Managerial Accounting 2002e Belverd E. Needles, Jr. Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Chapter 11 Pricing Decisions, Including Target Costing and Transfer Pricing Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. LEARNING OBJECTIVES Identify the objectives and rules used to establish prices of goods and services, and relate pricing issues to the management cycle. Describe traditional economic pricing concepts. Use cost-based pricing methods to develop prices. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. LEARNING OBJECTIVES Describe target costing and use that concept to analyze pricing decisions. Use target costing to evaluate a new product opportunity. Define transfer pricing; use cost-based, market-based, and negotiated methods to develop transfer prices; and use transfer prices to evaluate performance. Copyright © Houghton Mifflin Company. All rights reserved.

The Pricing Decision and the Manager OBJECTIVE 1 Identify the objectives and the rules used to establish prices of goods and services, and relate pricing issues to the management cycle. Copyright © Houghton Mifflin Company. All rights reserved.

Pricing Policy Objectives Possible pricing policy objectives include: Identifying and adhering to both short-run and long-run pricing strategies. Maximizing profits. Maintaining or gaining market share. Setting socially responsible prices. Maintaining a minimum rate of return on investment. Being customer-driven. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Selling Price To stay in business, a company’s selling price must: Be equal to or lower than the competitor’s price. Be acceptable to the customer. Recover all costs incurred in bringing the product or service to market. Return a profit. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. The Management Cycle Pricing issues should be addressed at each stage of the management cycle. During the planning stage, managers must consider how much to charge for each product or service and identify the maximum price the market will accept. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. The Management Cycle During the executing stage, the products or services are sold at the specified prices. During the reviewing stage, managers evaluate sales to determine which pricing strategies were successful and which failed. During the reporting stage, analyses of actual versus targeted prices and profits are prepared for use inside the organization. Copyright © Houghton Mifflin Company. All rights reserved.

Pricing and the Management Cycle Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What are some examples of possible pricing policy objectives? A. Maximizing profits. 1. Maintaining or gaining market share. 2. Setting socially responsible prices. 3. Maintaining a minimum rate of return on investment. 4. Being customer driven. Copyright © Houghton Mifflin Company. All rights reserved.

Traditional Economic Pricing Concepts OBJECTIVE 2 Describe traditional economic pricing concepts. Copyright © Houghton Mifflin Company. All rights reserved.

Total Revenue and Total Cost Curves The traditional approach to pricing is based on microeconomic theory. Profits are maximized when total revenue minus total expenses is greatest. On a graph, profits are maximized where the marginal revenue and marginal cost lines intersect. Copyright © Houghton Mifflin Company. All rights reserved.

The Economist’s Approach Marginal revenue is the change in total revenue caused by a one-unit change in output. Marginal cost is the change in total cost caused by a one-unit change in output. Copyright © Houghton Mifflin Company. All rights reserved.

Microeconomic Pricing Theory Copyright © Houghton Mifflin Company. All rights reserved.

Microeconomic Pricing Theory Copyright © Houghton Mifflin Company. All rights reserved.

The Traditional Approach Significant uncertainty and the necessity of using estimates make the microeconomic approach difficult to apply. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What is the problem with using the traditional approach to pricing? A. Significant uncertainty and the necessity of using estimates make the microeconomic approach difficult to apply. Copyright © Houghton Mifflin Company. All rights reserved.

Cost-Based Pricing Methods OBJECTIVE 3 Use cost-based pricing methods to develop prices. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. External Factors Current prices of competing products or services. Customers’ preferences for quality versus price. Seasonal demand or continual demand. Life of the product or service. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Pricing Methods To set a price, managers should combine their experience with an appropriate pricing method. Gross margin pricing. Return on assets pricing. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Gross Margin Pricing Gross margin pricing is a cost-based pricing method that establishes a selling price at a percentage above an item’s total production costs. The following formulas are used: Markup percentage. Gross margin-based price. Copyright © Houghton Mifflin Company. All rights reserved.

Desired Profit + Total Selling, General, and Administrative Expenses Markup Percentage Desired Profit + Total Selling, General, and Administrative Expenses Markup Percentage = X 100 Total Production Costs Copyright © Houghton Mifflin Company. All rights reserved.

Gross Margin-Based Price Total Production Costs per unit = + (Markup Percentage x Total Production Costs per Unit) Copyright © Houghton Mifflin Company. All rights reserved.

Return on Assets Pricing Return on assets pricing is a pricing method based on a specific rate of return on assets employed in the generation of the product or service. Copyright © Houghton Mifflin Company. All rights reserved.

Return on Assets Pricing [ ] Return-on-Assets-Based Price Total Costs and Expenses per Unit (Desired Rate of Return Total Cost of Assets Employed = + X Anticipated Units to be Produced) Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Cost Bases Cost bases include: Total product costs per unit. Total costs and expenses per unit. Copyright © Houghton Mifflin Company. All rights reserved.

Cost-Based Pricing Methods: Pearson Company Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Pricing Services Time and materials pricing is a common practice in service-oriented businesses. Two primary types of costs used in this method: Materials and parts. Labor. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What cost bases should be considered when determining unit cost? A. 1. Total product costs per unit. 2. Total costs and expenses per unit. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. External Factors There are many external factors that influence a product’s price in a competitive environment. Competitors’ prices. Customers’ expectations. Cost of substitute products and services. Copyright © Houghton Mifflin Company. All rights reserved.

Pricing Based on Target Costing OBJECTIVE 4 Describe target costing and use that concept to analyze pricing decisions. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Target Costing Target costing is a pricing method that involves the following: Identifies competitive price. Defines the desired profit. Computes target cost by subtracting desired profit from the competitive market price. Target Price - Desired Profit = Target Cost Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Target Costing Target costing gives managers the ability to control or dictate the costs of a new product beginning at the planning stage of the product’s life cycle. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Target Costing Committed costs are the estimated costs that are engineered into a product or service at the design stage of development and should occur if all design specifications are followed during production. Incurred costs are the actual costs to make the product. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Target Costing When cost-based pricing is used, cost control efforts focus on incurred costs after the product has been introduced to the marketplace. Controlling costs at this point is difficult. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Target Costing By designing and building a product to a specific cost goal, target costing controls costs before they are actually committed and incurred. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What is an advantage of target costing? A. By designing and building a product to a specific cost goal, target costing controls costs before they are actually committed and incurred. Copyright © Houghton Mifflin Company. All rights reserved.

OBJECTIVE 5 Use target costing to evaluate a new product opportunity. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Target Costing To identify a new product’s target cost, the following formula is applied: Target Desired Target Price Profit Cost Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Target Costing The target cost is then given to the engineers and product designers, who use it as a maximum cost to be incurred for materials and other resources needed to design and manufacture the product. Copyright © Houghton Mifflin Company. All rights reserved.

Meeting Cost Requirements Sometimes the cost requirements cannot be met. In such a case, the organization should try to adjust the product’s design and the approach to production. If those attempts fail, the organization should discontinue its plans to market the product. Copyright © Houghton Mifflin Company. All rights reserved.

Transfer Pricing Decisions OBJECTIVE 6 Define transfer pricing; use cost-based, market-based, and negotiated methods to develop transfer prices; and use transfer prices to evaluate performance. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Transfer Pricing A transfer price is an artificial price at which goods and services are charged and exchanged between a company’s divisions or segments. Transfer prices are used only to help determine the performance of a cost center. Transfer prices are therefore used only for internal purposes. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Transfer Pricing A decentralized organization assigns separate managers to control the operations of each business segment. A cost center manager is responsible only for the costs incurred in that organizational unit. A profit center manager is responsible for revenues and costs and the resulting profits of the organizational unit. Copyright © Houghton Mifflin Company. All rights reserved.

Developing Transfer Prices Approaches to developing transfer prices include: The price may be based on the cost of the item up to the point at which it is transferred to the next department or process. A cost-plus transfer price is the sum of costs incurred by the producing division plus an agreed-on profit percentage. Copyright © Houghton Mifflin Company. All rights reserved.

Developing Transfer Prices The price may be based on a market value if this item has an existing external market. A market transfer price is based on the price that would be charged (or paid) to an external party. Copyright © Houghton Mifflin Company. All rights reserved.

Negotiated Transfer Price A negotiated transfer price is a price that is reached through bargaining between managers of the selling and buying divisions or segments. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. Discussion Q. What is a transfer price? A. A transfer price is an artificial price at which goods and services are charged and exchanged between a company’s divisions or segments. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. OK, Let’s Review Identify the objectives and rules used to establish prices of goods and services, and relate pricing issues to the management cycle. Describe traditional economic pricing concepts. Use cost-based pricing methods to develop prices. Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved. OK, Let’s Review Describe target costing and use that concept to analyze pricing decisions. Use target costing to evaluate a new product opportunity. Define transfer pricing; use cost-based, market-based, and negotiated methods to develop transfer prices; and use transfer prices to evaluate performance. Copyright © Houghton Mifflin Company. All rights reserved.