices are interpreted in foreign markets. Customer reactions to price and the judgements that customers make will be conditioned by their perceptions and attitudes toward the country of origin of imported goods. For example, if the image of the exporting country held by buyers is favorable and the price of a product from there is low, it will be viewed as ‘good value for the money.’ If the price was high, a product from there would be perceived as ‘high quality.’ With an unfavorable country image the perceptions would be ‘low quality’ and ‘poor value for the money,’ respectively. Such perceptions are thought to be more true the less the market knows about the products themselves and the suppliers. In short, this situation is most likely to face the new exporter as well as the smaller company with a limited market reputation. 504 Relation of export to domestic price policies The channel of distribution utilized also affects price. Certain channels such as export merchants may require a higher operating margin than a manufacturer’s export agent, depending, of course, on the nature of the product, the markets served, and the cost of performing the required functions. Thus, if dual channels are used and if the price to marketing intermediaries is uniform, the price to ultimate users will probably vary. However, if the prices to intermediaries are varied in approximate proportion to their different costs of operations (or operating gross margin), it would be possible to achieve some degree of uniformity in prices to ultimate consumers or users. But such a price structure would be complex and difficult to implement and maintain. Utility of a product depends not only on its physical characteristics but also on how it is sold and serviced. For example, a manufacturer of a diversified line of electrical control products and other electrical equipment once found that a price disadvantage (vis-à-vis foreign competitors) can often be overcome by the following: ● careful appointment and training of technical representatives; ● continued analysis and comparison of product features with competitors’ products and exploitation of design advantages by demonstrating to customers superior performance characteristics, ease and low cost of maintenance, long life, and ease of installation; ● prompt delivery, which is in some cases facilitated by maintaining inventories abroad. Thus such factors as the type of channels selected, the relations with foreign representatives or dealers, the distinctiveness of the product, and the services provided determine the price that customers are willing to pay. Promotional policies are also interrelated with pricing. Communication activities (e.g., advertising, personal selling, and sales promotion) should be designed to provide customers with appropriate information and persuasive appeals. The cost of preparing and conducting international promotional activities helps to set the price floor; such costs also contribute to the utility of the product and thereby influence the price ceiling. Summary We now summarize what has been said in this section of the chapter. The value of a product to the last prospective customer fixes the ceiling on price while cost sets the floor. However, there are two cost floors: one set by direct or relevant costs (the lowest floor) and one set by full costs. In any export price decision the appropriate cost floor depends upon the company’s goals or objective in pricing. Between the cost floor and demand ceiling is a gap. Where in this gap to set the price depends upon such factors as the nature and type of competition, the legal/political situation, and the overall export marketing program. Relation of export to domestic price policies The second aspect of price policy for the export marketing manager is the relation of export price policy to the company’s domestic policy or policies. The manager must decide whether to price at higher levels, the same level, or lower levels than domestic prices. There are arguments for and against each of these alternatives. 505 Chapter 11 Pricing decisions Export prices lower than domestic One argument for export prices lower than domestic prices is that the manufacturer’s product is probably less well known in foreign markets than domestic. To secure market acceptance and initial purchase the lowest possible price should be quoted. Furthermore, as part of securing market acceptance the manufacturer should be willing to absorb any additional expenses such as transportation, marine insurance, and on occasion even the foreign import duties. Others believe that export prices should be lower because foreign competitors can manufacture more cheaply due to lower labor costs, government subsidies, or other advantages that they are said to enjoy. Still another argument advanced in favor of lower export prices is the lure of increased sales volume in order to assist in absorbing manufacturing and overhead costs. A further argument is that the manufacturer has incurred certain necessary expenses in initiating its business that have been disbursed and cannot be escaped. Therefore, any export business is in a sense plus business and should not be charged with this burden. It may be that the export price turns out to be lower than the domestic price simply because the manufacturer feels that domestic customers are nationalistic and will pay a higher price for a domestic product. For example, cars in Germany in some cases are more expensive (before taxes) than in neighbouring Denmark. A potential problem that may arise by following this policy is that the exporter may be considered to be dumping. Consequently, the exporter should watch for ‘local’ government reaction in export markets. Export prices higher than domestic One of the arguments most frequently advanced in favor of higher export prices is that the increased initial cost of equipping an organization to enter the export field is considerable. The probability is that selling expense may be higher than in the domestic market due to the complexities of procedure, difficulties in language, differing commercial customs, and varying legal needs and tastes of customers in export markets (Exhibit 11.8). There is frequently extra investment and added expense in preparation of special documents and forms in packing, preparation, and alteration of the products. Some believe that the cost of extending credit to and financing foreign accounts means a slower turnover of invested capital and higher expense. Some manufacturers and producers feel that there is added risk in doing business abroad due to unsettled economic and political conditions, and that this risk should be compensated for in the form of a higher price. Exhibit 11.8 Price escalation Price escalation in exporting is a phenomenon that occurs all too often. If the exporting firm does not pay conscious attention to the conditions that lead to price escalation it may find itself in a situation where it prices itself out of a foreign market. In general, it is the physical and economic distance between the initial manufacturer and the consumer (or user for industrial products) that provides the environment for price escalation to emerge. These distances may mean that a longer channel of distribution with more intermediaries is needed 506 ➨ Relation of export to domestic price policies than in the domestic market. In addition, there are other costs involved such as documentation and import duties. Export price escalation occurs when there is a significant increase in the price of a product as it goes from the exporting manufacturer to the industrial user or ultimate consumer. Since usually exporting is more complex (in terms of stages) than is domestic marketing and each stage has a fixed cost, the final price in export markets can be much greater than in the exporter’s domestic market. For example, in 1995 a Jeep Cherokee vehicle produced in the United States at a factory cost of US$19,100 had a retail price in Japan of US$31,372. A comparable model was priced in the United States at US$20,698 (WuDunn, 1995). A short example illustrates this point. In Table 11.3 we show relative illustrative cost figures for a domestic sale and an export sale of a consumer product. The various markups and so on are not unusual. It is quite clear that there can be an escalation in the export price such that it ends up more than 50% higher than the comparable price in the domestic market. Obviously, there are situations where escalation will be less than that shown in the example; there may also be situations where it is greater. Whenever there is escalation such as that illustrated, the exporter is almost bound to price higher than in the domestic market. In trying to overcome the problems that arise with this phenomenon, Terpstra (1988, p. 138) has indicated that the exporter can consider at least four possible strategies, as follows: 1. shipping modified or unassembled products that might lower transportation costs and duties; 2. lowering its export price at the factory, thus reducing the multiplier effect of all the markups; 3. getting its freight and/or duty classifications changed for a possible lowering of these costs; 4. producing within the export market to eliminate the extra steps. The last option amounts to sourcing for the foreign market within the market itself by making a direct investment in manufacturing facilities, or by forming a strategic alliance through licensing, joint venture or contract manufacturing. Export prices on a par with domestic prices The policy of carrying the domestic price into the export market has much to commend it, particularly to the manufacturer or producer who is entering export for the first time and who has not yet explored all the varieties of conditions that may be found later in the foreign markets. There are several arguments in favor of this policy. It enables the manufacturer to fix export prices that costs and experience in the domestic market have indicated are necessary and fair. It gives the manufacturer a feeling of safety upon entering the export market when the opportunity for marketing research, knowledge of competitive conditions, and previous experience are still lacking. It dispels any fear the manufacturer may have of becoming involved in antidumping regulations that exist in many foreign countries. It is a policy that can be easily altered when the manufacturer gains experience and acquires a more comprehensive knowledge of export markets. This approach is easy to implement but may not be suitable if the domestic price is low because of unusual circumstances, such as intense competition. Before following 507 Chapter 11 Pricing decisions this approach, or pricing lower than domestic price for that matter, the export manager should be certain that the domestic price is, in fact, the usual or ‘normal’ price. Exports priced the same as domestic assumes that objectives are similar. It should be recognized, however, that company objectives and market conditions may not be the same across markets. Differential pricing Since the market and competitive conditions and other environmental factors vary from one foreign market to another, possibilities arise for setting a different export price to each market. However, in a study of pricing practices of US multinational corporations (Samli and Jacobs, 1994), the findings indicate that 70% of US firms standardized their prices in most markets. Much has been said and written in conventional international economics textbooks about the conditions under which price differentials occur among foreign markets. The most important conditions are: (1) differential elasticities of demand, and (2) effective separation of markets. Differential elasticities of demand are necessary if there is to be a profit incentive for the exporter to set a higher price in one market than another. High price elasticity suggests low prices; price inelasticity suggests high prices. Another necessary condition for differential pricing is that the relevant markets must be separated effectively. Unless tariffs, transportation costs, or reexporting costs are higher than the price differential, or unless other restrictions on the free transfer of goods across political boundaries exist, products sold in a low-price market may find their way into a high-price market. In the case where export prices are higher than domestic prices, the exporter must guard against setting the differential so high that foreign customers or their representatives find it attractive to enter the domestic market and perform the exporting functions for themselves. Within the European Union, prices of automobiles vary by country. For example, in 2000 the price for a Volkswagen Golf (made in Germany) varied from a low of US$8290 in Finland to a high of US$13,040 in the United Kingdom. In Germany, the price was US$11,040 (Businessweek, 2000). In some instances the differential was greater than differences in taxes, etc. This has been called ‘pricing to the market.’ In addition, there have been reports that the manufacturers have been ‘encouraging’ dealers not to sell to people in other countries. Currency differences even arise in the European Union, where not all countries have adopted the euro. The euro is supposed to equalize prices, but they may vary as much as 30% from country to country for the same model of automobile. In 1999 the price of a BMW 318i was priced in the United Kingdom in pounds at 30% more than the euro-denominated price, converted to pounds, in the Netherlands. The higher price in the United Kingdom was partly due to the pound’s appreciation against the euro. This is the issue of the price of goods obtained through parallel imports or the so-called gray market, which was discussed earlier in Chapter 8. If buyers in one country are able to purchase at a lower price than in another country, there will be an incentive for customers in the lower price market to divert goods to the higher price market in order to make a profit. Obviously the exporter’s distributor and dealers in the higher price country will complain about such unauthorized imports since they represent a loss in sales to them. The laws of many countries including those in the European Union and Japan encourage such parallel imports as a means of stimulating competition and forcing the authorized 508 Relation of export to domestic price policies distributor to reduce its price. In the European Union, any attempts to prohibit a distributor from selling outside its country, but within the European Union, can be a violation of law. European pharmaceutical companies are particularly concerned over gray markets. Each country within the EU sets its own prices on what it will pay for prescription drugs, with substantial differences between countries. Thus the drug companies face different sales prices in different countries within the eurozone, making parallel trade attractive to importers and exporters. Countries outside of the eurozone at least have different, and in some cases variable, exchange rates. Germany is the largest importer of parallel pharmaceuticals in Europe, with the UK and the Netherlands tied and others including Sweden, Denmark, Ireland and Norway accounting for smaller shares. North Korea has used the gray market to get around sanctions imposed by the United Nations. British American Tobacco Company had shipped at least 15,000 cases of State Express 555 branded cigarettes, worth $6.3 million, to North Korea. Made in Singapore, the cigarettes were worth at least $6.3 million. North Korea diverted or reexported them to Vietnam, the Philippines, and China where they commanded a higher price. This supplied North Korea with additional foreign currency, much needed because of international sanctions imposed upon the country. While tobacco companies dislike gray market or parallel exports, Customs officials are generally more concerned with counterfeits rather than simple diversions of genuine products. Smuggling, however, is a crime. In 2001 the European Union accused several large US tobacco companies of complicity in cigarette smuggling by selling oversupplies to neighboring non-European Union countries. At the same time smuggling of cheap imitations of Philip Morris’s Marlboro cigarettes made in China, South America, and eastern Europe were causing approximately $100 million in lost profits to Philip Morris International. It was estimated that smuggling costs the European Union $1 billion annually in lost taxes. In 2004 Philip Morris agreed to a settlement with the European Union in which the company will work with the European Union to fight smuggling, and will pay the European Union $1 billion over a period of 12 years. Part of the money will be used to hire and train more Customs officers and buy equipment and technology (Geitner, 2004). If RFID (Radio Frequency Identification) equipment is used it should be relatively easy to determine if checked cross-border shipments of cigarettes are actually legal, and if cigarettes delivered through legitimate distributors are authorized. The tobacco giant Altria, makers of Marlboro brand cigarettes, has hired undercover agents to hunt for fake Marlboros and ones that do not have genuine tax markings in New York State and New Jersey. Marlboro has a direct interest in stopping the flow of counterfeit cigarettes made in China. Genuine Marlboros are also illegally transported across state borders in the United States because some states, for example, New York, charge much higher sales taxes on cigarettes than others do. This makes it profitable for professional crooks and some other people to smuggle the cigarettes across the state line from lower-tax jurisdictions. Marlboro is also interested in preventing cross-border evasion of taxes because it feels this indirectly affects its sales. Altria has no legal standing to take direct action about fakes or tax evasion, but passes the evidence to law enforcement officials. Altria’s brand integrity unit also works for other companies trying to stop smuggling (Byrnes, 2010). The exporter considering differential pricing must also look at other factors, including local competition in each market, the company’s products’ fixed-cost/variable-cost ratio, 509 Chapter 11 Pricing decisions the stability of demand in the domestic market, and the overall marketing strategy to be employed. Reasons for following a policy of differential pricing often arise because the marketing strategy varies from market to market. For example, in one country a policy of intensive distribution coupled with heavy advertising may go hand in hand with a low price to serve a mass market. In another country a direct marketing channel with little advertising may call for a high unit price to serve a small number of high-income persons. Product line considerations may also contribute to the desirability of differential pricing. For example, so-called full-line considerations can be important. If customers expect to buy certain products from a common source the exporter that does not have all of the expected items in the product mix is likely to have difficulty selling any of the mix. The buyer might reason: ‘Why should I split my orders among two or more suppliers when I can order all of my requirements from one supplier at one time, thus saving both time and effort?’ Under these conditions it may be necessary for a seller to include an item in the product mix that cannot be sold at as high a price as in other markets; thus the price of the item must vary from country to country. Product line pricing in another sense may also contribute to the desirability of differential pricing of certain items in the line. The products in a line often must be priced so that there is a reasonable relationship between them. For example, tractors of varying sizes and specifications may, to some degree, be substituted for each other. But the degree to which they are not substitutes, that is, the evaluation by customers as to the degree to which one product is better or more suitable than another, should correspond approximately to the price differential. Since groups of customers in diverse markets may evaluate products differently, the appropriate differences in the prices of items in the line will vary; thus it may be desirable for prices of identical products to vary from country to country. A policy of differential pricing may also be desirable on an occasional basis. In industries that require heavy fixed investment it may be expedient, when there is periodic overcapacity due to short-term fluctuations in demand, to lower prices in foreign markets if such sales make some contribution to fixed costs. Although the selection and exploration of nonhomogeneous marketing targets require varying marketing strategies, there is the possibility that a firm may try to select similar market targets from within the varying segments in each country. For example a manufacturer may make a product that appeals to persons of a certain economic or social position, regardless of nationality. National markets may be segmented on the basis of income, education, family size, leisure time, and so forth, and such segments of the markets of Canada, Denmark, France, Germany, Australia, Japan, and other nations may have similar motivations or needs, which a standardized product and marketing strategy can satisfy. Customer requirements in certain market segments for such products as household furniture, airline service, or automobiles may be quite similar in many respects. Likewise the marketing strategy, including price, may be similar. On the other hand, the greatest opportunities for growth often exist in new or developing market segments that have not been reached or served adequately in the past. In fact, one of the frequently stated objectives of differential prices is to enter ‘new markets’ or attract a new class of buyer. This objective can sometimes be achieved by selecting an additional marketing channel, which may provide a different mix of functions and reach additional segments of the market. Such a channel is likely to have a cost structure different 510 Exchange rate changes, currency issues, and hedging from other channels and thus will require a different operating margin. The operating margin required by marketing channels may vary for many reasons, including costs of market development (e.g., the need for heavy advertising in some areas, light in others), labor costs, or margins offered to marketing agencies by competitors. Either the manufacturer’s price or the marketing intermediary’s price, or both, should differ from prices in the previously established normal channel. In view of the great diversity among foreign markets and foreign marketing channels, therefore, a policy of differential pricing is often logical. The size of an exporter and its share of market also has a bearing on the desirability of following a policy of differential pricing. A small exporter is likely to feel that there is greater flexibility since the company may have a relatively minor share of the total world market. If customers are small and scattered widely, customer pressures for equal prices may be minimal. However, a large exporter, depending on large customers for a significant percentage of volume, may find that customer pressures call for uniform prices in order to avoid customer discontent. Also, in the cases where markets are not effectively separated by transportation costs, tariffs, or other barriers to trade, large customers are likely to make purchases in lowprice countries. Or, if the product is important in a market, perhaps marketing intermediaries will purchase the product in the low-price market and sell it in the high-price market under the price umbrella provided by a manufacturer that sells at inordinately large price differentials. Differential pricing may also be advisable seasonally or cyclically. For example, if a product has a seasonal sales pattern in the northern hemisphere it may have just the opposite pattern in the southern hemisphere. Thus a manufacturer in the north may find South American markets during the domestic slack season. It may be that price variations seasonally may contribute to the proper exploitation of both markets. Exchange rate changes, currency issues, and hedging Changes in exchange rates Exchange rates between the currencies of most countries often change significantly in the short run, and more greatly in the long run. Obviously there are no changes between countries within the eurozone, but the euro’s value changes with respect to the Japanese yen, the US dollar, and many other currencies. Some smaller countries actually use the US dollar as their currencies (Equador, El Salvador, East Timor, and others), several other countries allow people to freely exchange their local currencies to dollars on a one-to-one basis, and finally there are some countries that peg their currency to the US dollar. In the latter case, they may use some type of exchange controls to maintain that rate. This can be done by requiring exporters to turn all foreign currencies into the national bank, and requiring all importers to purchase foreign exchange from that bank. This is likely to lead to violations of the law and other problems as people try to get around the exchange controls. Some typical examples of changes are the following. In a shorter run, the amount of dollars required to buy one euro went from a little less than 1.3 in April 2009 to more 511 Chapter 11 Pricing decisions than 1.5 in late 2009 (an increase of over 15%), and back down to 1.37 early in 2010 (Garnham, 2010). In the longer run, the euro bought 160 yen at one point in 1995, 120 at one point in 1998, 200 at one point in 2000, and 105 at one point in 2008 (Whipp and Garnham, 2009). Significant changes in exchange rates between countries often lead to increased or decreased competitiveness and/or increases or decreases in profits, as discussed in Exhibit 11.8. Countries may attempt to bring about changes in exchange rates by buying or selling large amounts of their own currency in financial markets. This seldom has a strong and lasting effect. People making decisions regarding international trade or investment need to understand what drives these changes, as well as the options and costs of hedging against them. At one time exchange rates were determined largely (or almost entirely) by how much the countries exported compared to how much they imported. In an over simplified version, if a country began to import more than it was exporting, there would be as a lack of demand for its currency relative to other currencies. The value of its currency would then fall. For many countries this is still the case, but for most countries in the short run and some in the long run, other factors become more important. The opening of financial markets has resulted in flows of short-term investment funds of over 2,000 trillion dollars per day, many times greater than the value of international investments and trade combined (Johnson, 2010). This has led to funds moving, and exchange rates changing, due to motives other than trade and long-term investment. Some of these factors are briefly noted below, in no particular order since the importance of any particular one may be greater or smaller at any given time. The relative strength of the US dollar, while greater or smaller at any given time, continues in spite of several decades of a negative balance of payments. It is viewed as a ‘haven’ or place of relative safety during crises. In 2010, the dollar surged to a seven-month high (on a trade-weighted basis) because of concerns over Greece’s budget and its possible effects on the euro, and because of the fall of global equity markets (Garnham, 2010). It has also surged because of a ‘haven’ demand when threats of a major armed conflict have arisen, even when the United States is expected to be a major participant. Additionally, US government debt is the most widely held asset in the foreign exchange reserves of many countries including China and Japan, reflecting years of willingness to purchase debt of a major customer. While China stopped adding dollars and increased addition of euros to its foreign exchange reserves when the dollar was weak in 2009, it resumed adding dollars in 2010. In 2009, the Japanese yen hit a 13-and-a-half year high against the dollar, a 7-year high against the euro, and a record high against the British pound because the yen was seen as a haven in a time of recession and nervous global markets (Whipp and Garnham, 2009). In 2014, the yen has fallen steadily for years and is trading above the 120 per dollar ratio (Money Morning, 2014). Another factor is the prospect of higher rates of return in a particular country if its economy is expected to grow rapidly. One more factor is relative interest rates. It is possible for large foreign companies to borrow yen in Japan at Japan’s very low interest rates (kept low by the government for reasons connected to its domestic economy). They can then sell the yen for dollars (or euros or pounds or whatever) and invest them at higher rates of interest in their own countries). Known as the yen ‘carry trade,’ this tends to drive down the price of the yen (as they sell) or raises the price as they buy to pay off the loans, as has happened more recently. 512 Exchange rate changes, currency issues, and hedging Currency issues If it is possible for an exporter to specify what currency should be used in a particular transaction, the decision is of great importance. The importer may require that its own currency be used. Otherwise, the exporter can choose his own currency, the buyer’s currency, or some ‘third party’ currency. To a large extent, which of these should be used will be dependent upon a number of factors including buyer preferences, exchange rates per se, and whether they are floating or fixed, freedom of exchange, the availability of currencies in the importer’s country, and government policies. If they are floating rates then their stability becomes a concern. Exhibit 11.9 shows the potential effects of changes in currency valuations. Another consideration is whether the exporter needs a particular currency. For example, exporters in developing countries often need foreign currency in order to purchase capital equipment that enables them to remain in business in the first place. Exhibit 11.9 The effects of changes in currency valuations Changes in currency valuations affect the ability of exporters to maintain competitiveness in foreign markets. In 2010, the weak euro resulted in increasing demand from overseas and manufacturers in the eurozone expanding production at the highest rate in a decade (Atkins, 2010). In 2007, a sharp rise in the value of the yen caused great concern by Japanese exporters. Every 1 yen rise in the value of the Japanese currency against the US dollar was estimated to reduce the operating profit of export-sensitive Toyota by 35 billion yen (approximately US$ 318 million) (The Nikkei Weekly, 2007). Exporters in the eurozone have been concerned about their competitiveness as the euro has risen to record highs against the dollar, and United Kingdom exporters have been worried about the climb of the British pound against both the euro and the dollar. Japan, the United Kingdom, the eurozone countries, and the United States have all felt that the Chinese currency was undervalued, giving Chinese exporters an unfair advantage in their rapid penetration of world markets. Exporters from countries with more highly valued currencies do face a dilemma. If they raise prices in foreign countries to maintain profits they may lose market share (or lose out in some markets altogether). If they do not raise prices they may lose profits and may even be unable to cover their costs. The exporters from countries with lowered currency valuations will find that they can lower prices to increase market share, or maintain prices and reap more profits, as long as the currency imbalance remains. In 2004 the continuing high value of the euro resulted in European automobile companies increasing the prices they charged in the United States, in turn leading to reduced exports. At the same time wine exports from California to Europe surged, with California displacing Italy as the third largest exporter to the United Kingdom (Emert, 2004). Currency devaluation does not always result in increased exports, as was illustrated by the Asian financial crisis of 1997. Exporters in some countries whose currencies had fallen sharply were unable to obtain export financing because of the financial crises within their countries, and their exports actually fell. The financial crisis and banking system problems in Argentina in 2003–4 also resulted in some companies being unable to obtain bank financing for exports. A currency crisis in one country may spread to others. This was a problem that occurred in the Asian financial crisis. Macroeconomic similarities may spread a crisis as countries similar to the one under crisis could face problems generated largely by expectations rather than concrete phenomena. Short-term investors may pull money out of similarly situated 513 ➨ Chapter 11 Pricing decisions countries, resulting in devaluation in those countries. Trade is another possible channel through which a crisis may spread, as countries that have not devalued find exports falling and their economy suffers. There is a strong tendency for devaluation of a currency to lead to inflation as raw materials cost more. It should be noted, however, that the value of a freely convertible currency is determined by other factors besides trade. Short-term investment flows, driven by interest rates or concerns over safety and other factors, are many times larger than trade and longterm investment flows. Thus currency levels do not necessarily follow trade balances even over fairly long periods of time. The currency in which the price of a product or service is quoted can have a great effect upon company performance in a foreign market. Exchange rate changes between the time of the price quotation in foreign currencies and receipt of funds can also affect profitability in the short run unless some form of hedging is undertaken. In the first half of 2010, McDonald’s hamburgers profits rose in Europe (in euros), but showed as a decline when converted into dollars in the financial reports of the company’s US headquarters. The weaker euro, as compared to the dollar, accounted for the difference. If avoidance of any foreign exchange risks were critical then exporters would prefer to receive their own currency and importers would prefer to pay with their currency. If, however, either party had to accept the other’s (or a third country’s) currency it could protect itself against exchange loss by entering the forward exchange market and hedge its open position. Hedging In July of 2007, Sony was concerned about the possible effects on its profits if the yen were to appreciate substantially. The company had owed about 40% of its net profits the previous quarter to the weaker-than-expected yen, with the result that the inflow of dollars from its overseas operations was worth more in its home currency (yen). However, in the weeks before the end of July the yen had appreciated sharply against the dollar. Worried that this would impact its profits during a period of economic problems for the company, Sony had entered the forward exchange market to hedge 80% of expected incoming dollar funds against the risk of an overvalued yen for the next quarter. Of course, if the yen were to drop in value rather than rise, Sony would miss a windfall profit. The company had not hedged for the quarter following the next since it felt that its other economic problems would be solved by then (Pilling, 2007). It should be noted that it is also possible to assure in advance that certain inputs can be obtained at set price. This is done by purchasing options to buy the required amounts of needed commodities at set prices at set times or within set time frames, often far in the future. Some airlines have been doing this for jet fuel for a long time. In the third quarter of 2005, Southwest Airlines saved $87 million in fuel costs because of its hedging. It had also made deals to purchase more than half its fuel needs through 2007 at prices that turned out to be far below market prices during the period. A number of other airlines also hedged varying amounts of their expected future fuel needs (San Francisco Chronicle, 2005). 514 The price quotation In 2009, EasyJet lost half of its profits after the company had hedged its jet fuel prices at a higher level than what the spot market turned out to be (O’Doherty, 2009). Three other large US airlines lost money on their hedges by paying more for jet fuel prices than they would have paid on the spot market (Baer, 2009). With options rather than straight futures contracts, they would not have needed to exercise the options if fuel prices had dropped rather than risen. But they still would have been out by the cost of purchasing the options. Not all companies believe that hedging is a good practice, even though a company can lose money in the short run. The reason why companies such as Exxon, Kodak, and 3M do little, if any, hedging is that currency fluctuations can help profits as often as they hurt them. Large companies can usually ride out negative currency moves without having to cut back on plans. In addition, hedging can be costly (Businessweek, 1998). Another way to lessen risk is to extend credit for a shorter period of time, if credit has been extended. This limits the extent of risk. It cannot be said categorically which currency is best under all conditions. It should be noted, however, that if necessary, price can be used to an extent to compensate for potential exchange losses. This is one situation where a price escalation provision may be used. The price quotation A third phase of export pricing should be based upon some examination of the elements included in the price quotation. Such a determination should be made by the exporter in conjunction with the customer abroad. Export prices are quoted in various ways. The two major systems available for use in quoting prices are known as trade terms. The use of such terms as FOB, FAS, C&F, and CIF (see pages discussed below) is important with regard to specifying not only where the exporter’s responsibility and liability end (and the buyer’s responsibility and liability begin), but they determine the costs that the exporter will bear. Thus it is customary in the calculation of a price quotation to add the appropriate costs to the basic price. There are two systems of definition that are used by exporters throughout the world – INCOTERMS 2010 (developed by the International Chamber of Commerce) and Revised American Foreign Trade Definitions – 1941 (originally developed by the Chamber of Commerce of the United States and two other trade organizations). Trade term definitions generally have no status at law unless there is specific legislation providing for them, or unless they are confirmed by court decisions. If sellers and buyers agree to their acceptance as part of the contract of sale, the definitions become legally binding on the parties to the sale. In Europe, while the application of INCOTERMS 2010 is voluntary, courts and arbitration bodies tend to apply them even if not explicitly stipulated. INCOTERMS 2010 is the eighth (and latest) revision of INCOTERMS since they were first issued in 1936. The latest changes reflect the increased number of free trade zones, the increased use of electronic communications, greater concerns about security, and other developments in trade since the previous 2000 version. 515 Chapter 11 Pricing decisions Comparison of terms The Revised American Foreign Trade Definitions – 1941 and INCOTERMS 2010 are shown in Table 11.4. As a means of comparing the different sets of terms as well as the different terms within a set, Figure 11.2 shows for each term the point at which the exporter’s liability, costs, and responsibilities cease. Although the detail is beyond the scope of this book, below we present a brief description of the major general trade terms. More detailed information about INCOTERMS and the American Foreign Trade Definitions may be obtained from the International Chamber of Commerce, Paris, France, 38 Cours Albert 1 er, 75008 Paris, France, and Chambers of Commerce in the United States and other nations. Foreign Freight Forwarders and Customs House Brokers can also provide information about terms and conditions as well as information about costs involved. The exporter and importer, however, need to have a basic understanding of what the terms mean and the rights and responsibilities of the parties under the terms agreed upon. Other terms are for any mode of transport (sea, inland waterway, road, air, rail, etc.) 1. Ex (point of origin). This term is referred to as ex factory, ex mill, ex mine, ex works, ex warehouse, and so on (point of origin). The seller’s responsibility and costs end at this point in his home country. 2. Free on board (FOB). In general, FOB means free on board a transportation carrier at some named point. There are a wide range of FOB terms, all but one of which specify a named point in the country of exportation. The comparable INCOTERM designation is FCA (free carrier) and is used for rail or air transport. The seller’s responsibility and cost end in most cases when the goods are loaded on the appropriate carrier and a clean bill of lading has been issued. A clean shipping document bill of lading is one that bears Table 11.4 Comparison of trade terms INCOTERMS 2010 Revised American Foreign Trade Definitions – 1941 EXW (ex works) Ex (point of origin) or ex mill FCA (free carrier), named place FOB (named inland carrier) Free on board at named point of departure FOB (named inland carrier – freight prepaid) FOB (named inland carrier – freight allowed) FOB (named inland carrier at named point of exportation) FAS* FAS (Free alongside) vessel FOB* FOB vessel CFR (Cost and freight)* C&F (Cost and freight) CIF* CIF (Cost, insurance and freight) CPT (Carriage paid to) CIP (Carriage and insurance paid to) DAT (Delivered at Terminal) DAP (Delivered at Place) Ex dock DDP (Delivered duty paid) FOB (named inland point in country of importation) *Sea and inland waterway transport only. 516 1. FOB named inland carrier, LC & R (use collect B/L) 2. FOB inland carrier ft prepaid, L & R but seller pays C to destination 3. FOB named inland carrier ft allowed, L & R but seller pays C, since buyer deducts it from invoice (use collect B/L) FOB vessel, LCR ex mill, LC & R Revised American Foreign Trade Definitions, 1941 RR in port city INCOTERMS 2010 CIF, L & R C & F, L & R FOB named point of exportation LC & R ex works LC & R FCA, LC & R C & F, CIF, C FAS vessel, LC & R FAS, LC & R (goods on dock within reach of ships tackle) both get received for shipment B/L FOB named inland point in country of importation, LC & R ex dock LC & R FOB vessel, LC & R seller has rights to payment once the goods are over the railing CIF/CIP, L & R CFR/CPT, L & R but seller pays C of shipment across the sea FOB, CFR and CIF require clean on board B/L LC & R DAP delivered at place LC & R DAT delivered at terminal LC & R Figure 11.2 Point of expiration of exporter’s liability, costs, and responsibilities 517 The price quotation L = Liability of exporter: legal. C = Cost of exporter. R = Responsibility of exporter: what he or she must do; obtain marine insurance, proper documentation and licenses, certificate of origin, consular invoice, etc. Chapter 11 Pricing decisions no superimposed clause or notation that expressly declares a defective condition of the goods and/or the packaging. The one exception to this is when the named point is inland in the country of importation. In this case the seller is responsible until the goods arrive on a carrier at the appropriate place in the overseas market. For INCOTERMS this would involve use of DDU or DDP. 3. Free alongside (FAS). Under this term the seller must provide for delivery of the goods free alongside, but not on board, the transportation carrier (usually an ocean vessel) at the port of shipment and export. Thus this term differs from that of FOB since the time and cost of loading are not included in the FAS term. 4. Cost and freight (C&F). The C&F (or CFR, CPT) term means that delivery costs are extended beyond the country of export. Although the seller’s liability ends when the goods are loaded on board a carrier or are in the custody of the carrier at the port of exportation, she is responsible for providing and paying for transportation to the overseas port of discharge. However, the buyer must still provide for the necessary insurance. 5. Cost, insurance, and freight (CIF). This trade term is identical to C&F except that the seller must also provide the necessary insurance. 6. Ex dock. The ex dock (and DAT, DAP) term goes one step beyond CIF and requires the seller to be responsible for the cost of the goods and all other costs necessary to place the goods on the dock at the named overseas port, with the appropriate import duty paid. Selection of trade terms In deciding when to use each term, exporters should consider the following factors: ● Whether shipment will be made on domestic or foreign carriers. ● Availability of insurance coverage. ● Availability of information on costs. ● Exporter’s need for cash (reason against C&F and CFR/CPT). ● Needs of importers to have quotes from several suppliers that can be readily compared (reason for CIF and CIP). ● Currency convertibility problems. FOB vessel is often desirable so that the buyer pays freight in his own currency. Of course, the carrier still has the convertibility problem, unless it is from the buyer’s country. ● Requirements of the government of the importing nation. For example, some developing nations require FOB point of exportation as a condition for receiving an import license. This allows them to foster their own developing merchant marine and insurance companies since the importer has the responsibility to arrange for insurance and transportation, and he may find it convenient (or required) to use certain facilities. Many importers request CIF (or CIP) terms so that they may compare alternative prices, and then they place the order in FOB point of exportation terms. Price quotations can be a meaningful part of export marketing strategy. Ideally, the price quote should be in a form that customers find suitable, and at least as convenient for the customer as those offered by competitors. Often this requires a CIF or CIP quote since it is the only quote (among those commonly used) that permits the buyer to compare prices easily from alternatively located suppliers. 518 The price quotation CIF quotations Only one of these quotations represents any considerable difficulty in reaching an accurate figure: CIF. This is one of the most commonly used quotations in export trade. It indicates that the terms of the quotation include the cost of the merchandise delivered on board the vessel, plus the cost of the insurance to destination, plus the freight charges to the named destination. A CIF quotation indicates that no other charges will accrue to the account of the buyer before the shipment arrives at the port of destination. The reason that the CIF quotation is more difficult to figure accurately is that it is customary in the export business to add a fixed percentage, usually 10%, to the insured value to take care of extra expenses and losses not covered by the simple CIF value. Therefore the insured CIF value is the sum of the cost, the freight to destination, and the insurance premium on 110% of the CIF value. Inasmuch as the premium is figured on the entire CIF value, the difficulty presents itself in figuring the I. There are two methods of ascertaining insured value when the total C&F value has been determined in a CIF calculation. A widely practiced method is the approximation or estimate method. The other is the formula method. The estimate method The exporter employing the estimate method simply adds 10% (or some other percentage) to the C&F value. Then, if the insurance rate is X%, he takes X% of the C&F value and adds it to the 10%. The resulting amount is then added to the C&F value. The formula method The most accurate method of computing a CIF quotation involves the use of a formula. The formula, which in this case is used for calculating the CIF price when 10% is added to the C&F value, is as follows: CIF = C&F N(1 - 0.011 R) where C F N R = FAS value = total freight charges = total weight to be shipped (or other unit of measure, e.g., volume, pieces) = insurance rate (per $100). To obtain the insured value the following formula is applied (assuming a 10% addition): Insured value = 110(C&F) 100 - 1.1 R There is no reason that only 10% should be added for insurance purposes, except that this is the general custom. Many firms add 15%, in which case 15% may be substituted in the above formula for 10%. As a matter of fact, any percentage that the exporter decides upon may be added and the formula changed accordingly. An example of a CIF calculation is shown in Exhibit 11.10. 519 Chapter 11 Pricing decisions Exhibit 11.10 CIF calculation An apple packer located in the Okanagan valley in British Columbia, Canada, received an inquiry from a potential buyer in France for 4,000 boxes of apples, five-tier, 175/215s, combination of extrafancy and fancy. The request asked for a firm price, CIF, Le Havre, France. The apple packer proceeds by examining relevant costs (in Canadian currency) as follows: $ Current price FOB, Penticton 7.50 per box Rail freight to Vancouver 1.00 per box Wharfage and handling 0.25 per box Ocean freight (Vancouver to Le Havre) 4.80 per box Marine insurance (coverage of cargo in refrigerated space) 0.20 per $100.00 French consular invoice fee 10.00 per invoice To determine the CIF price, the packer wants to insure the shipment for a value that is the CIF price plus 10%. The formula for calculating the CIF price is as follows: CIF = C&F N(1 - 0.011 R) where C = FAS value, determined as $ FOB = 30,000.00 Rail freight = 4,000.00 Wharfage, etc. = 1,000.00 Consular fee = 10.00 FAS = 35,010.00 F = ocean freight = 19,200.00 R = insurance rate = 0.20 (per $100) N = total number of boxes = 4,000 Now, we determine the CIF, Le Havre price per box to be: CIF = 35,010.00 + 19,200.00 4,000(1 - 0.011 * 0.20) = $13.58 per box Computation of ocean freight In general, ocean freight is calculated either on the weight or on the measurement of the shipment, carrier’s option. The standard unit is the long ton, which weighs 2,240 lb and measures 40 cubic feet. In quoting a price, care should be taken to distinguish between terms that seem to be the same but may be different. For example, the ton may be a short ton 520 Transfer pricing (2,000 lb), a long ton (2,240 lb), or a metric ton (2,204.62 lb); a gallon may be a US gallon or an imperial gallon, which is five US quarts. A British hundredweight is equal to 112 lb US weight. Transfer pricing Prices must be set not only on products sold to independent customers, but also on products transferred to foreign subsidiaries or transferred to foreign operations in which the seller has part ownership. For our purposes, prices to wholly or partially owned operations are defined as transfer prices. The problem of establishing international transfer pricing policies is in a broad sense essentially the same as the problem of establishing domestic transfer pricing policies. However, upon close examination it can be observed that not only are the details of international transfer pricing more complex than domestic transfer pricing, but additional factors influence the decision-making process. Decentralization and profit centers At the outset it must be made clear that the need for transfer pricing arises only when a company decentralizes managerial authority and responsibility, making each unit responsible for operating profitably. The reasons for such decentralization may be both legal and managerial. Laws relating to corporate organization, taxation, and other matters may make it desirable for certain units or divisions of a company to be incorporated separately. Under such conditions the financial records of the unit must be kept in such a way that the company appears to operate as a profit center, if for no other reason than to satisfy foreign and domestic tax authorities. Indeed, transfer pricing has been viewed by many primarily as a means for controlling divisional performances and coordinating cash and income flows from foreign subsidiaries. However, there is strong evidence that transfer pricing, including export transfer pricing, can be used for marketing decisions. Transfer pricing has great potential for helping marketing managers achieve strategic objectives in changing international environments. Transfer pricing to wholly owned foreign subsidiaries For a company with wholly owned foreign subsidiaries such factors as distance, expense of communicating, and decentralization of authority to the local level complicate the process of setting export transfer prices. Also, a complex set of taxes, tariffs, and governmental regulations affect the decision. Since competitive and market conditions vary from country to country, it is difficult to develop a policy that can be applied uniformly. In the case where 100% ownership is held, a company has complete freedom to decide who will control the establishment of transfer prices, for example company management, the selling units, competitors (by the market price), the buying unit, or some combination. The determination of who should set the transfer price, and the method to be used, depends in part on the needs of the company for cost and profit information. Typically this information is used for such decisions as whether to ‘make or buy,’ determining the price of the end product, deciding whether to add or drop products, and determining the budget for capital expenditure. 521 Chapter 11 Pricing decisions The problem of transfer pricing has two dimensions: (1) how (by what method) should transfer prices be set, and (2) who should establish transfer pricing policies and set specific transfer prices? These questions are interrelated, since whoever sets the price will have some influence on deciding which factors to consider and the relative weight to give each factor. How should transfer prices be set? A number of methods of setting transfer prices have been tried and tested by companies of various sizes and product lines. Out of this experience have come a number of guidelines. Nevertheless, as yet, there is no general agreement as to which method of setting transfer prices has the most merit. No one method is best for all circumstances since the ‘best’ method for a company depends on the characteristics of the company and the purpose of the transfer price. The factors that influence transfer prices fall into three general categories: 1. competitive market prices, including competitor’s list prices or bids; 2. costs, including production costs, physical distribution costs, foreign and domestic tariffs, and corporate income taxes; 3. legal restrictions, including political policies, governmental controls, and foreign laws against practices such as price discrimination and dumping. If the purpose of transfer pricing is to provide profitability data, then it is necessary that an accurate profitability figure be obtained. Such decisions must be made on the basis of alternative rates of return on investment, in the short run as well as in the long run; opportunity costs also must be considered. Thus it may seem desirable to base the transfer price on the competitive market price, or the best estimate of a market price, and to require the purchasing unit to buy internally. Under this policy, if the selling unit has unduly high costs, its profits will suffer, and the divisional manager will soon have to correct the situation or face corporate management with a poor profit record. If the purpose of the transfer price is to assist management in setting the cost floor for prices of the end product, or if the purpose is to shift profits to the foreign operation, the use of costs is desirable as a means of determining the transfer price. There are different relevant cost concepts to consider. In the short run, marginal costs may be the relevant minimum, since any amount over such costs would result in a direct contribution to net profit. In the long run, full costs or standard costs may be closer to the ideal minimum that will help management to determine whether or not the resources of the corporation are being used to maximize profits, and if not, how to correct the situation. The views of foreign Customs officials (for purposes of valuation of goods and assessment of duties) are also important. To minimize Customs duties, it is often desirable to set the price as close to cost as possible. However, some countries require that the Customs duty valuation be the ‘fair market value,’ or some concept of value related to the market price of the item in the country of exportation. Domestic and foreign tax regulations and enforcement of those regulations also influence whether or not cost can be used as the basis for prices. Tax rates vary from country to country. When the home country corporate income tax is higher than the tax rate in the country in which the subsidiary is located, the recommended procedure is to set transfer 522 Transfer pricing Exhibit 11.11 Legal problems in transfer pricing A number of countries have become increasingly concerned about losses in tax revenues caused by the transfer pricing policies of subsidiaries of foreign companies. It is possible for international companies to shift profits from their wholly owned foreign subsidiaries to their home countries by inflating the prices of parts, services, or intellectual property supplied from the home country, and/or by charging below market prices on products sold to subsidiaries in third countries with lower taxes. In 2004, Nissan paid 37 million pounds to the UK tax authority to settle a tax dispute over shifting profits out of the country. Nissan’s factory in the United Kingdom had been rated as having the highest productivity of any automobile plant in Europe, but had not shown a profit in several years of operation. Honda was also under investigation over alleged selling of UK-made motorcycles to its Brazilian subsidiary at artificially low prices (Mackintosh, 2004). In the United States, GlaxoSmithKline paid $3.4 billion in 2006 to the IRS to settle a case of allegedly inflating prices the American unit paid to its British parent (Matthews and Whalen, 2006). Merck & Co. paid $2.3 billion to the United States to settle a dispute related to payments made for the use of patents that had been transferred to a Bermuda-based subsidiary. Merck was also in a tax dispute with Canadian tax authorities. The IRS also had victories in disputes over the use of tax shelters by General Electric Co., Black and Decker Corporation, and Coltec Industries Inc. (Drucker, 2007). prices as close to costs as permissible. Income tax authorities, however, may object to using taxes as a criterion for setting transfer prices. Legal problems can arise because of transfer prices used (see Exhibit 11.11). Cost-plus transfer pricing has disadvantages beyond not being able to set a price that assures maximized profits, if that is the objective. Prices set in this way may not provide sufficient incentive for the producing unit to reduce costs to the absolute minimum. However, standard costs may be satisfactory as a basis for cost-plus transfer prices if the standards are proper. A transfer pricing method that uses both costs and competitive market prices may permit the accomplishment of desired objectives without incurring the disadvantages of either method when it is used alone. For example, a system might be set up whereby the transfer price is set at cost, but the selling unit is credited with a certain percentage of the net profit that results from any further processing and the ultimate sale. Such a system could be used to minimize taxes and tariffs and at the same time generate profitability data. It is desirable that some degree of flexibility in the process of formulating transfer prices be maintained. If flexibility is to be maintained, and if the interests of the buying and selling units as well as the corporate entity are to be considered, a system of negotiation or bargaining is required. Negotiation also has some disadvantages. Discussions can be long and tedious and they may erupt into unharmonious interdivisional squabbles. Even though the negotiations and agreements must be reviewed periodically, the amount of time spent in negotiation can be kept within acceptable limits. Perhaps the greatest disadvantage of negotiation, on the other hand, is the occurrence of disputes. If the dispute is resolved on the basis of strength of personality or power position within the company, healthy, cooperative intracompany relations may be destroyed. If transfer prices are imposed on managers, this may also hamper morale and the profit incentive. 523 Chapter 11 Pricing decisions The desirability of each type of transfer pricing system is related to the characteristics of a company and the products it sells. A relatively small company with only a few foreign operating units, staffed by managers who are well acquainted with each other, can often operate on a somewhat more flexible basis than a large company. The size of the company is also related to the number and types of products in the company’s product mix. Since the transfer price of different products should sometimes be set by different methods, the situation faced by large companies is complex. Generally, most authorities on transfer pricing feel that if profitability data from profit centers are used to accomplish management purposes, the pricing policy must be aimed at setting ‘competitive’ transfer prices. Another reason for using competitive transfer prices is that tax laws are often written to prevent the arbitrary shifting of income among taxable units of companies in order to evade taxes. A key test seems to be whether a transfer price is reasonable rather than arbitrary. One of the strongest pieces of evidence that a price is fair and reasonable is that the price is not only at the market value, but that it was established by dealing at ‘arm’s length.’ The arm’s length requirement is also a strong argument in favor of permitting the price to be set by bargaining between the selling and buying units, with the buying unit free to buy outside if it desires. Since competitive prices may differ from market to market, a company that bases transfer prices on competitive conditions in each market may have to set a different price for each market. Not only would such a pricing schedule be complex and costly to administer, but disagreements may arise among company units. Moreover, tariff authorities may object if they feel that valuation should be based on the price in the seller’s home market. Last, but certainly not least, foreign and domestic income tax authorities may object if they feel that differential transfer prices may operate to shift profits from one nation to another and thereby affect taxable income. The so-called business purpose test requires that there be a demonstrable managerial purpose for the adoption of a particular method of transfer pricing. Where different but equally satisfactory methods of transfer pricing are available, a business firm is not precluded from choosing the method that is to its advantage tax-wise. However, in general, the business purpose must be paramount. Thus it seems that transfer pricing methods would be acceptable to governments if the method meets either the arm’s length or the business purpose test and is not for the purpose of avoiding payment of taxes. Who should set transfer prices? The power to set the transfer price can be retained by company management or delegated to the selling or buying unit. A compromise may be to permit the selling unit to set the price, but to permit the buying unit to buy outside if it desires. Or, management may prefer that the buying and selling divisions negotiate the transfer price. When this is the policy, corporate management enters into the negotiations only if a dispute arises. Transfer pricing to partially owned foreign enterprises It is relatively common for companies to have only a part interest in a foreign operation in partnership with either a foreign concern or with another firm domiciled in the same home country. When only a partial interest is held, or in the case of a joint venture, the seller cannot dictate prices to the same degree as if it were an internal transfer. The independent nature of the buyer requires that the price be set so as to take account of the interests of the other owners or partners in the venture. 524 Summary Setting transfer prices to foreign operations that are not wholly owned involves some considerations in addition to those that are relevant for pricing to wholly owned subsidiaries. There is little reason to set the transfer price as close to cost as possible since the ‘shifting’ of profits abroad would mean that the foreign partner would share in them. Likewise, it would not be reasonable for transfers to be made at prices higher than the competitive market price. In fact, there may be pressures on the part of the foreign partner to reduce the transfer price below the ‘outside’ price. The transfer pricing process under such circumstances is similar to the process of pricing to third parties. The normal practice is likely to be arm’s length negotiation, with the buyer having the freedom to buy outside. However, if a joint venture has been formed for some special purpose, perhaps to produce an item not available elsewhere, the transfer price may be set on the basis of factors in addition to those already discussed. For example, suppose a joint venture is entered into by two noncompeting German firms to produce abroad a component that both of them need in their foreign products. Equal amounts of capital funds for the establishment of the foreign plant may be contributed by both parties. Thus, any profit that the firm would earn would be either paid out equally to the two stockholders or retained in the business. As long as each partner also takes exactly 50% of the output of the joint venture, both firms are benefiting equally from it. Under such conditions, in order to minimize income taxes on any profits that the joint venture might earn, it may be well to operate the plant on a break-even basis. Prices charged to its two customers by the joint venture might be set just high enough to cover costs. But, if one of the partners takes a disproportionate share of the output of the joint venture, one partner will benefit more from the joint venture than the other partner. If the joint venture’s product requires components that are produced by one of the partners, the situation is even more complex. Generally, under this circumstance, the partner selling the component to the joint venture would want to set a high price for it. The other partner would desire a low price. Summary This chapter has examined pricing for export. The major issues covered include the determinants of price, pricing objectives, pricing strategy, how foreign prices are related to domestic prices, the elements of the price quotation, and transfer pricing. Although export pricing issues are in many ways similar to domestic price considerations, there are elements that are unique to export marketing. The issues facing an exporter become more complex when a number of often quite diverse export markets are to be served. In the future, export pricing is likely to gain rather than lose importance. As most markets reach saturation, companies will find it increasingly difficult to achieve higher sales without actively using pricing as a competitive tool. At the same time, communication technologies such as the Internet lead to more transparency, rendering it more difficult for firms to establish and maintain price differentials across markets. Disappearing retail price maintenance and shortening product life cycles add pressure for more sophisticated pricing practices to achieve quicker payback times. Finally, trade liberalization and growing economic integration render traditional market-per-market pricing obsolete and require improved pricing strategies. 525 Chapter 11 Pricing decisions Questions for discussion 11.1 What is the meaning of the ‘anatomy of a price’ as it refers to an export price? 11.2 Explain why export prices should or should not be established using the same methods and according to the same criteria as prices set in the domestic market. 11.3 Discuss the relationship between objective and strategy in pricing. 11.4 What alternative pricing strategies are available to the exporter and what objective(s) does each seek to achieve? Is any one more desirable than the others? Explain. 11.5 Can a small exporter use experience-curve pricing? If so, how? If not, why not? 11.6 Under what conditions might an exporter establish a policy of differential pricing for foreign markets? 11.7 ‘Since all trade terms are basically the same, there is no need for using them in export sales contracts.’ Discuss. 11.8 Under what conditions might an exporter prefer to use INCOTERMS for a price quotation and under what conditions might this exporter prefer to use Revised American Foreign Trade Definitions – 1941? Does an exporter always have the choice of which trade term schema to use? 11.9 What factors must the exporter consider when making a decision on price quotation? 11.10 From the perspective of the ‘parent’ company, is it better to use a low export transfer price or a high price? What effect does extent of ownership of the importing unit have on your answer? Explain fully. 11.11 How does the nature of the product involved affect what might be a desirable transfer pricing policy? 11.12 Discuss what you consider to be the ideal approach for establishing an export transfer price. 11.13 Explain when the export firm should no longer be concerned about the pricing of its products. References Atkins, R. (2010). Currency slide lifts eurozone output. Financial Times, April 23, 3. Baer, J. (2009). Airlines stung by jet fuel hedges. Financial Times, January 3, 17. Bandler, J. (2004). As Kodak eyes digital future, a big partner starts to fade. The Wall Street Journal, 23 January, A1, A8. Bergstein, B. (2007). Software takes on a new job: setting retail prices. San Francisco Chronicle, 30 April, C6. Berner, R. (2002). Why P&G’s smile is so bright. Businessweek, 12 August, 58–60. Businessweek (1998). Perils of the hedge highwire. 26 October, 74ff. Businessweek (2000). The end of a free ride for carmakers? 26 June, 70. Byrnes, N. (2007). Home is where the airport is. Businessweek, 20 & 27 August, 89–91. Byrnes, N. (2010). The Sheriffs of Marlboro Country. Bloomberg Businessweek, April 19, 50–4. Chaffin, J. (2009). EU struggles for support to extend shoe import duties. Financial Times, November 19, 6. 526 References Costco (2009). Costco to accept food stamps. San Francisco Chronicle, October 29, C3. Dolan, R. J. (1995). How do you know when the price is right? Harvard Business Review, September– October, 174–83. Drucker, J. (2007). Merck to pay $2.3 billion in tax case. The Wall Street Journal, 15 February, A4. Emert, C. (2004). For California wine exports, it was a very good year. San Francisco Chronicle, 27 April, A1, A10. Gapper, J. (2007). A bid to reprint the pricing rule book. Financial Times, 21 May, 11. Garnham, P. (2010). Haven demand powers dollar. Financial Times, February 6–7, 15. Geitner, P. (2004). EU, Philip Morris near deal on smuggling. San Francisco Chronicle, 6 April, C3. International Chamber of Commerce (2000). INCOTERMS 2000. Paris: ICC. Johnson, S. (2010). Forex market revives but as a different animal. Financial Times Special Report, April 12, 4. Johnson, T. E. (1994). Export/Import Procedures and Documentation, 2nd edn. New York: AMACOM. Katz, R. (2003). Too rich for their own good? The Oriental Economist, May, 3–4. Keenan, F. (2003). The price is really right. Businessweek, 31 March, 62–7. Kurasawa, H. (2007). Toyota rolls out new Tundra in Texas. The Nikkei Weekly, 25 December 2006 and 1 January 2007, 12. Lapper, R. (2010). Banks find potential in mobile phone growth. Financial Times, June 4, 6. Mackintosh, J. (2004). Nissan pays £37m to settle UK tax dispute. Financial Times, 11 November, 24. Matthews, R. G. and Whalen, J. (2006). Glaxo will settle a US tax case for $3.4 billion. The Wall Street Journal, 12 September, A1. Mercado, S., Welford, R. and Prescott, K. (2001). European Business, 4th edn. Upper Saddle River, NJ: Prentice Hall. Money Morning (2014). Currencies in 2015: How Far Will the Yen and Euro Fall? 22 December 9. O’Doherty, J. (2009). EasyJet profits halved after wrong bet on oil. Financial Times, November 18, 18. Pilling, D. (2007). Sony admits profit vulnerability to sharp appreciation of the yen. Financial Times, 30 July, 13. Samli, A. C. and Jacobs, L. (1994). Pricing practices of American multinational firms: standardization vs. localization dichotomy. Journal of Global Marketing, 8(2), 51–74. San Francisco Chronicle (2005). Southwest Alaska profit from hedging. 21 October, C3. San Francisco Chronicle (2007). Examples of software helping to ensure that the price is right. 30 April, C6. Sinha, I. (2000). Cost transparency: the Net’s real threat to prices and brands. Harvard Business Review. March–April, 43–50. Tanaka, Y. (2003). Red ink sparks McDonald’s shuffle. The Nikkei Weekly, 10 March, 2. Terpstra, V. (1988). International Dimensions of Marketing, 2nd edn. Boston, MA: PWS-Kent. The Economist (Economic focus) (2010). Worth a hill of soyabeans. January 9, 77. The Japan Times (2003). US ruling says that exporters dumping catfish, chips. 19 June, 13. The Nikkei Weekly (2007). Sharp rise in yen threatens expected profit growth. 20 August, 1, 4. Tierney, C. (2007). A big plunge for General Motors. San Francisco Chronicle, 4 July, C3. Wallis, W. and Burgis, T. (2010). Attitudes change to business in region. Financial Times, June 4, 6. 527 Chapter 11 Pricing decisions Whipp, L. and Garnham, P. (2009). Yen soars despite Japan’s troubles. Financial Times. January 24–25, 15. White, J. (2004). Prices rise on European cars. The Wall Street Journal, 18 March, D1, D4. WuDunn, S. (1995). Cost of Jeep driven skywards when it leaves US shores. Sydney Herald, 18 May. Further reading Czinkota, M. R., Ronkainen, I. A. and Tarrant, J. J. (1995). The Global Marketing Imperative. Lincolnwood, IL: NTC Business Books, Chs 8–9. Gaul, W. and Lutz, U. (1994). Pricing in international marketing and western European economy. Management International Review, 34(2), 101–14. Raymond, M. A., Turner, J. F. Jr. and Kim, J. (2001). Cost complexity of pricing decisions for exporters in developing and emerging markets. Journal of International Marketing, 9(3), 19–40. Sousa, C. M. P. and Bradley, F. (2009). Price adaptation in export markets. European Journal of Marketing, 43(34), 438–58. Theodosiou, M. and Katsikeas, C. S. (2001). Factors influencing the degree of international pricing strategy standardization of multinational corporations. Journal of International Marketing, 9(3), 1–18. CASE STUDY 11.1 RAP Engineering and Equipment Company This company, located in Seattle, Washington, in the United States, is a distributor of engineering equipment and machine tools. The company receives an order from the Matens Company in Portugal for ten light earth-moving machines. Since the company does not normally carry this number in stock, the export manager, Mr Green, places an option on ten machines with the CPPC Manufacturing Company in Akron, Ohio, and requests a firm price quotation to be held in force for 90 days. The CPPC Company agrees to this and quotes a price of US$4500 ex warehouse, Akron, Ohio, for each machine. Mr Green checks with his traffic manager and is told that railroad freight from Akron to Seattle for these machines will average approximately US$750 per machine. Other costs are as follows: US$ Trucking and handling Export packing Shipping to pier Wharfage and handling Heavy lift charges: (applicable to items weighing over 5000 lb) Ocean freight: Seattle to Lisbon 5.00 per short ton 70.00 per machine 4.20 per short ton 3.30 per 40 cubic feet (cf) 17.00 per 2000 lb 142.50 per 2000 lb or 40 cubic feet, weight/measure Marine insurance: 528 shipped under deck 1.70 per $100 shipped above deck 2.50 per $100 ➨ Case study 11.2 US$ Portugal consular invoice fee 20.00 per invoice Seattle Engineering & Equipment Company markup 20% of machine cost Weights and measurements 10 crates containing chassis, each 6400 lb, 180 cf 10 boxes containing rails, chains, and parts, each 6000 lb, 50 cf 10 bundles containing wheels and tires, each 240 lb, 20 cf Questions 1. Calculate the C&F Lisbon price per machine and the CIF Lisbon price per machine. 2. At what point in time, or place, will RAP’s responsibilities for arrangements of the shipment end? When does RAP’s legal liability end and when does it acquire the right to payment? 3. How would your answer to question 2 change if the terms of sale were FOB vessel (FOB) or ex dock (DEQ)? CASE STUDY 11.2 The Capitool Company (This is an abridged version of a Capitool case study, originally written by Gordon E. Miracle, Michigan State University. All monetary figures have been adjusted to disguise the actual values. For the most part, the relationships between numbers were maintained.) The Capitool Company, with headquarters and main manufacturing plant in Racine, Wisconsin, in the United States, produces a line of capital equipment for use in a variety of industries, especially for automobiles, trucks, farm equipment, and construction equipment. The company was founded over 70 years ago, with sales (turnover) growing slowly to about US$60 million by the end of World War II, and since then more rapidly to more than US$3.5 billion at present. After-tax profits have grown correspondingly, usually amounting to about 3–4% of turnover. Capitool has been a leader in offering an advanced line of products. Heavy research and product development expenditures coupled with customer orientation have enabled the company to achieve a dominant position in the US market. In order to continue to grow rapidly and profitably Capitool decided in the mid-1950s to move into foreign markets. The company had exported a number of products for many years, but increasing foreign demand made it not only feasible, but desirable, to establish manufacturing facilities abroad. Within a 10-year period Capitool had wholly owned manufacturing plants in New Zealand, England, and Germany; joint ventures in Germany and Italy; and licensees in England, Argentina, and Turkey. In addition to manufacturing facilities, Capitool has sales branches in England, Argentina, and Turkey to handle the marketing of the products of licensees in those countries. Since the licensees take only a part of their output of the licensed products for use in their own end products, the remainder is marketed to third parties by the Capitool sales branches. In areas of the world not served by Capitool manufacturing or licensing affiliates, Capitool Exports Ltd, a wholly owned subsidiary incorporated in Bermuda, functions as an ‘offshore’ trading company. Capitool Exports Ltd has 20 regional offices located strategically to serve about 100 independent distributors who act as sales and service outlets in more than 100 countries. The German subsidiary company The Capitool Company GmbH, a wholly owned manufacturing subsidiary in Germany, is responsible for the operation of two factories, one in Duisburg and one in Düsseldorf. The Düsseldorf plant manufactures components for various items of capital equipment, and has customers throughout Europe. Sales are concentrated in Germany, with a large proportion going to a joint venture with a 529 ➨ Chapter 11 Pricing decisions large US automobile manufacturer; the joint venture is incorporated under the name Genforsler-Capitool GmbH. The Duisburg plant manufactures a piece of equipment that is a mainstay in the Capitool line in the United States and worldwide. The prices of this piece of equipment range from US$90 to US$700, depending on the size and performance characteristics of the item. The Duisburg plant and three major German competitors account for over 95% of sales of the piece of equipment in Germany. The fact that the Duisburg and Düsseldorf plants are part of the same company permits a ‘tax loss carry forward’ from the Duisburg plant to be used to minimize the total German tax obligation. By itself, the Düsseldorf plant is quite profitable. Recently the Duisburg plant has also become profitable. The ‘tax loss carry forward’ is expected to be depleted within the next three or four years. The total Capitool investment in the Duisburg plant since the mid-1950s has been US$10,500,000. The plant has an area exceeding 221,000 square feet and employs over 1100 people currently. Capacity to produce exceeds demand by about 20%. Within three years demand is expected to exceed capacity, and expansion will be required. The output of the Duisburg plant is sold throughout the European continent, England, Canada, and Mexico. Annual sales of the Duisburg plant exceed US$10 million. Although the Duisburg plant is a manufacturing operation, only 35% of the contents of the product are actually manufactured at the Duisburg plant or in Düsseldorf. Local German suppliers furnish about 30% of the finished components, and the remaining 35% are imported from one of Capitool’s divisions in the United States. Components are purchased from the United States when one or more of the following conditions apply to a specific component: ● technically adequate manufactured components are not available in Germany; ● the total of the US transfer price (as defined below) plus freight, insurance, and duty is less than the purchase price in Germany; ● delivery from the United States is faster than from the German supplier, and the need warrants use of the fastest source. Transfer pricing policies Corporate policy on transfer pricing is as follows: ● 530 If there is a market price for the item, the basis for establishing the transfer price will be the market price. ● If the product is available elsewhere but there is no market price, the basis is negotiation between the selling and buying division. Negotiation is guided by (a) costs, and (b) outside competitive bids, if realistic bids are available. If not available, an estimate of a realistic outside quote is made. ● If the product is not available elsewhere, that is, if it is a unique part which is made only by Capitool, the basis for establishing the transfer price is negotiation based on: (a) costs, (b) anticipated volume, and (c) an ‘equitable’ markup. The policy with regard to ‘international’ transfer pricing is basically the same, but with some additional complications. A major additional consideration is to minimize unnecessary Customs duties and taxes. In addition, the policy depends in part on the types of overseas operations, for example: 1. If the transfer price is to a subsidiary that is 100% owned, the policy would be to price as near to cost as possible. The policy is designed to accomplish two objectives: (a) to minimize Customs duties, and (b) to let the maximum amount of profit be taken by the subsidiary so as to minimize taxes, while at the same time satisfying the US Internal Revenue Service authorities that there is no intent to avoid legitimate taxes by shifting profits abroad. 2. In the case where products are sold to a 50–50 joint venture, the policy is to set the price as high as possible, but to keep it competitive (since the joint venture could buy outside). This policy permits the profits to be earned by the Capitool Company rather than shifting it to the joint venture so that the foreign partner shares it. The joint venture is in this way limited to the profits that are properly earned as a result of its operations and efficiency. A limiting factor is the trade-off in taxes or in duties. For example, if the duty is exceedingly high, the Capitool Company share of joint venture profits might be enough to make a low transfer price more profitable than a high transfer price. In some cases, the transfer prices are covered in the joint venture contract; that is, an upper limit may be set. When there is a specific price ceiling it is renegotiable periodically. However, in the special case of the Genforsler-Capitool joint venture (special because Genforsler-Capitool produces machines for sales only to Genforsler and to Capitool) the philosophy is for Genforsler-Capitool to develop a high-volume operation by operating ➨ Case study 11.2 just above the break-even point, and charging both Genforsler and Capitool as low a price as possible while earning enough profit to satisfy German tax authorities. In the case of a joint venture in which the transfer price has not been specified, the policy is to take as much of the profit as possible in the transfer price. Since the company goal is to maximize corporate profits rather than divisional profits, there inevitably arise situations where a domestic division must take a reduced profit (by lowering the transfer price) in order that the International Division may capitalize on a favorable tax or Customs duty situation, or vice versa. Usually, the division that must give up the profits sees the reason clearly, and there is no friction. However, in complex situations, transfer price negotiations between divisions can result in disputes. When such an occasion arises, and when the dispute cannot be resolved satisfactorily, it is referred to the Control Committee. This committee consists of the financial vice president of the corporation (the chairman of the committee), the corporate controller, the controller of the domestic division that is involved, and the International Division controller. Company officials are reviewing their transfer pricing policy on components shipped to the Duisburg plant. When the original policy was established, the following considerations were evaluated in determining the transfer price: ● At what price would corporate profits be greatest? Capitool GmbH is in a ‘tax loss carry forward’ position. ● What price would be most advantageous for computing shipping insurance, freight, and duty? These costs are estimated at 40% of the FOB US price. ● What transfer price would the US Internal Revenue Service consider adequate for determining taxable income for the Capitool Company? ● What transfer price would the German authorities consider adequate for determining the taxable income of Capitool GmbH? ● What transfer price would the German authorities consider adequate for determining a duty base? ● Should the company encourage Capitool GmbH to seek maximum indigenous content through high transfer prices? ● What is the relative quality of German-sourced components versus US components? ● What transfer price is necessary to keep the landed cost of components at a level that will allow Capitool GmbH to price their machines competitively and obtain a satisfactory gross margin? Currently the FOB US transfer price on components shipped from the US plant to the Duisburg plant is the sum of: ● actual direct material; ● actual direct labor; ● full manufacturing expense; ● 14.2% markup on cost. This formula has been reviewed and approved by the United States Internal Revenue Service and the German Income Tax and Customs Authorities as the lowest acceptable basis for determining: (a) taxable profits at each location and (b) the value to be used in assessing Customs duty payments. Company officials have been concerned about the meaning and usefulness of transfer prices. In the past the policy has been one of decentralization of authority to managers that head profit centers. Profit centers have been used both as a managerial incentive (so that a manager can see the profits for which he can take credit), and as a method of measuring the performance of executives. Under such a system, whenever there are intracompany transfers of products, a ‘transfer price’ must be established. Company officials are concerned that there are inequities in the system, since maximum corporate profit may not be achieved simply by letting divisions maximize profits individually. One company official went so far as to suggest that perhaps it would be better to determine all transfer prices at headquarters; and that the ‘profit’ centers should be changed to ‘cost’ centers. The general manager of each cost center would have no control over centrally administered transfer prices; he or she would simply be forced to accept them as they are set by headquarters. Under this arrangement managers would be evaluated not on profits but according to other measures, for example, share of market, sales increases, cost reductions, and so forth. The company’s tax counsel pointed out that this policy would cause problems with tax and Customs authorities. Another company official expressed the view that managers of cost (or profit) centers should be permitted to buy wherever landed cost is lowest, except when the corporate interest is served by ‘buying’ internally, for example: (1) when there is excess capacity (probably there would be no difficulty in this regard if the ‘selling’ division were willing to set the price as near to marginal cost as necessary to be competitive), or (2) when tax or duty factors make it desirable to transfer at a ‘higher than competitive’ price. ➨ 531 Chapter 11 Pricing decisions Questions 1. What should be Capitool’s general policy on the formulation of international transfer prices? 2. What methods should be used to set Capitool’s transfer prices and who should be involved in the process? 3. Should Capitool have a system of multiple transfer prices: (a) for different products, (b) to different countries, or (c) to different classes of customers? CASE STUDY 11.3 Strato Designs Exchange rate fluctuations between the Japanese yen, the euro, and the US dollar have posed serious problems for Strato Designs (the name of the company is disguised). The California company produces graphics components for nine of the top ten PC makers, other specialty logic chips for PCs, and modems. Approximately 35% of its sales are to Japanese companies, and approximately 10% to European companies. Japanese customers require that prices be quoted in yen, and many European customers are now requiring that prices be quoted in euros. Payments in foreign currencies could, of course, be converted to dollars at the spot (current) exchange rate when received. However, when the yen or euro has increased in value between the time of price quotation and the receipt of payment, it means a windfall profit for Strato Designs. A decrease in the value of the yen or euro means an exchange loss that might exceed the margin on the sale, resulting in a loss on the sale. The fluctuations in exchange rates over the past ten years have been substantial and unpredictable. From its launch in January 1999, the euro lost over 30% of its value relative to the dollar by October 2000. It rallied, fell again, and then greatly increased. At one point in 2007, the euro stood at 1.35 per dollar, an increase of over 55% from its low. The British pound has increased in value against the euro as well as against the dollar. During the 1999–2007 period, the yen moved up and down in a range of about 25% relative to the dollar. Daily fluctuations were sometimes substantial. Short-term changes in the value of the yen were dampened somewhat by massive Japanese government interventions in the foreign exchange market. Overall margins in the industry are not high enough to allow Strato Designs to make quotations to cover possible losses due to a weakening of a foreign currency. Even windfall profits from a strengthening foreign currency 532 could be a problem for the company. Foreign customers who contracted for products when their currencies were weak, and subsequently paid when their currencies were strong, would realize that they were paying high prices in dollars. They might ask for rebates if Strato Designs’ competitors were offering products at lower prices based on revised exchange rates. Company officials discussed the problem with their bank, and with other companies facing similar problems, using the yen as an example. At least six strategies are available: 1. The company could enter into a forward exchange contract to sell the yen for dollars at a specified date in the future for a specified price. The date for sale of the yen (purchase of dollars) would be set for the time when the yen would be received from the Japanese importer of the goods. Such a contract, available at a relatively low price and usually with a rate very near to the spot rate, would lock in the profit. But it would also prevent Strato Designs from benefiting from a windfall profit. Further, it would not solve the potential problem of having a dissatisfied customer if the yen became stronger during the period between the sales contract and the time of payment. 2. The company could purchase an option to sell the yen (buy dollars) at a specified rate at the date when the yen are due to be received. With an option, Strato Designs would not have to sell the yen to the option provider. It could do so if the yen had become weaker, or it could simply not exercise the option and instead sell the yen at the spot rate (current rate) if the yen had become stronger. The disadvantage of this method is that options are relatively expensive to purchase. 3. Strato Designs might be able to arrange a swap of currencies at a predetermined rate with a US-based ➨ Case study 11.3 exporter who will need to pay yen at the time that Strato Designs will receive yen. 4. Depending upon Strato Designs’ need for parts or other goods from Japan, it might be able to partially or totally offset potential exchange losses/gains from export sales with balancing gains/losses from import purchases at the same time. 5. Strato Designs could make contracts or purchase options only when it believes that the yen will become weaker. When it believes that the yen will become stronger, it could simply wait to sell the yen when received, thereby making an additional profit. 6. Strato Designs could simply not take any advance action, accepting exchange losses or gains as they might occur. From these possible models, Strato Designs has to decide upon a specific system to use. Questions 1. Are the Japanese customers of Strato Designs likely to be willing to accept price quotations in dollars? Discuss. 2. What should be the company’s objective in managing the exchange rate situation? 3. What model or system would you recommend that Strato Designs use? Defend your choice! 4. Is your choice in Question 3 something that the company should do for all the foreign currencies that it might have to manage or only for the Japanese yen? Explain. 533