8-1

8 Pricing

Learning Objectives
Compute a target cost when the market determines a product
1 price.

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

Use time-and-material pricing to determine the cost of services

3 provided.

Determine a transfer price using the negotiated, cost-based,

4 and market-based approaches.

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LEARNING Compute a target cost when the market
OBJECTIVE 1 determines a product price.

The price of a good or service is affected by many factors.

Illustration 8-1
Pricing factors

Regardless of the factors involved, the price must cover the costs
of the good or service as well as earn a reasonable profit.
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 Pricing Goods for External Sales

The price of a good or service is affected by many factors.

 Company must have a good understanding of market
forces.
 Where products are not easily differentiated from
competitor goods, prices are not set by the company, but
rather by the laws of supply and demand – such
companies are called price takers.
 Where products are unique or clearly distinguishable from
competitor goods, prices are set by the company.

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8-5 LO 1
 Target Costing

 Laws of supply and demand significantly affect product

price.
 To earn a profit, companies must focus on controlling
costs.
 Requires setting a target cost that will provide the
company’s desired profit.

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 Target Costing

 Target cost: Cost that provides the desired profit when

the market determines a product’s price. Illustration 8-2
Target cost as related
to price and profit

 If a company can produce its product for the target cost or

less, it will meet its profit goal.

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 Target Costing

 First, company should identify its market niche where it

wants to compete.
 Second, company conducts market research to
determine the target price – the price the company
believes will place it in the optimal position for the target
consumers.
 Third, company determines its target cost by setting a
desired profit.
 Last, company assembles a team to develop a product
to meet the company’s goals.

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 1 Target Costing

Fine Line Phones is considering introducing a fashion cover for its

phones. Market research indicates that 200,000 units can be sold if
the price is no more than $20. If Fine Line decides to produce the
covers, it will need to invest $1,000,000 in new production
equipment. Fine Line requires a minimum rate of return of 25% on all
investments. Determine the target cost per unit for the cover.

The desired profit for this new product line is

$1,000,000 x 25% = $250,000
Each cover must result in profit of $250,000 ÷ 200,000 units = $1.25
Market price Desired profit Target cost per unit
$20 - $1.25 = $18.75 per unit

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 Target Costing

Question
Target cost related to price and profit means that:
a. Cost and desired profit must be determined before
selling price.
b. Cost and selling price must be determined before
desired profit.
c. Price and desired profit must be determined before
costs.
d. Costs can be achieved only if the company is at full
capacity.

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 LEARNING Compute a target selling price using cost-plus
OBJECTIVE 2 pricing.

Cost-Plus Pricing
 In an environment with little or no competition, a company
may have to set its own price.
 When a company sets price, the price is normally a
function of product cost: cost-plus pricing.
 Approach requires establishing a cost base and adding a
markup to determine a target selling price.

Illustration 8-4
Cost-plus pricing formula
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 Cost-Plus Pricing

 In determining the proper markup, a company must

consider competitive and market conditions.
 Size of the markup (the “plus”) depends on the desired
return on investment for the product:

ROI = net income ÷ invested assets

Illustration 8-3
Relation of markup to cost
and selling price

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 Cost-Plus Pricing

Illustration: Thinkmore Products, Inc. is in the process of

setting a selling price on its new video camera pen. It is a
functioning pen that will record up to 2 hours of audio and
video. The per unit variable cost estimates for the new video
camera pen are as follows.

Illustration 8-5
8-14 Variable cost per unit LO 2
 Cost-Plus Pricing

In addition, Thinkmore has the following fixed costs per unit

at a budgeted sales volume of 10,000 units.

Illustration 8-6
Fixed cost per unit, 10,000 units

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 Cost-Plus Pricing

Thinkmore has decided to price its new video camera pen to

earn a 20% return on its investment (ROI) of $2,000,000.

Markup = 20% ROI of $2,000,000

Expected ROI = $400,000 ÷ 10,000 units = $40

Markup price
per unit =

Illustration 8-8
Computation of
selling price,
10,000 units

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 Cost-Plus Pricing

Use markup on cost to set a selling price:

 Compute the markup percentage to achieve
Illustration 8-9
a desired ROI of $20 per unit: Computation of
markup percentage

Illustration 8-10
Computation of selling
 Compute the target selling price: price—markup approach

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 Cost-Plus Pricing

LIMITATIONS OF COST-PLUS PRICING

 Advantage of cost-plus pricing: Easy to compute.
 Disadvantages:
► Does not consider demand side:
 Will the customer pay the price?

► Fixed cost per unit changes with change in sales

volume:
 At lower sales volume, company must charge higher
price to meet desired ROI.

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 LIMITATIONS OF COST-PLUS PRICING

Illustration: If budgeted sales volume for Thinkmore’s

Products was 5,000 instead of 10,000, Thinkmore’s variable
cost per unit would remain the same. However, the fixed cost
per unit would change as follows. Illustration 8-11
Fixed cost per unit, 5,000 units

Thinkmore's desired 20% ROI now results in a $80 ROI per unit
[(20% x $2,000,000) ÷ 5,000].

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 LIMITATIONS OF COST-PLUS PRICING

Thinkmore computes the selling price at 5,000 units as follows.

Illustration 8-12
Computation of selling
price, 5,000 units

At 5,000 units, how much would Thinkmore mark up its total

unit costs to earn a desired ROI of $80 per unit.

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 Variable-Cost Pricing

Alternative pricing approach:

Simply add a markup to variable costs.
 Avoids the problem of uncertain cost information related to
fixed-cost-per-unit computations.
 Helpful in pricing special orders or when excess capacity
exists.

Major disadvantage is that managers may set the price too

low and fail to cover fixed costs.

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 Cost-Plus Pricing

Question
Cost-plus pricing means that:

a. Selling price = variable cost + (markup percentage +

variable cost).
b. Selling price = cost + (markup percentage X cost).
c. Selling price = manufacturing cost + (markup
percentage + manufacturing cost).
d. Selling price = fixed cost + (markup percentage X
fixed cost).

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 2 Target Selling Price

Air Corporation produces air purifiers. The following per unit

cost information is available: direct materials $16, direct labor
$18, variable manufacturing overhead $11, variable selling and
administrative expenses $6. Fixed selling and administrative
expenses are $50,000, and fixed manufacturing overhead is
$150,000. Using a 45% markup percentage on total per unit
cost and assuming 10,000 units, compute the target selling
price.

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 2 Target Selling Price

Using a 45% markup percentage on total per unit cost and

assuming 10,000 units, compute the target selling price.

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 LEARNING Use time-and-material pricing to determine the
OBJECTIVE 3 cost of services provided.

Time-and-material pricing is an approach to cost-plus

pricing in which the company uses two pricing rates:
 One for labor used on a job - includes direct labor time
and other employee costs.
 One for material - includes cost of direct parts and
materials and a material loading charge for related
overhead.

Widely used in service industries, especially professional

firms such as public accounting, law, and engineering.

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 Time and Material Pricing

Illustration: Assume the following data for Lake

Illustration 8-13
Holiday Marina, a boat and motor repair shop. Total annual budgeted
time and material costs

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 STEP 1: CALCULATE THE LABOR RATE

 Express as a rate per hour of labor.

 Rate includes:
► Direct labor cost (includes fringe benefits).
► Selling, administrative, and similar overhead costs.
► Allowance for desired profit (ROI) per hour.
 Labor rate for Lake Holiday Marina for 2017 based on:
► 5,000 annual labor hours.
► Desired profit margin of $8 per hour of labor.

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 STEP 1: CALCULATE THE LABOR RATE

Illustration 8-14
Computation of hourly
time-charge rate
Multiply the rate of $38.20 by the number of labor hours
used on any particular job to determine the labor
charges for the job.
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 STEP 2: CALCULATE THE MATERIAL
LOADING CHARGE

 Material loading charge added to invoice price of materials.

 Covers the costs of purchasing, receiving, handling, storing
+ desired profit margin on materials.
 Expressed as a percentage of estimated costs of parts and
materials for the year:

Estimated purchasing, receiving,

handling, storing costs Desired profit
+ margin on
Estimated costs of parts and materials
materials
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 STEP 2: MATERIAL LOADING CHARGE

The marina estimates that the total invoice cost of parts and
materials used in 2017 will be $120,000. The marina desires a
20% profit margin on the invoice cost of parts and materials.

Illustration 8-15
8-31 Computation of material loading charge LO 3
 STEP 3: CALCULATE CHARGES FOR A
PARTICULAR JOB

Labor charges
+
Material charges
+
Material loading charge

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 STEP 3: CALCULATE CHARGES FOR A
PARTICULAR JOB

Lake Holiday Marina prepares a price quotation to estimate the cost

to refurbish a used 28-foot pontoon boat. Lake Holiday Marina
estimates the job will require 50 hours of labor and $3,600 in parts
and materials.

Illustration 8-16
8-33 Price quotation for time and material LO 3
 Time and Material Pricing

Question
Crescent Electrical Repair has decided to price its work on a time-and-
material basis. It estimates the following costs for the year related to
labor.
Technician wages and benefits $100,000
Office employee’s salary/benefits $40,000
Other overhead $80,000
Crescent desires a profit margin of $10 per labor hour and budgets 5,000
hours of repair time for the year. The office employee’s salary, benefits,
and other overhead costs should be divided evenly between time charges
and material loading charges. Crescent labor charge per hour would be:

a. $42 b. $34 c. $32 d. $30

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 3 Time-and-Material Pricing

Presented below are data for Harmon Electrical Repair Shop for
next year. The desired profit margin per labor hour is $10. The
material loading charge is 40% of invoice cost. Harmon estimates
that 8,000 labor hours will be worked next year.

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 3 Time-and-Material Pricing

If Harmon repairs a TV that takes 4 hours to repair and uses parts

of $50, compute the bill for this job.

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 LEARNING Determine a transfer price using the negotiated,
OBJECTIVE 4 cost-based, and market-based approaches.

Vertically integrated companies

 Grow in either direction of its suppliers or its customers.
 Frequently transfer goods to other divisions as well as
outside customers.

How do you price

goods “sold”
within the
company?

Illustration 8-17
8-38 Transfer pricing example
 Transfer Price

Transfer price - price used to record the transfer between

two divisions of a company.
 Ways to determine a transfer price:
1. Negotiated transfer prices.
2. Cost-based transfer prices.
3. Market-based transfer prices.
 Conceptually - a negotiated transfer price is best.
 Due to practical considerations, companies often use the
other two methods.

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 Negotiated Transfer Prices

Illustration: Alberta Company makes rubber soles for work &

hiking boots.
 Two Divisions:
► Sole Division - sells soles externally.
► Boot Division - makes leather uppers for hiking boots
which are attached to purchased soles.

 Division managers compensated on division profitability.

 Management now wants Sole Division to provide at least
some soles to the Boot Division.

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 Negotiated Transfer Prices

Computation of the contribution margin per unit for each division

when the Boot Division purchases soles from an outside supplier.

Illustration 8-18
Computation of contribution
margin for two divisions, when “What would be a fair transfer price if the Sole
Boot Division purchases soles
from an outside supplier
Division sold 10,000 soles to the Boot Division?”

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 Negotiated Transfer Prices

NO EXCESS CAPACITY
 If Sole sells to Boot,
► payment must at least cover variable cost per unit
plus
► its lost contribution margin per sole (opportunity cost).
 The minimum transfer price acceptable to Sole is:

Illustration 8-19
Minimum transfer price—no excess capacity
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 Negotiated Transfer Prices

From the perspective of the Boot Division (the buyer), the

most it will pay is what the sole would cost from an outside
supplier.

Illustration 8-20
Transfer price negotiations—no deal
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 Negotiated Transfer Prices

EXCESS CAPACITY
 Can produce 80,000 soles, but can sell only 70,000.
 Available capacity of 10,000 soles.
 Contribution margin of $7 per unit is not lost.
 Minimum transfer price acceptable to Sole:

Illustration 8-21
Minimum transfer price
formula—excess capacity
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 Negotiated Transfer Prices

In this case, the Boot Division and the Sole Division should
negotiate a transfer price within the range of $11 to $17.

Illustration 8-22
Transfer pricing
negotiations—deal
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 Negotiated Transfer Prices

VARIABLE COSTS
 In the minimum transfer price formula, variable cost is
the variable cost of units sold internally.
 May differ - higher or lower - for units sold internally
versus those sold externally.
 The minimum transfer pricing formula can still be used
– just use the internal variable costs.

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 Negotiated Transfer Prices

SUMMARY
 Transfer prices established:
► Minimum by selling division.
► Maximum by the purchasing division.
 Often not used because:
► Market price information sometimes not easily
obtainable.
► Lack of trust between the two divisions.
► Different pricing strategies between divisions.

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 Cost-Based Transfer Prices

 Uses costs incurred by the division producing the

goods as its foundation.
 May be based on variable costs alone or on variable
costs plus fixed costs.
 Selling division may also add markup.
 Can result in improper transfer prices causing:
► Loss of profitability for company.
► Unfair evaluation of division performance.

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 Cost-Based Transfer Prices

Illustration: Alberta Company requires the division to use a

transfer price based on the variable cost of the sole. With no
excess capacity, the contribution margins per unit for the two
divisions are:
Illustration 8-24
Cost-based transfer price—10,000 units Cost-based transfer
price—10,000 units

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 Cost-Based Transfer Prices

 Cost-based pricing is bad deal for Sole Division – no

profit on transfer of 10,000 soles to Boot Division and
loses profit of $70,000 on external sales.
 Boot Division is very happy; increases contribution
margin by $6 per sole.
 If Sole Division has excess capacity, the division reports
a zero profit on these 10,000 units and the Boot Division
gains $6 per unit.

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 Cost-Based Transfer Prices

 Overall, the Company is worse off by $60,000.

Illustration 8-25

 Does not reflect the division’s true profitability nor provide

adequate incentive for the division to control costs.
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 Market-Based Transfer Prices

 Based on existing market prices of competing goods.

 Often considered best approach because it is objective
and generally provides the proper economic incentives.
 It is indifferent between selling internally and externally
if can charge/pay market price.
 Can lead to bad decisions if have excess capacity.
 Why? No opportunity cost.
 Where there is not a well-defined market price,
companies use cost-based systems.

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 Market-Based Transfer Prices

Question
The Plastics Division of Weston Company manufactures
plastic molds and then sells them for $70 per unit. Its variable
cost is $30 per unit, and its fixed cost per unit is $10.
Management would like the Plastics Division to transfer 10,000
of these molds to another division within the company at a
price of $40. The Plastics Division is operating at full capacity.
What is the minimum transfer price that the Plastics Division
should accept?
a. $10 c. $40
b. $30 d. $70

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 Effect of Outsourcing on Transfer Pricing

Outsourcing - Contracting with an external party to provide a

good or service, rather than doing the work internally.
 Virtual companies outsource all of their production.
 Use incremental analysis to determine if outsourcing is
profitable.
 As companies increasingly rely on outsourcing, fewer
components are transferred internally thereby reducing the
need for transfer pricing.

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 Transfers Between Divisions in Different
Countries

Companies “globalize” their operations

 Going global increases transfers between divisions
located in different countries.
 60% of trade between countries is estimated to be
transfers between divisions.
 Different tax rates make determining appropriate transfer
price more difficult.

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 4 Transfer Pricing

The clock division of Control Central Corporation manufactures

clocks and then sells them to customers for $10 per unit. Its
variable cost is $4 per unit, and its fixed cost per unit is $2.50.
Management would like the clock division to transfer 8,000 of
these clocks to another division within the company at a price of
$5. The clock division could avoid $0.50 per clock of variable
packaging costs by selling internally. (a) Determine the
minimum transfer price, assuming the clock division is not
operating at full capacity.

Opportunity cost + Variable cost = Minimum transfer price

$0 $3.50 $3.50

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 4 Transfer Pricing

The clock division of Control Central Corporation manufactures

clocks and then sells them to customers for $10 per unit. Its
variable cost is $4 per unit, and its fixed cost per unit is $2.50.
Management would like the clock division to transfer 8,000 of
these clocks to another division within the company at a price of
$5. The clock division could avoid $0.50 per clock of variable
packaging costs by selling internally. (b) Determine the
minimum transfer price, assuming the clock division is
operating at full capacity.

Opportunity cost + Variable cost = Minimum transfer price

$6 $3.50 $9.50

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 LEARNING APPENDIX 8A: Determine prices using
OBJECTIVE 5 absorption-cost pricing and variable-cost pricing.

Absorption-Cost Pricing
 Consistent with GAAP: includes both variable and fixed
manufacturing costs as product costs
 Both variable and fixed selling and administrative costs are
excluded from product cost base
 Steps in approach:
1. Compute the unit manufacturing cost.
2. Compute the markup percentage – must cover the
desired ROI as well as selling/administrative expenses.
3. Set the target selling price

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 Absorption-Cost Pricing
Illustration 8A-1
Step 1: Compute the unit manufacturing cost. Computation of unit
manufacturing cost

Illustration 8A-2

Illustration 8A-2
Other information
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 Absorption-Cost Pricing
Illustration 8A-3
Step 2: Compute the markup percentage. Markup percentage—
absorption-cost pricing

Solving, we find:
MP = ($40 + $38) ÷ $87 = 89.66%

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 Absorption-Cost Pricing

Step 3: Set the target selling price. Illustration 8A-4

Computation of target price—
absorption-cost pricing

Because of fixed costs, if more than 10,000 units are sold, the
ROI will be greater than 20% and vice versa.

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 Absorption-Cost Pricing

Proof of 20% ROI—absorption-cost pricing

Illustration 8A-5

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 Absorption-Cost Pricing

Most companies that use cost-plus pricing use either

absorption cost or full cost as the basis.
Reasons:
1. Information readily available – cost effective.
2. Use of only variable costs may result in too low a price –
suicidal price cutting.
3. Most defensible base for justifying prices.

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 Variable-Cost Pricing

 Cost base consists of all variable costs associated with

a product – manufacturing, selling, administrative.

 Since fixed costs are not included in base, markup

must provide for fixed costs (manufacturing, selling,
administrative) and the target ROI.

 Useful for making short-run decisions because variable

and fixed cost behaviors are considered separately.

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 Variable-Cost Pricing

Steps:
1. Compute the unit variable cost.

2. Compute markup percentage.

3. Set target selling price.

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 Variable-Cost Pricing

Step 1: Compute the unit variable cost.

Illustration 8A-6

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 Variable-Cost Pricing

Step 2: Compute the markup percentage.

Illustration 8A-7

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 Variable-Cost Pricing

Step 3: Set target selling price.

Illustration 8A-8

Using the $165 target price produces the desired 20% ROI at a
volume level of 10,000 units.

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 Proof of 20% ROI—contribution approach Illustration 8A-9

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 Variable-Cost Pricing

Avoids blurring effects of cost behavior on operating income.

Reasons:
1. More consistent with CVP analysis.
2. Provides data for pricing special orders by showing
incremental cost of accepting one more order.
3. Avoids arbitrary allocation of common fixed costs to
individual product lines.

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 APPENDIX 8B: Explain issues involved in
LEARNING
OBJECTIVE 6 transferring goods between divisions in different
countries.

Illustration: Alberta’s Boot Division is located in a country with a

corporate tax rate of 10%, and the Sole Division is located in a country
with a tax rate of 30%. The following illustrates the after-tax
contribution margin per unit under transfer prices of $18 and $11.

Illustration 8B-1

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 APPENDIX 8B: Explain issues involved in
LEARNING
OBJECTIVE 6 transferring goods between divisions in different
countries.

Illustration 8B-1

The after-tax contribution margins differ because more of the

contribution margin is attributed to the division in the country with
the lower tax rate.
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 Copyright

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