Cost Management, Second Canadian Edition

LO1 Compare the different pricing methods and calculate prices using each method LO2 Discuss other market-based sources of pricing information LO3 Explain the uses and limitations of cost-based and market-based pricing LO4 Explain price elasticity of demand and its impact on pricing LO5 Discuss the additional factors that affect price LO6 Compare the different pricing methods used for transferring goods and services within an organization LO7 Discuss the uses and limitations of different transfer pricing methods LO8 Discuss additional factors that affect transfer prices © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 3

© John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13 Slide 5  A selling price that is computed as the product’s cost plus a markup is known as a cost-based price.  The costs included in the base cost can be variable costs only or variable plus fixed costs.  Some companies include only production costs in the cost base and others include production, selling, and administrative costs.

 In service organizations, cost-based pricing is determined by calculating a labour rate and a materials loading charge.  The labour rate includes 1) direct labour salaries plus benefits, 2) selling and administrative costs and related overhead costs, 3) A desired profit amount.  The materials loading charge includes 1) all costs associated with purchasing, receiving, handling, and storing materials, 2) a desired profit percentage. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 6

© John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13 Slide 7  A product’s selling price depends on the degree of competition and the degree to which the company’s product is differentiated from competitors’ products.  Market-based prices are based on customer demand for the product.  The sensitivity of customer demand to changes in the selling price is called the price elasticity of demand.

 Companies sometimes use competitors’ prices to establish their own market prices.  The Internet makes it possible to learn about market prices for items.  The Internet and global competition have forced an increasingly large number of organizations to use market-based pricing. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 9

 A major drawback of cost-based pricing is that it ignores customer demand.  With cost-based prices, sales volumes inappropriately influence the price, causing a downward demand spiral, known as the death spiral.  The major benefit of using cost-based pricing is its simplicity. Prices are calculated from readily available cost data. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 11

 Using market-based prices to estimate revenues, managers make better decisions about sales volumes or whether to sell goods or services.  The disadvantage is that estimating market demand and prices is often difficult. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 12

© John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 14  The sensitivity of sales to price increases is called the price elasticity of demand.  When small increases in price result in large decreases in demand, the demand for that product is considered elastic.  The profit-maximizing price occurs when marginal costs equal marginal revenues.

© John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13 Slide 15 Elastic demand: Total Revenue = Selling price x Quantity of units sold Inelastic demand: Total Revenue = Selling price x Quantity of units sold

© John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 16 Using the price elasticity of demand, we can determine a profit-maximizing price and a mark-up percentage for the product. The steps for these calculations are:

Ted’s Trailers sells horse trailers in a competitive market. The variable costs of producing the one-horse trailer are $850 per unit. Information from prior years indicates that a 10% increase in the trailer’s selling price results in a 15% decrease in customer demand. Calculate the price elasticity of demand and the profit-maximizing price for the one-horse trailer. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13 Slide 17 Price elasticity of demand = ln( ) ln( ) = = = Profit-maximizing price x $850 = $2,055

 Some industries charge different prices at different times to reduce capacity constraints, a practice called peak load pricing.  Price skimming occurs when a higher price is charged for a product or service when it is first introduced than later on.  Penetration pricing is the practice of setting low prices when new products are introduced, to increase market share.  Price gouging is the practice of charging a price viewed by consumers as too high.  Transfer prices are the prices charged for transactions that take place within an organization. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 19

 NPOs have objectives other than maximization on profits which results in more complex pricing decisions.  NPOs do not necessarily expect to recover all costs of their products.  NPOs receive funding from government funding, grants, donations, etc.  Prices may reflect organizational goals.  Prices that are based on income with the objective of making services accessible to the wider population.  Tuition fees reduced for high-performing students to attract quality students to a learning institution. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13 Slide 20

In Canada, illegal pricing practices are regulated under the Competition Act.  Price fixing is an agreement between competitors to sell a common product at the same price.  Bid rigging, considered a form of price fixing, is an agreement with another person that interferes with the bidding process.  Price maintenance occurs if a business uses its influence to encourage an increase or discourage a decrease in the price of a product in Canada. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 21

 Price discrimination is the practice of setting different prices for different customers.  Predatory pricing is the deliberate act of setting prices low to drive competitors out of the market and then raising prices.  Dumping occurs when a foreign-based company sells products in an international market at prices that are below the market value in the country where the product is produced. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 22

 A transfer price is the price used to record revenue and cost when goods or services are transferred between departments within an organization.  The perfect transfer price would be the opportunity cost of transferring goods and services internally.  If external demand is zero, and the selling division has excess capacity, the transfer price would be the variable cost.  If capacity is limited and goods or services can be sold externally, then the opportunity cost would be the market price. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 24

 Cost-Based Transfer Price.  The cost of the good or service transferred is used as the basis of cost-based transfer pricing.  Activity-Based Transfer Price.  The purchasing unit is charged for the unit-level, batch-level, and possibly some product-level costs of products transferred, plus an annual fixed fee that is a portion of the facility-level costs.  Market-Based Transfer Prices.  Competitors’ prices or supply-and-demand relationships are the basis for market-based transfer prices. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 25

 Dual-Rate Transfer Prices.  The selling department is credited for the market price and the purchasing department is charged the variable cost under dual-rate transfer pricing.  Negotiated Transfer Prices.  Negotiated transfer prices are based on agreements reached between the managers of the selling and purchasing departments. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 26

 When compensation is tied to the financial performance of subunits, managers tend to overlook their contribution to the entire organization and focus instead on how decisions affect only their subunit’s financial performance.  Conflicts arise among managers, leading to suboptimal operating decisions. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 28

 For organizations that do business internationally, the taxable location of profit is affected by transfer price policies.  An organization with subsidiaries located in high- tax and low-tax countries could potentially charge a high transfer price in the low-tax countries so that most of the contribution margin arises where taxes are lowest. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 30

 When support departments provide services without charge to user departments, the user departments tend to use the support services inefficiently.  In turn, inefficient use tends to encourage support departments to grow unnecessarily large.  High transfer prices can encourage user departments to outsource the support services.  This can cause internal services to be duplicated, resulting in excess capacity and inefficient use of resources. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 31

 Because top managers prefer to have support services used efficiently, they want to set transfer prices that motivate this behaviour.  The best transfer price policy may be seen as an opportunity cost approach.  Implementing a transfer price policy based on opportunity costs may be problematic because opportunities change over time with changes in demand and capacity. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 32

 A particular type of transfer price occurs when corporate overhead costs are allocated to departments.  Under responsibility managers should be held accountable only for costs they control.  Because they have little or no control over corporate costs, they should not be held responsible for those costs in performance evaluations. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 33

Copyright © 2012 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. © John Wiley & Sons, 2012 Eldenburg, Cost Management, 2ce, Chapter 13Slide 34