Pricing decisions


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Pricing decisions

  1. 1. Pricing Decisions EMBA 5411 Budgeting and Pricing
  2. 2. Pricing <ul><li>External sales- outside </li></ul><ul><ul><li>Target costing </li></ul></ul><ul><ul><li>Cost plus pricing </li></ul></ul><ul><ul><li>Variable cost pricing </li></ul></ul><ul><ul><li>Time and material pricing </li></ul></ul><ul><li>Internal-within the company among divisions </li></ul><ul><ul><li>Negotiated transfer prices </li></ul></ul><ul><ul><li>Cost based transfer prices </li></ul></ul><ul><ul><li>Market based transfer prices </li></ul></ul><ul><ul><li>Effect of outsourcing on transfer prices </li></ul></ul><ul><ul><li>Transfers between divisions in different countries </li></ul></ul>/30
  3. 3. Profit Maximization <ul><li>Economic Theory </li></ul><ul><ul><li>The quantity demanded is a function of the price that is charged </li></ul></ul><ul><ul><li>Generally, the higher the price , the lower the quantity demanded </li></ul></ul><ul><li>Pricing </li></ul><ul><ul><li>Management should set the price that provides the greatest amount of profit </li></ul></ul>/30
  4. 4. /30 Quantity made and sold per month Determining the Profit-Maximizing Price and Quantity Dollars per unit Demand Marginal revenue q* p* Marginal cost Profit is maximized where marginal cost equals marginal revenue, resulting in price p* and quantity q*.
  5. 5. Determining the Profit-Maximizing Price and Quantity /30 Total revenue Dollars Total cost Total profit at the profit-maximizing quantity and price, q* and p*. Quantity made and sold per month q*
  6. 6. Price Elasticity /30 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.
  7. 7. Who determines the price? <ul><li>Price takers- when there is a competitive market and the company has no influence on price </li></ul><ul><ul><li>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. </li></ul></ul><ul><li>Price makers- companies that influence the price </li></ul><ul><li>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. </li></ul>/30
  8. 8. Influences on Price <ul><li>Customer demand </li></ul><ul><li>Competitors’ behavior/prices/actions </li></ul><ul><li>Costs </li></ul><ul><li>Regulatory environment – legal, political and image related </li></ul>/30
  9. 9. Pricing approaches <ul><li>Cost plus mark-up </li></ul><ul><ul><li>Variable – contribution margin approach, contribution margin( reflecting mark-up) should cover desired return on investment, all fixed costs </li></ul></ul><ul><ul><li>Absorption – common- mark-up covers all expenses except cost of goods sold plus the desired return on investment </li></ul></ul><ul><li>Target costing – price is known, desired return on investment is known, price is known = determine the maximum cost per unit </li></ul>/30
  10. 10. Product Life Cycle /30
  11. 11. Life Cycle Costing <ul><li>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). </li></ul><ul><li>The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996). </li></ul>/30
  12. 12. /30
  13. 13. Cost-plus Pricing <ul><li>Cost + mark-up = price </li></ul><ul><li>Mark-up = cost x desired % return </li></ul>/30
  14. 14. Which cost? <ul><li>Variable manufacturing cost </li></ul><ul><li>Price= costs + markup% * </li></ul><ul><li>Mark-up should cover the remaining costs and provide for the desired profit, i.e. variable selling and all fixed costs </li></ul><ul><li>Desired profit = desired % return * investment </li></ul>/30
  15. 15. Which costs? <ul><li>Total variable costs </li></ul><ul><ul><li>Variable manufacturing and selling costs </li></ul></ul>/30 Price= variable costs + markup %* variable costs
  16. 16. Which costs? <ul><li>Absorption – manufacturing costs </li></ul><ul><li>Unit manufacturing costs – both variable and fixed </li></ul>/30 Price= unit manuf. cost + markup %* unit manufacturing cost
  17. 17. Which costs? <ul><li>Absorption – total costs </li></ul><ul><ul><li>Total costs – manufacturing and selling and administrative –fixed (direct or allocated, variable costs) </li></ul></ul>/30 Price= unit cost + markup %* unit cost
  18. 18. Example - Pricing <ul><li>Annual production 480 units </li></ul><ul><li>Unit costs: </li></ul><ul><ul><li>Variable manufacturing cost $ 400 </li></ul></ul><ul><ul><li>Applied fixed manufacturing cost $ 250 </li></ul></ul><ul><ul><li>Absorption manufacturing cost $ 650 </li></ul></ul><ul><ul><li>Variable selling costs $ 50 </li></ul></ul><ul><ul><li>Allocated and direct fixed selling and administrative costs $ 100 </li></ul></ul><ul><ul><li>Total cost $ 800 </li></ul></ul><ul><li>Investment $ 600,000 </li></ul><ul><li>Desired profit 10% of investment $ 60,000 </li></ul><ul><li>Annual Fixed Manufacturing Costs $ 120,000 </li></ul><ul><li>Annual Fixed (allocated and direct) Selling and Administrative Costs $ 48,000 </li></ul>/30
  19. 19. Cost Plus Pricing Versions /30
  20. 20. Cost Plus Pricing Versions /30
  21. 21. Time and Material Pricing <ul><li>Determine a charge for labor that includes overhead </li></ul><ul><li>Determine a charge for materials that includes handling and storage costs </li></ul><ul><li>Include a profit </li></ul><ul><li>Sum = price </li></ul><ul><li>Used in service companies mainly; appropriate for construction companies as well </li></ul>/30
  22. 22. Example /30
  23. 23. Time and Material Charges <ul><li>Time Charge per hour = </li></ul><ul><li>hourly labor cost </li></ul><ul><li>+ annual overhead (excluding material overhead) / annual labor hours </li></ul><ul><li>+ hourly charge to cover profit margin </li></ul><ul><li>= $18 + ($200,000 / 10,000 hours) + $7 = $ 45 per hour </li></ul><ul><li>Material Charge formula </li></ul><ul><li>Material cost incurred on job </li></ul><ul><li>+[material cost incurred on job *(material handling and storage costs / annual cost of materials used in Repair department)] </li></ul><ul><li>= material costs incurred on job +[material costs incurred on job ($40,000/$1,000,000)] </li></ul><ul><li>=1.04 x material costs incurred on job </li></ul>/30 4% of material costs
  24. 24. Example con’t /30
  25. 25. Internal Pricing – Transfer pricing issue <ul><li>Transfer Price is: </li></ul><ul><li>the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firm </li></ul><ul><li>Such as: </li></ul><ul><li>Internal charge paid by final assembly division for components produced by other divisions </li></ul><ul><li>Service fees to operating departments for telecommunications, maintenance, and services by support services departments </li></ul>/30
  26. 26. Effects of Transfer Prices <ul><li>Performance measurement: </li></ul><ul><li>Reallocate total company profits among business segments </li></ul><ul><li>Influence decision making by purchasing, production, marketing, and investment managers </li></ul><ul><li>Rewards and punishments: </li></ul><ul><li>Compensation for divisional managers </li></ul><ul><li>Partitioning decision rights: </li></ul><ul><li>Disputes over determining transfer prices </li></ul>/30
  27. 27. Ideal Transfer Pricing <ul><li>Ideal transfer price would be </li></ul><ul><li>Opportunity cost, or the value forgone by not using the transferred product in its next best alternative use </li></ul><ul><li>Opportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm </li></ul>/30
  28. 28. Transfer Pricing Methods <ul><li>External market price </li></ul><ul><ul><li>If external markets are comparable </li></ul></ul><ul><li>Variable cost of production </li></ul><ul><ul><li>Exclude fixed costs which are unavoidable </li></ul></ul><ul><li>Full-cost of production </li></ul><ul><ul><li>Average fixed and variable cost </li></ul></ul><ul><li>Negotiated prices </li></ul><ul><ul><li>Depends on bargaining power of divisions </li></ul></ul>/30
  29. 29. Transfer Pricing Implementation <ul><li>Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers </li></ul><ul><li>Internal accounting data are often used to set transfer prices, even when external market prices are available </li></ul><ul><li>Classifying costs as fixed or variable can influence transfer prices determined by internal accounting data </li></ul><ul><li>To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms </li></ul>/30
  30. 30. Transfer Pricing for International Taxation <ul><li>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. </li></ul><ul><li>Segment in higher tax country: </li></ul><ul><li>Reduce taxable income in that country by charging high prices on imports and low prices on exports. </li></ul><ul><li>Segment in lower tax country: </li></ul><ul><li>Increase taxable income in that country by charging low prices on imports and high prices on exports. </li></ul><ul><li>Government tax regulators try to reduce transfer pricing manipulation. </li></ul>/30