This document discusses various pricing strategies and considerations, including: 1) It describes different types of pricing such as external pricing, internal transfer pricing, cost-plus pricing, and time and material pricing. 2) It explains concepts like determining the profit-maximizing price using marginal cost and marginal revenue, as well as price elasticity. 3) It outlines factors that influence pricing decisions and different approaches to setting prices like cost-plus markup, variable costing, and absorption costing.

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 /30

3. Profit Maximization Economic Theory The quantity demanded is a function of the price that is charged Generally, the higher the price , the lower the quantity demanded Pricing Management should set the price that provides the greatest amount of profit /30

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. 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. 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. 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. /30

8. Influences on Price Customer demand Competitors’ behavior/prices/actions Costs Regulatory environment – legal, political and image related /30

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 /30

10. Product Life Cycle /30 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). /30

12. /30

13. Cost-plus Pricing Cost + mark-up = price Mark-up = cost x desired % return /30

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 /30

15. Which costs? Total variable costs Variable manufacturing and selling costs /30 Price= variable costs + markup %* variable costs

16. Which costs? Absorption – manufacturing costs Unit manufacturing costs – both variable and fixed /30 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) /30 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 /30

19. Cost Plus Pricing Versions /30

20. Cost Plus Pricing Versions /30

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 /30

22. Example /30

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 /30 4% of material costs

24. Example con’t /30

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 /30

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 /30

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 /30

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 /30

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

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 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