3 Pricing_-2.pptx

# The importance and influencing factors of pricing Pricing is a fundamental element of any business, significantly impacting revenue and profitability by influencing customer purchasing decisions and competitive positioning. ## 1. The importance and influencing factors of pricing The price of a product or service is a critical determinant of a company's total receipts and, consequently, its profit. It is often considered the most significant of the "four Ps" of marketing (product, price, place, promotion), as adjustments to price can directly affect financial outcomes, sometimes more readily than changes in product features, distribution channels, or promotional efforts. While costs are important, prices should not be solely based on them, as customer willingness to pay and market dynamics play a crucial role. ### 1.1 The fundamental significance of pricing * **Revenue and Profit Generation:** The price level directly dictates the revenue generated from sales and, in turn, contributes significantly to a company's overall profit. * **Customer Perception and Demand:** Pricing communicates value to customers. A price set too high may deter buyers, while a price set too low might signal poor quality or an unsustainable business model. * **Competitive Positioning:** Pricing strategies help differentiate a company and its products from competitors, allowing it to carve out a specific market position. > **Tip:** While costs are a foundational element, solely basing prices on cost without considering customer value and market conditions can lead to missed opportunities or an uncompetitive market position. ### 1.2 Key influencing factors on pricing decisions Pricing is not an isolated decision; it is influenced by a complex interplay of internal and external factors. #### 1.2.1 Internal influencing factors * **Marketing Strategy:** Pricing is an integral part of the overall marketing strategy. The chosen pricing strategy must align with and support the broader marketing mix (product, place, promotion) and the company's positioning strategy. Different products within a company might have different pricing strategies. * **Costs of Production:** The direct and indirect costs associated with producing a good or service, including raw materials, labor, and overhead, establish a baseline for pricing. These costs determine the minimum price required to avoid losses. #### 1.2.2 External influencing factors * **The Marketing Environment:** Broader environmental factors, such as economic conditions, public health concerns, and ecological considerations, can indirectly influence pricing by affecting consumer spending power and market demand. * **Competition:** The pricing strategies and actions of competitors are a major consideration. Companies must be aware of competitor pricing to remain competitive and avoid losing market share. * **Price Takers:** In markets with little product differentiation and intense competition, companies are often "price takers," meaning they have little control over the price, which is primarily dictated by supply and demand. * **Price Makers:** Conversely, companies with unique or highly differentiated products are "price makers" and have more freedom to set their own prices. * **Customer or Demand-Related Factors:** Understanding the customer is paramount. * **Willingness to Pay:** The maximum price a customer is willing to pay for a product or service, influenced by perceived value, income levels, and alternatives. * **Market Conditions:** Factors like the local competitive landscape, average income of the population, and general economic health of a region significantly impact pricing. For instance, the presence of a strong competitor might lead to lower prices for a product in that area. * **Consumer Reaction:** Companies must consider how consumers will react to price changes, whether increases or decreases. ### 1.3 Common pricing strategies Companies employ various strategies to set prices, often depending on their market objectives and product positioning. #### 1.3.1 Strategic pricing approaches * **Premium Pricing:** Setting a relatively high price to signal superior quality, advanced features, or a prestigious brand image. * **Going Price Strategy:** Pricing products at the level charged by most competitors, often adopted by market leaders and followers alike (follow-the-leader). * **Discount Pricing:** Pricing products significantly lower than competitors, often to attract price-sensitive customers or gain market share. * **Skimming Price (Price Skimming):** Introducing a new product at a high price to capture early adopters and innovators, then gradually lowering the price over time to appeal to broader market segments. * **Penetration Price:** Setting an initially low price for a new product to quickly gain market share and establish a presence in a new market. * **Stay-out Pricing:** Utilizing a relatively low pricing strategy to deter potential competitors from entering the market. * **Put-out Pricing (Predatory Pricing):** An established company charges very low prices to deliberately drive competitors out of the market. This can sometimes involve pricing below cost. * **Backward Pricing (Target Pricing/Market-Driven Pricing):** Starting with a sales price that is acceptable to buyers and then working backward to determine the permissible costs, including intermediary and company profit margins. The feasibility of production at this cost is then assessed. > **Example:** Sony's PlayStation 5 console was initially sold below its cost price. While this resulted in a loss on the hardware, the strategy aimed to increase sales volume, leading to higher profits from the sale of game software. This exemplifies a penetration or, in some contexts, a put-out pricing strategy for hardware to drive revenue through complementary products. ### 1.4 Target Costing: When the Market Dictates Price Target costing is a strategic approach used when the market, rather than the company, determines the product's price, particularly for price takers. #### 1.4.1 Defining target cost * **Target Cost:** This is the maximum cost a company can incur to produce a product and still achieve its desired profit margin at a market-determined selling price. * **Process of Target Costing:** 1. Identify the target market niche. 2. Conduct market research to determine the target price (the price that optimizes market position). 3. Determine the target cost by subtracting the desired profit from the target price. 4. Assemble a team to develop a product that can be produced within this target cost. > **Tip:** For price takers, effective cost management is crucial for profitability, as they cannot unilaterally increase prices. Target costing helps ensure that products can be produced profitably within market constraints. * **Formula for Target Cost:** $$ \text{Target Cost} = \text{Target Selling Price} - \text{Desired Profit} $$ #### 1.4.2 Target costing example Fine Line Phones is considering a new phone cover. Market research suggests they can sell 200,000 units if the price is no more than 20 dollars. They require a 25% return on a 1,000,000 dollar investment. * Total investment: $1,000,000$ dollars * Desired profit on investment: $25\%$ * Desired total profit: $\$1,000,000 \times 0.25 = \$250,000$ dollars * Desired profit per unit: $\$250,000 \div 200,000 \text{ units} = \$1.25$ dollars per unit * Target selling price per unit: $20$ dollars * **Target cost per unit:** $\$20 - \$1.25 = \$18.75$ dollars per unit ### 1.5 Cost-Plus Pricing: A Traditional Approach Cost-plus pricing is a method where a company establishes a cost base and adds a markup to determine the selling price. This is often used in environments with limited competition. #### 1.5.1 The cost-plus pricing formula * **Formula:** $$ \text{Selling Price} = \text{Cost} + \text{Markup} $$ The markup is often expressed as a percentage of the cost or, in some variations, a percentage of the selling price. #### 1.5.2 Determining the markup The size of the markup depends on the desired return on investment (ROI) and market conditions. * **Formula for Markup based on Cost:** $$ \text{Markup} = (\text{Desired Profit}) + (\text{Cost}) $$ If markup is a percentage of cost: $$ \text{Selling Price} = \text{Cost} \times (1 + \text{Markup Percentage on Cost}) $$ * **Formula for Markup based on Selling Price (Margin):** $$ \text{Selling Price} = \frac{\text{Cost}}{1 - \text{Markup Percentage on Selling Price}} $$ > **Example:** Thinkmore Products wants to set a price for a new video camera pen. > * Variable cost per unit: $20$ dollars > * Fixed cost per unit (at 10,000 units): $40$ dollars > * Total cost per unit: $\$20 + \$40 = \$60$ dollars > * Desired ROI: $20\%$ on an investment of $2,000,000$ dollars. > * Total desired markup: $\$2,000,000 \times 0.20 = \$400,000$ dollars. > * Markup per unit (at 10,000 units): $\$400,000 \div 10,000 \text{ units} = \$40$ dollars per unit. > * **Target Selling Price (Cost-Plus with Markup on Cost):** $\$60 + \$40 = \$100$ dollars per unit. #### 1.5.3 Limitations of cost-plus pricing * **Ignores Demand and Competition:** It does not consider customer willingness to pay or competitor pricing. A price set by cost-plus might be too high for the market or too low to be competitive. * **Changes with Volume:** Fixed costs per unit change with sales volume. If sales are lower than budgeted, the company needs to charge a higher price to achieve the desired return, potentially making the product less attractive. > **Tip:** While cost-plus pricing is straightforward, it should be used cautiously and often supplemented with market-based analysis. ### 1.6 Transfer Pricing Transfer pricing refers to the price set for goods or services transferred between two divisions or segments within the same company. #### 1.6.1 Methods for determining transfer prices * **Negotiated Transfer Prices:** Division managers agree on a price. This is conceptually ideal as it reflects each division's perspective but can be difficult to implement. * **Minimum Transfer Price (Selling Division):** The minimum price the selling division will accept is its variable cost per unit plus any lost contribution margin (opportunity cost) if it has no excess capacity. If there is excess capacity, the minimum is just the variable cost. $$ \text{Minimum Transfer Price} = \text{Variable Cost per Unit} + \text{Opportunity Cost per Unit} $$ * **Maximum Transfer Price (Purchasing Division):** The maximum price the purchasing division will pay is the cost it would incur to purchase the good or service from an external supplier. * **Cost-Based Transfer Prices:** Uses the costs incurred by the producing division as the foundation. * **Variable Cost Pricing:** Transfer price is based solely on the variable costs of the producing division. This often benefits the buying division but may not provide sufficient profit to the selling division. * **Full Cost Pricing:** Transfer price includes both variable and allocated fixed costs. A markup may also be added. * **Limitations:** Can lead to suboptimal company-wide decisions and may not accurately reflect the division's true profitability or provide incentives for cost control. * **Market-Based Transfer Prices:** Uses existing market prices of comparable goods or services as the basis for the transfer price. * **Advantages:** Objective, provides proper economic incentives, and is indifferent between selling internally and externally if market prices are used. * **Disadvantages:** Market price information may not be readily available, and it can lead to poor decisions if there is excess capacity (as the opportunity cost is ignored). > **Example:** If the Sole Division has excess capacity and can produce soles for 11 dollars (variable cost), and the Boot Division can buy them externally for 17 dollars, a negotiated transfer price between 11 dollars and 17 dollars would be mutually beneficial. If the Sole Division has no excess capacity, its minimum transfer price would include its lost contribution margin per sole, increasing the floor price. ### 1.7 Pricing for Services: Time-and-Material Pricing This approach is commonly used for services, where the cost of labor (time) and materials used are billed to the client. The pricing involves determining the appropriate labor rates (which include overhead and profit) and the markup on materials. ### 1.8 Pricing in International Contexts When transfers occur between divisions in different countries, tax rates become a significant factor. Different tax regimes can influence the optimal transfer price, as more profit can be attributed to the division in the country with the lower tax rate. This can complicate negotiations and company-wide profit maximization. ### 1.9 The Impact of Outsourcing As companies increasingly outsource production and services, the need for internal transfer pricing may decrease. However, outsourcing decisions themselves are subject to rigorous pricing analysis to ensure they are cost-effective compared to internal production. --- # Pricing strategies and their relation to company objectives Pricing strategies are fundamental to a company's financial success, as they directly influence revenue and profitability, and must be carefully aligned with overarching company objectives. ## 2. Pricing strategies and their relation to company objectives The price of a product or service is a critical determinant of a company's total receipts and, consequently, its profit. While often considered the most significant element of the marketing mix, pricing must be integrated with other "P"s (product, place, promotion) to achieve the desired market positioning. Pricing decisions are influenced by various factors, including the company's overall marketing strategy, the external market environment, competitive actions, customer demand, and the cost of production. ### 2.1 Influencing factors in pricing The development of a pricing strategy is an integral part of a company's broader marketing strategy. It must be coordinated with the other elements of the marketing mix to ensure a consistent and effective market position for the product or service. ### 2.2 Common pricing strategies Various pricing strategies can be employed, each with specific implications for market positioning and company goals: * **Premium pricing:** Setting a relatively high price for products or services perceived to have superior quality or a higher market positioning. This strategy is often associated with maximizing profit and signaling high product quality. * **Going price:** Adopting a price level that is commonly charged by most competitors. This strategy is often followed by "followers" who aim to stabilize the market by mirroring the "market leader." * **Discount pricing:** Charging a price significantly lower than competitors. This strategy is typically used to gain market share quickly. * **Skimming price (or price skimming):** Introducing a product at a high price to target innovators and early adopters, with the intention of gradually lowering the price over time. This strategy aims to maximize profit from different customer segments and recover development costs. * **Penetration price:** Setting an initially low price to rapidly capture a substantial market share in a new market. This is a common strategy for increasing market share. * **Stay-out pricing:** Employing a relatively low pricing strategy to deter potential competitors from entering the market. This strategy aims to prevent competition from emerging. * **Put-out pricing (or predatory pricing):** An established company charges low prices to deliberately force competitors out of the market. This is an aggressive strategy to eliminate competition. * **Backward pricing (or target costing):** Starting with a sales price that is acceptable to buyers, then deducting the desired intermediary margin and the company's own profit margin to determine the maximum allowable cost price. The company then assesses if it's possible to produce the product within this cost. > **Tip:** The choice of pricing strategy should be a deliberate decision that aligns with specific company objectives, whether it's market share growth, profit maximization, or market stabilization. ### 2.3 Pricing strategy and company objectives The relationship between pricing strategies and company objectives is direct and significant: * **Increase market share:** This objective is often pursued using discount pricing or penetration pricing strategies. * **Maximize profit:** This goal is frequently associated with premium pricing or price skimming strategies. * **Highest product quality:** This objective is typically supported by premium pricing, signaling superior value. * **Stabilize the market:** This is often achieved by adopting the going price, aligning with competitors. * **Deterring competitors:** This can be accomplished through stay-out pricing. * **Ensuring continuity of the company:** While not a direct strategy itself, all pricing strategies ultimately contribute to the financial health and continuity of the company. ### 2.4 Target costing Target costing is a pricing approach where the market determines the product's price, and the company must then manage its costs to achieve a desired profit. * **Price Takers vs. Price Makers:** Companies that operate in markets with little product differentiation and intense competition are **price takers**, meaning they must accept the market price. Companies with unique or clearly distinguishable products are **price makers** and can set their own prices. * **Process of Target Costing:** 1. Identify the target market niche. 2. Conduct market research to determine the target price that will appeal to the intended consumers. 3. Set a desired profit margin. 4. Calculate the **target cost**: `Target Cost = Target Price - Desired Profit`. This is the maximum cost the company can incur to meet its profit goal. 5. Assemble a team to develop a product that can be produced at or below the target cost. > **Example:** Fine Line Phones can sell 200,000 phone covers if the price is no more than $20. With an investment of $1,000,000 and a required rate of return of 25% on investment, the desired profit is $250,000. > > Desired profit per unit = $\frac{\$250,000}{200,000 \text{ units}} = \$1.25$ > > Target cost per unit = Target Price - Desired profit per unit > Target cost per unit = $\$20 - \$1.25 = \$18.75$ ### 2.5 Cost-plus pricing Cost-plus pricing is an approach where a company establishes a cost base and adds a markup to determine the selling price. This method is typically used when a company is a price maker. * **Formula:** `Selling Price = Cost + Markup` * **Markup Calculation:** The markup is often a percentage of the cost. `Markup Amount = Markup Percentage \times Cost`. * **Determining the Markup:** The size of the markup depends on competitive and market conditions, as well as the desired return on investment. `Return = Net Income \div Invested Assets`. > **Illustration:** Thinkmore Products, Inc. wants to price a new video camera pen. > > * Variable cost per unit: $20 dollars > * Fixed cost per unit (at 10,000 units): $40 dollars > * Total unit cost (at 10,000 units): $20 + \$40 = \$60$ dollars > * Investment: $2,000,000$ dollars > * Desired Return: 20% > * Total Markup required: $20\% \times \$2,000,000 = \$400,000$ dollars > * Markup per unit (at 10,000 units): $\frac{\$400,000}{10,000 \text{ units}} = \$40$ dollars > * Target Selling Price: Total Unit Cost + Markup per unit = $\$60 + \$40 = \$100$ dollars * **Limitations of Cost-Plus Pricing:** * It does not adequately consider demand or competition; customers may not be willing to pay the calculated price. * Fixed costs per unit change with sales volume. If sales volume is lower than budgeted, a higher price must be charged to achieve the desired return, potentially making the product uncompetitive. ### 2.6 Pricing and margins The selling price (SP) can be viewed as the sum of the margin (M) and the average cost per unit (C), where the margin can be expressed as a percentage of cost or a percentage of the selling price. * **Margin as a percentage of cost:** `SP = C + (m \times C)` or `SP = C \times (1 + m)` * **Example:** If cost is $100$ dollars and the margin is 25% of cost, `SP = \$100 + (0.25 \times \$100) = \$125` dollars. * **Margin as a percentage of the selling price:** `SP = C + (m \times SP)` which can be rearranged to `SP \times (1 - m) = C`, so `SP = \frac{C}{(1-m)}` * **Example:** If cost is $100$ dollars and the margin is 25% of the selling price, `SP = \frac{\$100}{(1-0.25)} = \frac{\$100}{0.75} = \$133.33` dollars. ### 2.7 Transfer pricing Transfer pricing refers to the price used to record the transfer of goods or services between two divisions within the same company. * **Methods for determining transfer prices:** * **Negotiated transfer prices:** Division managers negotiate a price. This is conceptually the best approach, as it reflects the divisions' perspectives. * **No excess capacity:** The minimum transfer price for the selling division is `Variable Cost per Unit + Lost Contribution Margin per Unit (Opportunity Cost)`. The maximum transfer price for the buying division is the `External Purchase Price`. A deal is struck if the minimum acceptable price for the seller is less than or equal to the maximum acceptable price for the buyer. * **Excess capacity:** If the selling division has excess capacity, it does not lose contribution margin from external sales. The minimum transfer price is simply the `Variable Cost per Unit`. * **Cost-based transfer prices:** Based on the costs incurred by the producing division. This can be based on variable costs alone, or variable costs plus a portion of fixed costs, and may include a markup for the selling division. This method can lead to suboptimal decisions for the company and unfair evaluation of division performance if not carefully managed. * **Market-based transfer prices:** Based on the existing market prices of comparable goods or services. This is often considered the best approach as it is objective and provides proper economic incentives, making the division indifferent between selling internally and externally. However, it may not be feasible if a well-defined market price does not exist. > **Tip:** Transfer pricing is particularly complex when divisions are located in different countries due to varying tax rates, which can influence the allocation of profits and tax liabilities. > > **Example:** Alberta Company's Sole Division, operating at full capacity, sells soles externally for $17 dollars per unit. The variable cost is $11 dollars per unit, and the lost contribution margin is $6 dollars per unit. The Boot Division can purchase soles externally for $17 dollars. > > Minimum transfer price for Sole Division = Variable Cost + Lost Contribution Margin = $\$11 + \$6 = \$17$ dollars. > Maximum transfer price for Boot Division = External Purchase Price = $17$ dollars. > > A negotiated transfer price of $17$ dollars would be acceptable to both divisions. ### 2.8 Outsourcing and its effect on transfer pricing As companies increasingly rely on outsourcing, the need for internal transfer pricing decreases. However, outsourcing is not always the most cost-effective solution, and internal transfer pricing remains relevant in many scenarios. --- # Target costing and cost-plus pricing methods This section explores two fundamental pricing strategies: target costing, driven by market price, and cost-plus pricing, determined by adding a markup to costs. ### 8.1 The role of pricing The price of any product or service is a critical factor influencing a company's total receipts and profitability. While many factors affect pricing, including marketing strategy, environment, competition, and customer demand, the costs of production are a primary determinant. However, pricing solely based on costs can be misguided, as consumer willingness to pay is paramount. #### 8.1.1 Influencing factors in pricing * **Marketing strategy:** Pricing is an integral part of the overall marketing strategy, requiring coordination with other marketing mix elements (product, place, promotion) to ensure consistent product positioning. * **Market environment:** External factors such as competition and consumer behavior significantly influence pricing decisions. Companies operating in markets with strong competition (price takers) have less control over pricing than those with unique products (price makers). * **Customer or demand factors:** Understanding consumer perception, willingness to pay, and demand elasticity is crucial. * **Costs of production:** These factors (raw materials, labor, etc.) establish the baseline cost for a product or service. #### 8.1.2 Pricing strategies overview Various pricing strategies exist, each with a specific objective: * **Premium pricing:** Setting a relatively high price for products perceived as having superior quality or positioning. * **Going price:** Aligning prices with the prevailing market rates set by competitors. * **Discount pricing:** Offering prices significantly lower than those of competitors. * **Skimming price:** Introducing a product at a high price to capture early adopters and innovators, gradually reducing it later. * **Penetration price:** Setting a low initial price to quickly gain market share in a new market. * **Stay-out pricing:** Employing relatively low prices to deter potential competitors from entering the market. * **Put-out pricing:** An established company charges low prices to deliberately drive competitors out of the market. * **Backward pricing:** Starting with an acceptable sales price to buyers, then accounting for intermediary margins and the company's desired profit to determine if production is feasible within the remaining cost. > **Tip:** The choice of pricing strategy should be closely aligned with the company's overall marketing strategy and its desired market positioning. ### 8.2 Target costing Target costing is a pricing method where the market price dictates the cost. It is particularly relevant for companies that are **price takers**, meaning they have little control over the price due to market forces. #### 8.2.1 The target costing process 1. **Identify market niche:** Determine the specific market segment the company wishes to serve. 2. **Determine target price:** Conduct market research to establish the price that will optimize the company's position with its target consumers. 3. **Determine target cost:** Set a desired profit margin, and subtract this from the target price to arrive at the target cost. $$ \text{Target Cost} = \text{Target Price} - \text{Desired Profit} $$ 4. **Product development:** Assemble a team to develop a product that can be produced at or below the target cost while meeting the company's quality and feature goals. #### 8.2.2 Target costing calculation example Fine Line Phones is considering introducing a fashion cover for its phones. * Market research indicates that 200,000 units can be sold at a maximum price of $20 per unit. * The company requires a minimum rate of return of 25% on its investment of $1,000,000 in new production equipment. **Calculation:** * **Desired profit per unit:** * Total desired profit: $1,000,000 \times 25\% = 250,000$ dollars * Desired profit per unit: $250,000 \text{ dollars} \div 200,000 \text{ units} = 1.25$ dollars per unit * **Target cost per unit:** * Target cost per unit = Target price per unit - Desired profit per unit * Target cost per unit = $20 - 1.25 = 18.75$ dollars per unit > **Tip:** Cost management is paramount in target costing to ensure the product can be produced within the determined target cost. ### 8.3 Cost-plus pricing Cost-plus pricing is a method used when a company has more control over pricing (**price makers**). It involves establishing a cost base and adding a markup to determine the selling price. #### 8.3.1 The cost-plus pricing formula The basic formula for cost-plus pricing is: $$ \text{Selling Price} = \text{Cost} + \text{Markup} $$ The markup can be expressed as a percentage of the cost or the selling price, and it represents the desired profit. #### 8.3.2 Determining the markup The size of the markup depends on several factors, including: * **Desired return on investment (ROI):** The markup should be sufficient to achieve the company's targeted ROI. $$ \text{Return on Investment} = \frac{\text{Net Income}}{\text{Invested Assets}} $$ * **Market conditions:** Competitive pressures and customer willingness to pay will influence the acceptable markup. * **Strategic marketing objectives:** The markup may be adjusted to support specific marketing goals. #### 8.3.3 Cost-plus pricing calculation example Thinkmore Products, Inc. is setting a selling price for a new video camera pen. * **Variable cost per unit:** $10$ dollars * **Fixed cost per unit (at budgeted sales volume of 10,000 units):** $6$ dollars * **Total cost per unit (at 10,000 units):** $10 + 6 = 16$ dollars * **Investment:** $2,000,000$ dollars * **Desired ROI:** 20% **Calculation (based on 10,000 units):** 1. **Calculate desired profit (markup):** * Total desired profit: $2,000,000 \text{ dollars} \times 20\% = 400,000$ dollars * Markup per unit: $400,000 \text{ dollars} \div 10,000 \text{ units} = 40$ dollars per unit 2. **Calculate selling price:** * Selling Price = Total unit cost + Markup per unit * Selling Price = $16 + 40 = 56$ dollars **Alternative Markup Calculation (using markup on cost):** If Thinkmore uses a 45% markup on total per unit cost and assumes 10,000 units: 1. **Total cost per unit:** $16$ dollars 2. **Markup amount:** $16 \text{ dollars} \times 45\% = 7.20$ dollars 3. **Selling Price:** $16 + 7.20 = 23.20$ dollars #### 8.3.4 Limitations of cost-plus pricing * **Ignores demand and competition:** It does not consider whether customers will actually pay the calculated price or what competitors are charging. * **Volume dependency of fixed costs:** The fixed cost per unit changes with sales volume. At lower volumes, a higher price is needed to achieve the desired return, which can make the product uncompetitive. > **Example:** If Thinkmore's sales volume dropped to 5,000 units, the fixed cost per unit would double. The required markup per unit to achieve the desired ROI of $40$ dollars per unit (based on the $2,000,000$ dollar investment) would increase significantly, leading to a much higher selling price. #### 8.3.5 Variable-cost pricing An alternative to full cost-plus pricing is to add a markup to variable costs. This avoids the issue of fluctuating fixed costs per unit but can lead to underpricing if fixed costs are not adequately covered. It is often useful for special orders or when a company has excess capacity. ### 8.4 Pricing and margins The relationship between sales price (SP), margin (M), and average cost per unit (C) can be expressed as: $$ \text{SP} = \text{M} + \text{C} $$ The margin can be calculated as a percentage of cost or a percentage of the selling price: 1. **Margin as a percentage of cost:** $$ \text{SP} = \text{C} + (\text{markup percentage} \times \text{C}) = \text{C}(1 + \text{markup percentage}) $$ 2. **Margin as a percentage of selling price:** $$ \text{SP} = \text{C} + (\text{markup percentage} \times \text{SP}) $$ Rearranging gives: $$ \text{SP} (1 - \text{markup percentage}) = \text{C} $$ $$ \text{SP} = \frac{\text{C}}{1 - \text{markup percentage}} $$ ### 8.5 Transfer pricing Transfer price is the price used to record the transfer of goods or services between two divisions within the same company. #### 8.5.1 Methods for determining transfer prices * **Negotiated transfer prices:** Division managers negotiate the price. This is theoretically the best method, as it reflects each division's perspective, but it can be time-consuming and lead to conflict. * **Minimum transfer price (selling division):** This is the variable cost per unit plus any lost contribution margin (opportunity cost). $$ \text{Minimum Transfer Price} = \text{Variable Cost per Unit} + \text{Opportunity Cost per Unit} $$ * **Maximum transfer price (purchasing division):** This is the lowest price at which the purchasing division can acquire the good or service externally. * **Negotiation range:** A transfer price is agreed upon within the range defined by the minimum acceptable price for the seller and the maximum acceptable price for the buyer. * **Cost-based transfer prices:** Uses the costs incurred by the producing division as the basis. This can be based on variable costs, variable costs plus a markup, or full costs. * **Limitation:** Can lead to suboptimal company-wide decisions and unfair division performance evaluations if not carefully implemented. It may not reflect the true profitability or provide adequate incentives for cost control. * **Market-based transfer prices:** Based on existing external market prices for similar goods or services. This is often considered the best approach as it is objective and provides proper economic incentives for both divisions, making them indifferent between selling internally or externally. > **Tip:** When there is excess capacity, the opportunity cost for the selling division is zero, lowering the minimum transfer price. #### 8.5.2 Effect of outsourcing and globalization * **Outsourcing:** As companies increasingly outsource, the need for internal transfer pricing decreases. * **Globalization:** Transfers between divisions in different countries introduce complexities, particularly due to varying tax rates, which can significantly impact after-tax contribution margins and necessitate careful transfer price setting. --- # Transfer pricing between company divisions Transfer pricing establishes the value of goods or services exchanged between different divisions within the same company. ### 4.1 The importance of transfer pricing Transfer prices are critical because they impact a company's total revenue and profitability. They are used to record the transfer of goods or services between divisions, influencing divisional performance evaluations and potentially the overall company's financial outcomes. ### 4.2 Methods for determining transfer prices There are three primary methods for determining transfer prices: #### 4.2.1 Negotiated transfer prices Conceptually, this is considered the most optimal method as it involves direct negotiation between the managers of the selling and buying divisions. The final price is agreed upon by both parties, reflecting their respective objectives and constraints. **Key considerations for negotiated transfer prices:** * **Minimum transfer price for the selling division:** * **No excess capacity:** The selling division must at least cover its variable costs and the opportunity cost (lost contribution margin) of selling internally rather than externally. $$ \text{Minimum transfer price} = \text{Variable cost per unit} + \text{Opportunity cost per unit} $$ * **Excess capacity:** If the selling division has excess capacity, the opportunity cost is zero, so the minimum transfer price is simply its variable cost. $$ \text{Minimum transfer price} = \text{Variable cost per unit} $$ * **Maximum transfer price for the buying division:** The buying division will not pay more for the good or service than it would cost to purchase it from an outside supplier. * **Negotiation range:** A deal can be reached if a transfer price can be negotiated within the range defined by the selling division's minimum acceptable price and the buying division's maximum acceptable price. **Factors that can hinder negotiated transfer prices:** * Market price information may not be readily available or easily obtainable. * A lack of trust or conflicting strategies between divisions can impede negotiations. #### 4.2.2 Cost-based transfer prices This method uses the costs incurred by the division producing the goods or services as the basis for the transfer price. It can be based on variable costs alone, variable costs plus allocated fixed costs, or variable costs plus a markup. * **Variable cost-based transfer price:** This is the simplest form, using only the variable costs of the producing division. * **Variable cost plus fixed cost markup:** This approach includes allocated fixed costs along with variable costs. * **Variable cost plus a markup:** The selling division may add a markup to cover its desired profit or return. **Disadvantages of cost-based transfer prices:** * **Improper transfer prices:** This can lead to a loss of profitability for the overall company. * **Unfair evaluation of division performance:** The producing division may not be fairly compensated, or the purchasing division may incur higher costs than necessary. * **Lack of profit for the selling division:** If based solely on costs without a markup, the selling division may not recognize any profit on the internal transfer, potentially distorting performance metrics. * **Company-wide impact:** A cost-based approach, especially when the selling division has excess capacity, can lead to suboptimal decisions for the company as a whole. #### 4.2.3 Market-based transfer prices This approach uses the existing market prices of competing goods or services as the basis for the transfer price. **Advantages of market-based transfer prices:** * **Objectivity:** It is an objective measure that is generally considered the best approach because it provides proper economic incentives. * **Divisional indifference:** If the selling division can charge the market price internally, it is indifferent to selling internally or externally. **Limitations of market-based transfer prices:** * **Market price availability:** A well-defined market price may not always exist or be easily obtainable. * **Suboptimal decisions with excess capacity:** If the selling division has excess capacity, using the market price might lead to decisions that don't fully consider the company's overall objectives, as the opportunity cost is not explicitly factored in. ### 4.3 Impact of outsourcing on transfer pricing As companies increasingly outsource activities, the need for internal transfer pricing diminishes because fewer components are transferred between divisions. However, outsourcing is not always the most cost-effective solution. ### 4.4 Transfers between divisions in different countries When divisions are located in different countries, transfer pricing becomes more complex due to varying tax rates. The allocation of profits between divisions can significantly impact the total tax liability of the multinational corporation. The goal is often to manage the overall tax burden effectively. > **Tip:** The choice of transfer pricing method can significantly impact divisional autonomy, performance evaluation, and overall company profitability. It is crucial to select a method that aligns with the company's strategic objectives and provides appropriate incentives for all divisions. --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Pricing | The process of determining what a company will charge for a product or service, considering costs, customer willingness to pay, and market conditions. | | Cost-plus pricing | A pricing method where a company establishes a cost base for a product or service and then adds a markup to determine the selling price. | | Target cost | The maximum allowable cost for a product or service, determined by subtracting the desired profit from the market-determined selling price. | | Skimming price | A pricing strategy where a higher price is set for a new product to capture maximum revenue from early adopters, with the price gradually decreasing over time. | | Penetration price | A pricing strategy where a low initial price is set for a new product to quickly gain market share and attract a large customer base. | | Going price | The price level that most competitors in a market charge for similar products or services; often followed by market leaders and their competitors. | | Discount pricing | A strategy where a product is priced significantly lower than competitors, often used to attract price-sensitive customers or to clear inventory. | | Backward pricing | A pricing method that starts with a sales price acceptable to buyers, then deducts the intermediary margin and the company's profit margin to determine the maximum production cost. | | Transfer price | The price used to record the transfer of goods or services between two divisions or departments within the same company. | | Cost-based transfer price | A transfer price determined by using the costs incurred by the producing division, which can be based on variable costs, full costs, or full costs plus a markup. | | Market-based transfer price | A transfer price determined by the existing market prices of competing goods or services, considered objective and providing proper economic incentives. | | Negotiated transfer price | A transfer price that is agreed upon by the managers of both the selling and purchasing divisions within a company. | | Price taker | A company or market participant that has no influence on the market price and must accept the prevailing price determined by supply and demand. | | Price maker | A company that can set its own prices for its products or services, typically due to unique or clearly distinguishable offerings. | | Outsourcing | The practice of contracting with an external party to provide goods or services that were previously performed internally. | | Contribution margin | The revenue generated by a product or service minus its variable costs. It represents the amount available to cover fixed costs and contribute to profit. |