Pricing Decisions EMBA 5411 Budgeting and Pricing FALL
Pricing Decisions EMBA 5411 Budgeting and Pricing FALL 2006 EMBA 5411 -C. Simga-Mugan /25
Pricing p External sales- outside n n p Target costing Cost plus pricing Variable cost pricing Time and material pricing Internal-within the company among divisions n n n Negotiated transfer prices Cost based transfer prices Market based transfer prices Effect of outsourcing on transfer prices Transfers between divisions in different countries 2
Profit Maximization Economic Theory n n The quantity demanded is a function of the price that is charged Generally, the higher the price, the lower the quantity demanded Pricing n Management should set the price that provides the greatest amount of profit 3
Determining the Profit. Maximizing Price and Quantity Dollars per unit Profit is maximized where marginal cost equals marginal revenue, resulting in price p* and quantity q*. p* Demand Marginal cost q* Marginal Quantity made revenue and sold per month 4
Determining the Profit-Maximizing Price and Quantity Total cost Total revenue Dollars Total profit at the profit-maximizing quantity and price, q* and p*. q* Quantity made and sold per month 5
Price Elasticity The impact of price changes on sales volume Demand is elastic if a price increase has a large negative impact on sales volume. Demand is inelastic if a price increase has little or no impact on sales volume. 6
Who determines the price? p Price takers- when there is a competitive market and the company has no influence on price n p 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. 7
Influences on Price Customer demand p Competitors’ behavior/prices/actions p Costs p Regulatory environment – legal, political and image related p 8
Pricing approaches p Cost plus mark-up n n p 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 9
Product Life Cycle 10 http: //www. hss. caltech. edu/~mcafee/Classes/BEM 106/PDF/Product. Life. Cycle. pdf
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). p The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996). p 11
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Cost-plus Pricing Cost + mark-up = price p Mark-up = cost x desired % return p 13
Which cost? p 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 14
Which costs? p Total variable costs n Variable manufacturing and selling costs Price= variable costs + markup %* variable costs 15
Which costs? Absorption – manufacturing costs p Unit manufacturing costs – both variable and fixed p Price= unit manuf. cost + markup %* unit manufacturing cost 16
Which costs? p Absorption – total costs n Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs) Price= unit cost + markup %* unit cost 17
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 18
Cost Plus Pricing Versions 19
Cost Plus Pricing Versions 20
Time and Material Pricing Determine a charge for labor that includes overhead p Determine a charge for materials that includes handling and storage costs p Include a profit p Sum = price p Used in service companies mainly; appropriate for construction companies as well p 21
Example 22
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 4% of material costs 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)] =1. 04 x material costs incurred on job 23
Example con’t 24
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: p Internal charge paid by final assembly division for components produced by other divisions p Service fees to operating departments for telecommunications, maintenance, and services by support services departments 25
Effects of Transfer Prices Performance measurement: p Reallocate total company profits among business segments p Influence decision making by purchasing, production, marketing, and investment managers Rewards and punishments: p Compensation for divisional managers Partitioning decision rights: p Disputes over determining transfer prices 26
Ideal Transfer Pricing Ideal transfer price would be p Opportunity cost, or the value forgone by not using the transferred product in its next best alternative use p Opportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm 27
Transfer Pricing Methods p p External market price n If external markets are comparable Variable cost of production n Exclude fixed costs which are unavoidable Full-cost of production n Average fixed and variable cost Negotiated prices n Depends on bargaining power of divisions 28
Transfer Pricing Implementation p Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers p Internal accounting data are often used to set transfer prices, even when external market prices are available p Classifying costs as fixed or variable can influence transfer prices determined by internal accounting data p To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms 29
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 low prices on exports. Segment in lower tax country: Increase taxable income in that country by charging low prices on imports and high prices on exports. Government tax regulators try to reduce transfer pricing manipulation. 30
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