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JWCL162_c08_336-385.qxd 7/30/09 7:04 PM Page 336 Find more at www.downloadslide.com chapter 8 Pricing ✓ ● the navigator ● Scan Study Objectives study objectives ● Read Feature Story After studying this chapter, you should be able to: ● Read Preview ● Read Text and answer Do it! p. 340 p. 344 p. 347 p. 352 1 Compute a target cost when the market determines a product price. ● Work Using the Decision Toolkit ● Review Summary of Study Objectives ● Work Comprehensive Do it! p. 363 ● Answer Self-Study Questions ● Complete Assignments 2 Compute a target selling price using cost-plus pricing. 3 Use time-and-material pricing to determine the cost of services provided. 4 Determine a transfer price using the negotiated, cost-based, and market-based approaches. 5 Explain issues involved in transferring goods between divisions in different countries. 336 JWCL162_c08_336-385.qxd 7/30/09 7:04 PM Page 337 Find more at www.downloadslide.com feature story “I’ll Call Your Bluff, and Raise You 46%” If you own a PC, then there is a demand. In the meantime, AMD of its chips. In the past, price wars roughly 85% chance that the was boasting that it had a chip that have typically hurt AMD worse since microprocessor chip that runs your was more powerful than Intel’s, and Intel’s massive volume allows it to machine was made by Intel. For as that it had plenty of supply to meet produce chips at a lower cost. In long as most people can remember, demand. The result was that Intel’s 2006 Intel’s gross profit rate was Intel has had at least an 85% share of market share fell—to 82%. about 50%, while AMD’s was only the market for PC computer chips. It To those familiar with Intel, its about 36%. An all-out price war, isn’t that nobody else makes computer response was easily predicted. It cut however, would leave both companies chips; it’s just that the competition prices by up to 26%. One analyst battered and bruised. The stock price can’t seem to get a foothold. noted, “When Intel screws up, they of both companies falls on the news can’t send flowers, so they cut of price cuts. Intel’s primary competition comes from a scrappy company prices.” Said another analyst, “Intel called Advanced Micro Devices (AMD). has drawn a line in the sand at 85% At one time, Intel made a couple of market share, and they will use price missteps that caused it to lose a few to regain that share.” points of market share to AMD. First, AMD had little choice but to Intel had two product recalls on its respond with price cuts of its own. chips. Then it had problems meeting It cut prices by up to 46% on some Inside Chapter 8 Wal-Mart Says the Price Is Too High (p. 340) At Least It Was Simple (p. 344) It Ain’t Like It Used to Be (p. 348) Transferring Profits and Reducing Taxes (p. 356) 337 Source: Molly Williams, “Intel Cuts Prices, Prompts AMD to Answer the Call.” Wall Street Journal, October 17, 2000. JWCL162_c08_336-385.qxd 7/30/09 7:04 PM Page 338 Find more at www.downloadslide.com preview of chapter 8 As the Feature Story about Intel and AMD indicates, few management decisions are more important than setting prices. Intel, for example, must sell computer chips at a price that is high enough to cover its costs and ensure a reasonable profit. But if the price is too high, the chips will not sell. In this chapter, we examine two types of pricing situations. The first part of the chapter addresses pricing for goods sold or services provided to external parties. The second part of the chapter addresses pricing decisions managers face when they sell goods to other divisions within the company. The content and organization of this chapter are as follows. Pricing External Sales • • • • Target costing Cost-plus pricing Variable-cost pricing Time-and-material pricing Internal Sales • • • • Negotiated transfer prices Cost-based transfer prices Market-based transfer prices Effect of outsourcing on transfer pricing • Transfers between divisions in different countries section one External Sales Establishing the price for any good or service is affected by many factors. Take the pharmaceutical industry as an example. Its approach to profitability has been to spend heavily on research and development in an effort to find and patent a few new drugs, price them high, and market them aggressively. Due to the AIDS crisis in Africa, the drug industry has been under considerable pressure recently to lower prices on drugs used to treat AIDS. For example, Merck Co. lowered the price of its AIDS drug Crixivan to $600 per patient in these countries. This compares with the $6,016 it typically charges in the United States.1 As a consequence, individuals in the United States are questioning whether prices in the U.S. market are too high. The drug companies counter that to cover their substantial financial risks to develop these products, they need to set the prices high. Illustration 8-1 indicates the many factors that can affect pricing decisions. In the long run, a company must price its product to cover its costs and earn a reasonable profit. But to price its product appropriately, it must have a good understanding of market forces at work. In most cases, a company does not set the prices. Instead the price is set by the competitive market (the laws of supply and demand). For example, a company such as ChevronTexaco or ExxonMobil cannot set the price of gasoline by itself. These companies are called price takers because the price of gasoline is set by market forces (the supply of oil and the 1 “AIDS Gaffes in Africa Come Back to Haunt Drug Industry at Home,” Wall Street Journal, April 23, 2001, p. 1. 338 JWCL162_c08_336-385.qxd 7/30/09 7:04 PM Page 339 Find more at www.downloadslide.com Target Costing 339 Illustration 8-1 Pricing factors Pricing Objectives Environment What price should we charge? Gain market share Achieve a target rate of return Political reaction to prices Patent or copyright protection Demand Cost Considerations Price sensitivity Demographics Fixed and variable costs Short-run or long-run demand by customers). This is the case for any product that is not easily differentiated from competing products, such as farm products (corn or wheat) or minerals (coal or sand). In other situations, the company sets the prices. This would be the case where the product is specially made for a customer, as in a one-of-a-kind product such as a designer dress by Zoran or Armani. This also occurs when there are few or no other producers capable of manufacturing a similar item. An example would be a company that has a patent or copyright on a unique process, such as the case of computer chips by Intel. However, it is also the case when a company can effectively differentiate its product or service from others. Even in a competitive market like coffee, Starbucks has been able to differentiate its product and charge a premium for a cup of java. Target Costing Automobile manufacturers like Ford or Toyota face a competitive market. The price of an automobile is affected greatly by the laws of supply and demand, so no company in this industry can affect the price to a significant degree. Therefore, to earn a profit, companies in the auto industry must focus on controlling costs. This requires setting a target cost that provides a desired profit. Illustration 8-2 shows the relationship and importance of a target cost to the price and desired profit. Market Price ⴚ Desired Profit ⴝ Target Cost If General Motors, for example, can produce its automobiles for the target cost (or less), it will meet its profit goal. If it cannot achieve its target cost, it will fail to produce the desired profit (and will most likely “get hammered” by stockholders and the market). In a competitive market, a company chooses the segment of the market it wants to compete in—that is, its market niche. For example, it may choose between selling luxury goods or economy goods in order to focus its efforts on one segment or the other. Once the company has identified its segment of the market, it conducts market research to determine the target price. This target price is the price that the company believes would place it in the optimal position for its target audience. Once the company has determined this target price, it can determine its target cost by setting a desired profit. The difference between the target price and the desired profit study objective Compute a target cost when the market determines a product price. Illustration 8-2 Target cost as related to price and profit 1 JWCL162_c08_336-385.qxd 8/4/09 10:23 AM Page 340 Find more at www.downloadslide.com 340 chapter 8 Pricing is the target cost of the product (shown in Illustration 8-2 on page 339). After the company determines the target cost, it assembles a team of employees with expertise in a variety of areas (production and operations, marketing, and finance). The team’s task is to design and develop a product that can meet quality specifications while not exceeding the target cost. The target cost includes all product and period costs necessary to make and market the product or service. Management Insight Wal-Mart Says the Price Is Too High “And the price should be $19 per pair of jeans instead of $23,” said the retailer Wal-Mart to jean maker Levi Strauss. What happened to Levi Strauss is what happens to many manufacturers who deal with Wal-Mart. Wal-Mart often sets the price, and the manufacturer has to find out how to make a profit, given that price. In Levi Strauss’s case, it revamped its distribution and production to serve Wal-Mart and improve its overall record of timely deliveries. Producing a season of new jeans styles, from conception to store shelves, used to take Levi 12 to 15 months. Today it takes just 10 months for Levi Strauss signature jeans; for regular Levi’s, the time is down to 7 1/2 months. As the chief executive of Levi Strauss noted, “We had to change people and practice. It’s been somewhat of a D-Day invasion approach.” Source: “In Bow to Retailers’ New Clout, Levi Strauss Makes Alterations,” Wall Street Journal, June 17, 2004, p A1. ? What are some issues that Levi Strauss should consider in deciding whether it should agree to meet Wal-Mart’s target price? DECISION TOOLKIT DECISION CHECKPOINTS How does management use target costs to make decisions about manufacturing products or providing services? INFO NEEDED FOR DECISION Target selling price, desired profit, target cost TOOL TO USE FOR DECISION Target selling price less desired profit equals target cost HOW TO EVALUATE RESULTS If actual cost exceeds target cost, the company will not earn desired profit. If desired profit is not achieved, company must evaluate whether to manufacture the product or provide the service. before you go on... Target Costing Action Plan • Recall that Market price ⫺ Desired profit ⫽ Target cost. • The minimum rate of return is a company’s desired profit. Do it! Fine Line Phones is considering introducing a fashion cover for its phones. Market research indicates that 200,000 units can be sold if the price is no more than $20. If Fine Line decides to produce the covers, it will need to invest $1,000,000 in new production equipment. Fine Line requires a minimum rate of return of 25% on all investments. Determine the target cost per unit for the cover. Solution The desired profit for this new product line is $250,000 ($1,000,000 ⫻ 25%) Each cover must result in $1.25 of profit ($250,000/200,000 units) Market price ⫺ Desired profit ⫽ Target cost per unit $20 ⫺ $1.25 ⫽ $18.75 per unit Related exercise material: BE8-1, E8-1, E8-2, and Do it! 8-1. JWCL162_c08_336-385.qxd 7/30/09 7:04 PM Page 341 Find more at www.downloadslide.com Cost-Plus Pricing 341 Cost-Plus Pricing As discussed, in a competitive, common-product environment the market price is already set, and the company instead must set a target cost. But, in a less competitive or noncompetitive environment, the company may be faced with the task of setting its own price. When the company sets the price, price is commonly a function of the cost of the product or service. That is, the typical approach is to use cost-plus pricing. This approach involves establishing a cost base and adding to this cost base a markup to determine a target selling price. This is the selling price that will provide the desired profit when the seller has the ability to determine the product’s price. The size of the markup (the “plus”) depends on the desired return on investment (ROI ⫽ Net income ⫼ Invested assets) for the product line, product, or service. In determining the proper markup, the company must also consider competitive and market conditions, political and legal issues, and other relevant risk factors. The cost-plus pricing formula is expressed as follows. Cost ⴙ Markup Percentage ⴛ Cost ⴝ study objective Compute a target selling price using cost-plus pricing. Illustration 8-3 Cost-plus pricing formula Target Selling Price To illustrate, assume that Cleanmore Products, Inc. is in the process of setting a selling price on its new top-of-the-line, 3-horsepower, 16-gallon, variablespeed wet/dry shop vacuum. The per unit variable cost estimates for the new shop vacuum are as follows. Illustration 8-4 Variable cost per unit Per Unit Direct materials Direct labor Variable manufacturing overhead Variable selling and administrative expenses $ 23 17 12 8 Variable cost per unit $60 In addition, Cleanmore has the following fixed cost per unit at a budgeted sales volume of 10,000 units. Fixed manufacturing overhead Fixed selling and administrative expenses Fixed cost per unit 2 Total Costs ⴜ Budgeted Volume ⴝ Cost per Unit $280,000 240,000 ⫼ ⫼ 10,000 10,000 ⫽ ⫽ $28 24 $52 Cleanmore decided to price its new shop vacuum to earn a 20% return on its $1,000,000 investment (ROI). Therefore, Cleanmore expects to receive income of $200,000 (20% ⫻ $1,000,000) on its investment. On a per unit basis, the desired ROI is $20 ($200,000 ⫼ 10,000 units). Given the per unit costs shown above, it computes the sales price to be $132 (Illustration 8-6, page 342). Illustration 8-5 Fixed cost per unit, 10,000 units JWCL162_c08_336-385.qxd 7/30/09 7:04 PM Page 342 Find more at www.downloadslide.com 342 chapter 8 Pricing Illustration 8-6 Computation of selling price, 10,000 units Per Unit Variable cost Fixed cost $ 60 52 Total cost Desired ROI 112 20 Selling price per unit $132 In most cases, companies like Cleanmore will use a percentage markup on cost to determine the selling price. The formula to compute the markup percentage to achieve a desired ROI of $20 per unit is as follows. Illustration 8-7 Computation of markup percentage Desired ROI ⴜ per Unit $20 ⫼ Total Markup ⴝ Unit Cost Percentage $112 ⫽ 17.86% Using a 17.86% markup on cost, Cleanmore Products would compute the target selling price as follows. Illustration 8-8 Computation of selling price—markup approach Total Unit Cost ⴙ $112 ⫹ ( Total Unit Cost ⴛ Markup Percentage ($112 ⫻ 17.86%) ) Target ⴝ Selling Price per Unit ⫽ $132 Cleanmore should set the price for its wet/dry vacuum at $132 per unit. LIMITATIONS OF COST-PLUS PRICING The cost-plus pricing approach has a major advantage: It is simple to compute. However, the cost model does not give consideration to the demand side. That is, will customers pay the price Cleanmore computed for its vacuums? In addition, sales volume plays a large role in determining per unit costs. The lower the sales volume, for example, the higher the price Cleanmore must charge to meet its desired ROI. To illustrate, if the budgeted sales volume was 8,000 instead of 10,000, Cleanmore’s variable cost per unit would remain the same. However, the fixed cost per unit would change as follows. Illustration 8-9 Fixed cost per unit, 8,000 units Fixed manufacturing overhead Fixed selling and administrative expenses Fixed cost per unit Total Costs ⴜ Budgeted Volume ⴝ Cost per Unit $280,000 240,000 ⫼ ⫼ 8,000 8,000 ⫽ ⫽ $35 30 $65 JWCL162_c08_336-385.qxd 8/4/09 10:26 AM Page 343 Find more at www.downloadslide.com Variable-Cost Pricing As indicated in Illustration 8-5, the fixed cost per unit for 10,000 units was $52. However, at a lower sales volume of 8,000 units, the fixed cost per unit increases to $65. Cleanmore’s desired 20% ROI now results in a $25 ROI per unit [(20% ⫻ $1,000,000) ⫼ 8,000]. Cleanmore computes the selling price at 8,000 units as follows. Per Unit Variable cost Fixed cost $ 60 65 Total cost Desired ROI 125 25 Selling price per unit $150 As shown, the lower the budgeted volume, the higher the per unit price. The reason: Fixed costs and ROI are spread over fewer units, and therefore the fixed cost and ROI per unit increase. In this case, at 8,000 units, Cleanmore would have to mark up its total unit costs 20% to earn a desired ROI of $25 per unit, as shown below. 20% ⫽ $25 (desired ROI) $125 (total unit cost) The target selling price would then be $150, as indicated earlier: $125 ⫹ ($125 ⫻ 20%) ⫽ $150 The opposite effect will occur if budgeted volume is higher (say, at 12,000 units) because fixed costs and ROI can be spread over more units. As a result, the cost-plus model of pricing will achieve its desired ROI only when Cleanmore sells the quantity it budgeted. If actual volume is much less than budgeted volume, Cleanmore may sustain losses unless it can raise its prices. Variable-Cost Pricing In determining the target price for Cleanmore’s shop vacuum, we calculated the cost base by including all costs incurred. This approach is referred to as full-cost pricing. Instead of using full costs to set prices, some companies simply add a markup to their variable costs. Using variable-cost pricing as the basis for setting prices avoids the problem of using uncertain cost information (as shown in Illustration 8-9) related to fixed-cost-per-unit computations. Variable-cost pricing also is helpful in pricing special orders or when excess capacity exists. The major disadvantage of variable-cost pricing is that managers may set the price too low and consequently fail to cover their fixed costs. In the long run, failure to cover fixed costs will lead to losses. As a result, companies that use variable-cost pricing must adjust their markups to make sure that the price set will provide a fair return. An example of how variable costs are used as the basis for setting prices is discussed in the appendix to this chapter. Illustration 8-10 Computation of selling price, 8,000 units 343 JWCL162_c08_336-385.qxd 8/4/09 10:29 AM Page 344 Find more at www.downloadslide.com 344 chapter 8 Pricing Management Insight At Least It Was Simple For nearly 90 years Parker Hannifin used the same simple approach to price its industrial parts. It calculated the production cost, then added on a percentage of the cost (about 35%) to arrive at the price. It didn’t matter if a product was a premium product or a standard product. And if Parker reduced its production costs, it then also cut the price for the product. The problem with this approach was that it made it difficult for the company to ever substantially increase its profit margins. So the company’s CEO decided to break with tradition and implement strategic pricing schemes similar to those used by retailers. It determined that for about a third of its products, it had a competitive advantage that would allow it to charge a higher markup. For example, there might be limited competition for the product, or its product might be of higher quality, or it might have the ability to produce a product faster. The company determined that the price increases raised net income by $200 million—not bad considering that net income was $130 million before the price increases. Source: Timothy Aeppel, “Changing the Formula: Seeking Perfect Prices, CEO Tears Up the Rules,” Wall Street Journal Online, March 27, 2007. ? What kind of help might the sales staff need in implementing this new approach? DECISION TOOLKIT DECISION CHECKPOINTS What factors should be considered in determining selling price in a less competitive environment? INFO NEEDED FOR DECISION Total cost per unit and desired profit (cost-plus pricing) TOOL TO USE FOR DECISION Total cost per unit plus desired profit equals target selling price HOW TO EVALUATE RESULTS Does company make its desired profit? If not, does the profit shortfall result from less volume? before you go on... Target Selling Price Action Plan • Calculate the total cost per unit. • Multiply the total cost per unit by the markup percentage, then add this amount to the total cost per unit to determine the target selling price. Do it! Air Corporation produces air purifiers. The following per unit cost information is available: direct materials $16, direct labor $18, variable manufacturing overhead $11, fixed manufacturing overhead $10, variable selling and administrative expenses $6, and fixed selling and administrative expenses $10. Using a 45% markup percentage on total per unit cost, compute the target selling price. Solution Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Variable selling and administrative expenses Fixed selling and administrative expenses Total unit cost Total unit cost $71 ⫹ ⫹ 冢unit cost Total ⫻ ($71 ⫻ 冣 Markup percentage 45%) $16 18 11 10 6 10 $71 ⫽ ⫽ Target selling price $102.95 Related exercise material: BE8-2, BE8-3, BE8-4, BE8-5, E8-3, E8-4, E8-5, E8-6, E8-7, and Do it! 8-2. JWCL162_c08_336-385.qxd 7/30/09 7:04 PM Page 345 Find more at www.downloadslide.com Time-and-Material Pricing 345 Time-and-Material Pricing Another variation on cost-plus pricing is called time-and-material pricing. Under this approach, the company sets two pricing rates—one for the labor used on a job and another for the material. The labor rate includes direct labor time and other employee costs. The material charge is based on the cost of direct parts and materials used and a material loading charge for related overhead costs. Time-and-material pricing is widely used in service industries, especially professional firms such as public accounting, law, engineering, and consulting firms, as well as construction companies, repair shops, and printers. To illustrate a time-and-material pricing situation, assume the following data for Lake Holiday Marina, a boat and motor repair shop. study objective 3 Use time-and-material pricing to determine the cost of services provided. Illustration 8-11 Total annual budgeted time and material costs LAKE HOLIDAY MARINA Budgeted Costs for the Year 2011 Time Charges Material Loading Charges* Mechanics’ wages and benefits Parts manager’s salary and benefits Office employee’s salary and benefits Other overhead (supplies, depreciation, property taxes, advertising, utilities) $103,500 — 20,700 — $11,500 2,300 26,800 14,400 Total budgeted costs $151,000 $28,200 *The material loading charges exclude the invoice cost of the materials. Using time-and-material pricing involves three steps: (1) calculate the per hour labor charge, (2) calculate the charge for obtaining and holding materials, and (3) calculate the charges for a particular job. STEP 1: CALCULATE THE LABOR CHARGE. The first step for time-and-material pricing is to determine a charge for labor time. The charge for labor time is expressed as a rate per hour of labor. This rate includes: (1) the direct labor cost of the employee, including hourly rate or salary and fringe benefits; (2) selling, administrative, and similar overhead costs; and (3) an allowance for a desired profit or ROI per hour of employee time. In some industries, such as auto, boat, and farm equipment repair shops, a company charges the same hourly labor rate regardless of which employee performs the work. In other industries, a company charges the rate according to classification or level of the employee. A public accounting firm, for example, would charge the services of an assistant, senior, manager, or partner at different rates; a law firm would charge different rates for the work of a paralegal, associate, or partner. Illustration 8-12 (page 346) shows computation of the hourly charges for Lake Holiday Marina during 2011. The marina budgets 5,000 hours of repair time in 2011, and it desires a profit margin of $8 per hour of labor. The marina multiplies this rate of $38.20 by the number of hours of labor used on any particular job to determine the labor charge for that job. STEP 2: CALCULATE THE MATERIAL LOADING CHARGE. The charge for materials typically includes the invoice price of any materials used on the job plus a material loading charge. The material loading charge covers the costs of purchasing, receiving, handling, and storing materials, plus any desired profit margin on the materials themselves. The material loading charge is expressed as a percentage of the total estimated costs of parts and materials for the year. To determine this percentage, the company does the following: (1) It estimates its total annual costs