Pricing Decisions

1. Pricing Decisions EMBA 5411 Budgeting and Pricing

2. Pricing • External sales- outside • Target costing • Cost plus pricing • Variable cost pricing • Time and material pricing • Internal-within the company among divisions • Negotiated transfer prices • Cost based transfer prices • Market based transfer prices • Effect of outsourcing on transfer prices • Transfers between divisions in different countries

3. Profit Maximization Economic Theory • The quantity demanded is a function of the price that is charged • Generally, the higherthe price, the lower the quantity demanded Pricing • Management should set the price that provides the greatest amount of profit

4. Determining the Profit-Maximizing Price and Quantity Dollarsper unit Profit is maximized where marginal cost equalsmarginal revenue, resultingin price p* and quantity q*. p* Demand Marginalcost Marginalrevenue Quantity made and soldper month q*

5. Determining the Profit-Maximizing Price and Quantity Total cost Dollars Total revenue Total profit at the profit-maximizingquantity and price,q* and p*. Quantity made and soldper month q*

6. Price Elasticity The impact ofprice changes onsales volume Demand is elastic ifa price increase has alarge negative impacton sales volume. Demand is inelastic ifa price increase haslittle or no impact on sales volume.

7. Who determines the price? • Price takers- when there is a competitive market and the company has no influence on price • Once competition enters the market, the price of a product becomes squeezed between the cost of the product and the lowest price of a competitor. • Price makers- companies that influence the price • Organizations that choose to compete by offering innovative products and services have a more difficult pricing decision because there is no existing price for the new product or service.

8. Influences on Price • Customer demand • Competitors’ behavior/prices/actions • Costs • Regulatory environment – legal, political and image related

9. Pricing approaches • Cost plus mark-up • Variable – contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costs • Absorption – common- mark-up covers all expenses except cost of goods sold plus the desired return on investment • Target costing – price is known, desired return on investment is known, price is known = determine the maximum cost per unit

10. Product Life Cycle http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

11. Life Cycle Costing • Life cycle costs are the total costs estimated to be incurred in the design, development, production, operation, maintenance, support, and final disposition of a product/system over its anticipated useful life span (Barringer and Weber, 1996). • The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996).

13. Cost-plus Pricing • Cost + mark-up = price • Mark-up = cost x desired % return

14. Which cost? • Variable manufacturing cost Price= vari.man. costs + markup% * var.man.cost Mark-up should cover the remaining costs and provide for the desired profit, i.e. variable selling and all fixed costs Desired profit = desired % return * investment

15. Which costs? • Total variable costs • Variable manufacturing and selling costs Price= variable costs + markup %* variable costs

16. Which costs? • Absorption – manufacturing costs • Unit manufacturing costs – both variable and fixed Price= unit manuf. cost + markup %* unit manufacturing cost

17. Which costs? • Absorption – total costs • Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs) Price= unit cost + markup %* unit cost

18. Example - Pricing Annual production 480 units Unit costs: Variable manufacturing cost $ 400 Applied fixed manufacturing cost $ 250 Absorption manufacturing cost $ 650 Variable selling costs $ 50 Allocated and direct fixed selling and administrative costs $ 100 Total cost $ 800 Investment $ 600,000 Desired profit 10% of investment $ 60,000 Annual Fixed Manufacturing Costs $ 120,000 Annual Fixed (allocated and direct) Selling and Administrative Costs $ 48,000

19. Cost Plus Pricing Versions

20. Cost Plus Pricing Versions

21. Time and Material Pricing • Determine a charge for labor that includes overhead • Determine a charge for materials that includes handling and storage costs • Include a profit • Sum = price • Used in service companies mainly; appropriate for construction companies as well

22. Example

23. Time and Material Charges Time Charge per hour = hourly labor cost + annual overhead (excluding material overhead) / annual labor hours + hourly charge to cover profit margin = $18 + ($200,000 / 10,000 hours) + $7 = $ 45 per hour Material Charge formula Material cost incurred on job +[material cost incurred on job *(material handling and storage costs / annual cost of materials used in Repair department)] = material costs incurred on job +[material costs incurred on job ($40,000/$1,000,000)] =1.04 x material costs incurred on job 4% of material costs

24. Example con’t

25. Internal Pricing – Transfer pricing issue Transfer Price is: the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firm Such as: • Internal charge paid by final assembly division for components produced by other divisions • Service fees to operating departments for telecommunications, maintenance, and services by support services departments

26. Effects of Transfer Prices Performance measurement: • Reallocate total company profits among business segments • Influence decision making by purchasing, production, marketing, and investment managers Rewards and punishments: • Compensation for divisional managers Partitioning decision rights: • Disputes over determining transfer prices

27. Ideal Transfer Pricing Ideal transfer price would be • Opportunity cost, or the value forgone by not using the transferred product in its next best alternative use • Opportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm

28. Transfer Pricing Methods • External market price • If external markets are comparable • Variable cost of production • Exclude fixed costs which are unavoidable • Full-cost of production • Average fixed and variable cost • Negotiated prices • Depends on bargaining power of divisions

29. Transfer Pricing Implementation • Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers • Internal accounting data are often used to set transfer prices, even when external market prices are available • Classifying costs as fixed or variable can influence transfer prices determined by internal accounting data • To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms

30. Transfer Pricing for International Taxation When products or services of a multinational firm are transferred between segments located in countries with different tax rates, the firm attempts to set a transfer price that minimizes total income tax liability. Segment in higher tax country: Reduce taxable income in that country by charging high prices on imports and lowprices on exports. Segment in lower tax country: Increase taxable income in that country by charging low prices on imports and highprices on exports. Government tax regulators try to reduce transfer pricing manipulation.