EMBA 5412 Pricing Decisions

Pricing Decisions

EMBA 5412Fall 2009

Pricing in today’s theory and practice* Not too much research on pricingcompany and academic

Managers have a general tendency to believe that price is an important issue for customers. Research, however,has shown that customers are frequently unaware of prices paid and that price is one of the least important purchase criteria for them.

the impact of even small increases in price on profitability by far exceeds the impact of other levers of operational management, as shown in Fig. 1 (based on a sample of Fortune 500 companies).

A 5% increase in average selling price increases earnings before interest and taxes (EBIT) by 22% on average, compared with the increase of 12% and 10% for a corresponding increase in turnover and reduction in costs of goods sold, respectively.

2Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778

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Fig. 1. Pricing and its impact on profitability

Hinterhuber,A, Towards value-based pricing—An integrative framework for decision making, Industrial Marketing Management 33 (2004) 765– 778


Fig. 2. High price and large market share—not as incompatible as commonly believed

In conclusion, it seems that managers, as price setters,have a general tendency to overestimate the importance ofprice for actual and potential customers

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Pricing and Business

How companies price a product or service ultimately depends on the demand and supply for it

Three influences on demand and supply:

1. Customers2. Competitors3. Costs

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Influences on Demand and Supply

Customers – influence price through their effect on the demand for a product or service, based on factors such as quality and product features

Competitors – influence price through their pricing schemes, product features, and production volume

Costs – influence prices because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply)

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Time Horizons and Pricing Short-run pricing decisions have a time

horizon of less than one year and include decisions such as: Pricing a one-time-only special order with no

long-run implications Adjusting product mix and output volume in a

competitive market Long-run pricing decisions have a time

horizon of one year or longer and include decisions such as: Pricing a product in a major market where there

is some leeway in setting price

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Pricing External sales- outside

Target pricing-Competition-based pricing Cost plus pricing Variable cost pricing Customer based pricing-value-based 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

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Profit MaximizationEconomic 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

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Quantity made and sold

per month

Determining the Profit-Maximizing Price and Quantity

Dollarsper unit

Demand

Marginalrevenue

q*

p*

Marginalcost

Profit is maximized where marginal cost equals

marginal revenue, resultingin price p* and quantity q*.

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Example 1Example 1 The editor of EMBA Magazine is considering three

alternative prices for her new monthly periodical. Her estimate of price and quantity demanded are:

Price QuantityTL 6 22,000TL 5 28,000TL 4 32,000

Monthly costs of producing and delivering the magazine include TL90,000 of fixed costs and variable costs of TL1.50 per issue.

Which price will yield the largest monthly profit?

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Solution Example 1

Price(TL) Demand

Variable Cost per unit(TL)

Contribution Margin per

unit(TL)Total CM

(TL)Fixed

Costs (TL)

Income Before

Tax (TL)6 22.000 1,5 4,5 99.000 90.000 9.0005 28.000 1,5 3,5 98.000 90.000 8.0004 38.000 1,5 2,5 95.000 90.000 5.000

Choose TL 6 TL based on quantitative factors given.

Need to consider qualitative factors as well.

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Determining the Profit-Maximizing Price and Quantity

Total revenueDollars Total cost

Total profit at the profit-maximizingquantity and price,

q* and p*.

Quantity made

and soldper month

q*

p*

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Price Elasticity

The impact ofprice changes on

sales volume

Demand is elastic ifa price increase has alarge negative impact

on sales volume.

Demand is inelastic ifa price increase has

little or no impact on sales volume.

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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.

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Markets and Pricing

Competitive Markets – use the market-based approach

Less-Competitive Markets – can use either the market-based or cost-based approach

Noncompetitive Markets – use cost-based approaches

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Influences on Price

Customer demand Competitors’ behavior/prices/actions Costs Regulatory environment – legal,

political and image related

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Differences Affecting Pricing:Long Run vs. Short Run

Costs that are often irrelevant for short-run policy decisions, such as fixed costs that cannot be changed, are generally relevant in the long run because costs can be altered in the long run

Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment – prices are decreased when demand is weak and increased when demand is strong

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Alternative Long-Run Pricing Approaches

Market-Based: price charged is based on what customers want and how competitors react

Cost-Based: price charged is based on what it cost to produce, coupled with the ability to recoup the costs and still achieve a required rate of return

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Market-Based Approach

Starts with a target price Target Price – estimated price for a

product or service that potential customers will pay

Estimated on customers’ perceived value for a product or service and how competitors will price competing products or services

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Understanding the Market Environment

Understanding customers and competitors is important because:

Competition from lower cost producers has meant that prices cannot be increased

Products are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakes

Customers have become more knowledgeable and demand quality products at reasonable prices

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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 (competitor’s), desired return on investment is known, price is known = determine the maximum cost per unit

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Cost-Plus PricingCompany estimates cost of production

Adds a markup to cost to arrive at price which allows for a reasonable profit

Benefits Simple approach

Limitations What % markup to use? Inherently circular for manufacturing firms Requires considerable judgment and

experimentation

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Product Life Cycle

http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

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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).

Product Life-Cycle spans the time from initial R&D on a product to when customer service and support are no longer offered on that product (orphaned)

The best balance among cost elements is achieved when the total LCC is minimized (Barringer and Weber, 1996).

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Life-Cycle Product Budgeting and Costing

Life-Cycle Budgeting involves estimating the revenues and individual value-chain costs attributable to each product from its initial R&D to its final customer service and support

Life-Cycle Costing tracks and accumulates individual value-chain costs attributable to each product from its initial R&D to its final customer service and support

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Important Considerations for Life-Cycle Budgeting

Nonproduction costs are large Development period for R&D and

design is long and costly Many costs are locked in at the R&D

and design stages, even if R&D and design costs are themselves small

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Example Murmur company produces electronic components that typically

have about 27-month life cycle. In October 2008, a new component was proposed. Below are the budgeted costs and profits over the life cycle of the product.

Unit production cost 6unit life cycle cost 10unit whole life cost 12budgeted unit selling price 15

Budgeted costs 2008 2009 2010 item totaldevelopment (200.000) (200.000)production (240.000) (360.000) (600.000)logistics (80.000) (120.000) (200.000) annual (200.000) (320.000) (480.000) (1.000.000)post purchase costs-born by the customer (80.000) (120.000) (200.000)Annual total (200.000) (400.000) (600.000) (1.200.000)Units produced and sold 40.000 60.000

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Example Budgeted Product Income Statement

Year Revenues CostsAnnual Income

Cumulative Income

2008 (200.000) (200.000) (200.000)2009 600.000 (320.000) 280.000 80.0002010 900.000 (480.000) 420.000 500.000

Performance Report

Year Cost Item Actual CostsBudgeted Cost Variance

2008 Development 190.000 200.000 10.000 F2009 Production 300.000 240.000 (60.000) U

Logistics 75.000 80.000 5.000 F2010 Production 435.000 360.000 (75.000) U

Logistics 110.000 120.000 10.000 F

110.000 U

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Cost-Based (Cost-Plus) Pricing

The general formula adds a markup component to the cost base to determine a prospective selling price

Usually only a starting point in the price-setting process

Markup is somewhat flexible, based partially on customers and competitors

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Forms of Cost-Plus Pricing Setting a Target Rate of Return on

Investment: the Target Annual Operating Return that an organization aims to achieve, divided by Invested Capital

Selecting different cost bases for the “cost-plus” calculation: Variable Manufacturing Cost Variable Cost Manufacturing Cost Full Cost

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Common Business Practice

Most firms use full cost for their cost-based pricing decisions, because: Allows for full recovery of all costs of the

product Allows for price stability It is a simple approach

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Cost-plus Pricing

Selling Price=Cost + mark-up% x Cost

Mark-up % =Desired profit per unit ÷ Unit cost

Desired profit = Desired ROI x Investment

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Which cost?

Variable manufacturing costPrice= variable manufacturing costs + markup% * variable manufacturing costMark-up should cover the remaining costs and provide for the

desired profit, i.e. variable selling and all fixed costs

nvmcu

fitdesiredproADMFCVSCmarkup

*%

VSC: variable selling costsFC: fixed costs – manufacturing and sellingADM: Administrative Expenses n : number of units to be soldvmcu: variable manufacturing cost per unit

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Which costs?

Total variable costs Variable manufacturing and selling costs

Price= variable costs + markup %* variable costs

nvmcu

fitdesiredproADMFCmarkup

*%

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Which costs?

Absorption – manufacturing costs Unit manufacturing costs – both

variable and fixed Price= unit manuf. cost + markup %* unit manufacturing cost

ntunit

fitdesiredproADMSmarkup

*cos

&%

S&ADM: Selling and administrative costs

Unit cost : unit manufacturing cost (variable and fixed)

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Which costs?

Absorption – total costs Total costs – manufacturing and selling

and administrative –fixed (direct or allocated, variable costs)

Price= unit cost + markup %* unit cost

ntTotalunit

fitdesiredpromarkup

*cos%

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Example - PricingAnnual sales 480 unitsUnit costs:

Variable manufacturing cost $ 400Applied fixed manufacturing cost $ 250Absorption manufacturing cost $ 650Variable selling costs $ 50Allocated and direct fixed selling and administrative costs

$ 100Total cost (Manufacturing and S&ADM) $ 800

Investment $ 600,000Desired profit 10% of investment $ 60,000Annual Fixed Manufacturing Costs $ 120,000Annual Fixed (allocated and direct) Selling and Administrative Costs

$ 48,000

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Cost Plus Pricing Versions

variable manufacturing cost-plus-pricingVariable manufacturing cost $400Total Variable Selling Costs ($50 x 480 units) $24.000Desired profit $60.000Fixed Costs $168.000mark -up % 131,25%markup $525Price = cost + markup $925

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variable total cost-plus-pricingTotal variable cost per unit $450

Fixed Costs $168.000Desired Profit $60.000mark -up % 105,56%markup $475Price = cost + markup $925

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manufacturing cost per unit $650

Total variable selling costs $24.000

Fixed Selling and Administration $48.000

Desired Profit $60.000mark -up % 42,31%markup $275Price = cost + markup $925

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total absorption- cost-plus-pricingTotal cost per unit $800

Desired Profit $60.000mark -up % 15,63%markup $125Price = cost + markup $925

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Cost plus comparison

Cost plus type

Variable manufacturing cost plus mark up

Variable cost plus mark up

Manufacturing costs plus mark up

Full cost plus mark up

Mark up %

131.25 105.56 42.31 15.63

Price 925 925 925 925

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Retail cost plus mark-up

Mark up on cost of goods sold= (selling and administrative costs + operating income) / COGS

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Retail Example Yesim Textile’s income statement for 2007 is as follows:

Revenues TL1.427.010Cost of goods sold (713.500)Gross profit 713.510Selling and Administrative Exp (535.750)Operating profit TL177.760

Mark up % 100,00%

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Project Example EMBA Consultancy Co needs to bid for a project.

EMBA’s recent income statement appears below:Revenues TL1.627.010Cost of Services

Material (TL45.000)Personnel (650.000)Overhead (555.000)

Total Cost of services (1.250.000)Gross profit 377.010Selling and Administrative Exp (235.750)Operating profit TL141.260

Mark up % 30,16%

Man-hour rate TL 65; overhead application 0.85 of personnel costs

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Project Example EMBA Consultancy needs to bid for a new project.

Material costs will be TL 5.000; 150 man hours will be used. What would be a guiding bidding price?

Material TL5.000,00Man-hour (150 man hourx65) 9.750,00Overhead (0.85*man-hour cost) 8.287,50Total Cost 23.037,50

mark up percentage 30,16%bid price TL29.985,79

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Pros and Cons of Cost plus pricing

Easy to compute No consideration to the demand side Sales volume plays an important role-

allocation of fixed costs over the products sold

If variable cost plus used then fixed costs might not be covered if not calculated correctly

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Pricing Special Orders

In some cases, it may be beneficial for a company to charge a price lower than its full cost Only if the order will not affect demand

for its other products

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Special Orders – Premier Lens Example

Given the following information, should Premier Lens produce 20,000 lenses to be sold to Blix Camera for $73 per lens?

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Special Orders – Premier Lens Example

The incremental analysis shows that it should. Note that the fixed costs are not incremental and need not be included in the decision making.

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Target Costing

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Five Steps in Developing Target Prices and Target Costs

1. Develop a product that satisfies the needs of potential customers

2. Choose a target price price is the same as the competition set price to increase customer base seek larger market share through price

3. Derive a target cost per unit: Target Price per unit minus Target Operating Income

per unit

4. Perform cost analysis5. Perform value engineering to achieve target

cost

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Value Engineering

Value Engineering is a systematic evaluation of all aspects of the value chain, with the objective of reducing costs while improving quality and satisfying customer needs

Managers must distinguish value-added activities and costs from non-value-added activities and costs

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Value Engineering Terminology Value-Added Costs – a cost that, if

eliminated, would reduce the actual or perceived value or utility (usefulness) customers obtain from using the product or service

Non-Value-Added Costs – a cost that, if eliminated, would not reduce the actual or perceived value or utility customers obtain from using the product or service. It is a cost the customer is unwilling to pay for

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Value Engineering Terminology

Cost Incurrence – describes when a resource is consumed (or benefit forgone) to meet a specific objective

Locked-in Costs (Designed-in Costs) – are costs that have not yet been incurred but, based on decisions that have already been made, will be incurred in the future Are a key to managing costs well

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Problems with Value Engineering and Target Costing

1. Employees may feel frustrated if they fail to attain targets

2. A cross-functional team may add too many features just to accommodate the wishes of team members

3. A product may be in development for a long time as alternative designs are repeatedly evaluated

4. Organizational conflicts may develop as the burden of cutting costs falls unequally on different business functions in the firm’s value chain

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Example Target costingNownew company feels that there is a market niche for a

mouse with special new features. After surveying the features and prices of available mouses on the market, Marketing department believes that a price of TL 30 would be about right for the new mouse. Marketing department estimates to sell about 40.000 mouses. To design, develop and produce these new mouses and investment of TL 2.000.000 would be required. The company desires 15% ROI on all new projects. What is the highest target cost to manufacture, sell and service the new product?

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Example target costing

Projected Sales 40000 mouse 30 1.200.000Less Desired profit 15% 2.000.000 300.000Target Cost for 40000 mouse 900.000

Target Cost per mouse TL22,50

Customer-based pricing Value based pricing-the price is based on the

customer ‘demand’ or need for the product Unique product – value based pricing might be

helpful to create demand use price to support product image set price to increase product sales design a price range to attract many consumer

groups set price to increase volume sales price a bundle of products to reduce inventory

or to excite customers62

concept of economic (or customer) value Two interpretations:

the difference between the consumer’s willingness to pay and the actual price paid, which is equal to the ‘‘consumer surplus,’’ the excess value retained by the consumer.

the maximum amount a customer would pay to obtain a given product, that is, the price that would leave the customer indifferent between the purchase and foregoing the purchase. Customer value in this sense is equal to the microeconomic concept of a customer’s ‘‘reservation price’’ and the use value of goods.

product’s economic value is the price of the customer’s best alternative—reference value—plus the value of whatever differentiates the offering from the alternative— differentiation value (Nagle & Holden, 1999).

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To quantify economic value Step 1: Identify the cost of the competitive

product and process that consumer views as best alternative put oneself in the eyes and in the shoes of

customers and ask what they view as best alternative to the purchase of the product being analyzed

Step 2: Segment the market e.g. Microsoft, for example, is known for handing

out beta-versions of its latest enterprise software products to particularly knowledgeable companies and customer segments


To quantify economic value Step 3: Identify all factors that differentiate the

product from the competitive product and process.

Step 4: Determine the value to the customer of these differentiating factors. Conjoint analysis is a simple tool which aims to

capture trade-offs in product features in a systematic way and to assign monetary values to specific attributes (Auty, 1995). Customers are presented with a set of two similar products differing in price and other qualitative features and are forced to indicate which set of attributes they prefer


To quantify economic value Step 5: Sum the reference value and the

differentiation value to determine the total economic value. The product’s economic value is simply the sum of

the price of the reference product plus its differentiation value.

Step 6: Use the value pool to estimate future sales at specific price points. For each price point, sales can be expected to

comprise a significant share of all market segments, which value the product higher than the specific price examined


Example of value based pricing Japanese industrial equipment manufacturer. In its home market, its standard model was priced at the

equivalent of US$80,000 compared with US$50,000 for a similar model by its main competitor from the United States.

In Japan, the company sold about 80% more units than its U.S. competitor, while in the United States, where the company had a weaker distribution system, both companies had roughly the same unit sales, although historical growth rates of the Japanese company had by far exceeded the growth rates of its U.S. rival.

What is the reason that the Japanese company was able to achieve both a high relative market share and a significant price premium?


WHY?

For each industry segment,the Japanese company had developed detailed financial models of different cost and benefit components of its own equipment versus its main competitor

For a customer in the printing ink industry, the positive and negative differentiation value was quantified in the following way:


Analysis

Under this angle, the price premium of the Japanese company is modest. If an interest rate of 8% is applied to the net benefits gained over the average life cycle of this equipment of 4 years, the positive differentiation value amounts to well over US$300,000. Customers are expected to pay only a small fraction—less than 10% and US $30,000—of the product’s economic value.


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Analyzing Customer Profitability

Customer Profitability Measurement System (CPM) Indirect costs of servicing customers are

assigned to cost pools For example the cost of processing orders and

handling returns

Costs are allocated to specific customers using cost drivers to determine customer profitability

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Customer Profitability Measurement System

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Example – Customer profitabilityExample – Customer profitability Delta Products has determined the following costs:

Order processing/order $5.00Additional handling cost per rush order $8.50Customer service calls/call $10.00Relationship management costs/customer $2,000.00

In addition to these costs, product costs amount to 90% of sales. In the prior year, Delta had the following experience with Johnson Brands:

Sales $53,800Number of orders 200Percent of orders marked rush 60Calls to customer service 140

Calculate the profitability of the Johnson Brands account.

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Example SolutionExample Solution

Profitability of Johnson Brand account

Sales $53,800

Less:Cost of good sold (.9 × $53,800) $48,420Order processing (200 × $5.00) $1,000Rush handling (.6 × 200 × $8.50) $1,020Customer service (140 × $10.00) $1,400Relationship management costs $2,000 $53,840

Profitability of Johnson Brands account $(40)

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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

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ExampleInvestment $700,000.00Desired profit 10% of investment $70,000.00Annual labor hours 10,000Hourly charge to cover profit margin $7.00

Labor rate per hour $18.00Annual overhead costs:

Material handling and storage $40,000.00

Other overhead costs(supervision,utilities, insurance,and depreciation) $200,000.00

Annual cost of materials used in repair department $1,000,000.00

4% x 1.000.000

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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 labor hour

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Time and Material Charges

Material Charge formulaMaterial 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

4% of material costs

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Example con’tJOB NO 101Labor hours 200cost of materials $8.000

total price of job 101material cost $8.000handling and storage $320 total material cost $8.320,00

Labor rate $45,00labor hours 200

$9.000,00TOTAL COST OF JOB 101 $17.320,00

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Activity-Based Pricing Customers are presented with separate

prices for services they request in addition to the cost of goods purchased Customers will carefully consider the services they request

Example

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Other Important Considerations in Pricing Decisions

Price Discrimination – the practice of charging different customers different prices for the same product or service Legal implications

Peak-Load Pricing – the practice of charging a higher price for the same product or service when the demand for it approaches the physical limit of the capacity to produce that product or service

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The Legal Dimension of Price Setting Price Discrimination is illegal if the

intent is to lessen or prevent competition for customers

Predatory Pricing – deliberately lowering prices below costs in an effort to drive competitors out of the market and restrict supply, and then raising prices

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The Legal Dimension of Price Setting

Dumping – a non-US firm sells a product in the US at a price below the market value in the country where it is produced, and this lower price materially injures or threatens to materially injure an industry in the US

Collusive Pricing – occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above the competitive price and so restrain trade

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Transfer pricing

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

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Transfer Pricing

The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income

Intermediate Product – the product or service transferred between subunits of an organization

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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

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Three Transfer Pricing Methods

1. Market-based Transfer Prices2. Cost-based Transfer Prices3. Negotiated Transfer Prices

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Market-Based Transfer Prices

Top management chooses to use the price of a similar product or service that is publicly available. Sources of prices include trade associations, competitors, etc.

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Market-Based Transfer Prices Lead to optimal decision making

when three conditions are satisfied:1. The market for the intermediate product

is perfectly competitive2. Interdependencies of subunits are

minimal3. There are no additional costs or benefits

to the company as a whole from buying or selling in the external market instead of transacting internally

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Market-Based Transfer Prices A perfectly competitive market exists when

there is a homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions

Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and subunit autonomy

Perhaps should not be used if the market is currently in a state of “distress pricing”

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Cost-Based Transfer Prices Top management chooses a transfer price

based on the costs of producing the intermediate product. Examples include: Variable Production Costs Variable and Fixed Production Costs Full Costs (including life-cycle costs) One of the above, plus some markup

Useful when market prices are unavailable, inappropriate, or too costly to obtain

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Cost-Based Transfer Pricing Alternatives

Prorating the difference between the maximum and minimum cost-based transfer prices

Dual-Pricing – using two separate transfer-pricing methods to price each transfer from one subunit to another. Example: selling division receives full cost pricing, and the buying division pays market pricing

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Negotiated Transfer Prices Occasionally, subunits of a firm are free to

negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties

May or may not bear any resemblance to cost or market data

Often used when market prices are volatile Represent the outcome of a bargaining

process between the selling and buying subunits

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Comparison of Transfer-Pricing Methods

Criteria Market-Based

Cost- Based

Negotiated

Achieves Goal Congruence

Yes, when markets are competitive

Often, but not always

Yes

Useful for Evaluating Subunit

Performance


Difficult unless transfer price

exceeds full cost and even then is

somewhat arbitrary

Yes, but transfer prices are affected

by bargaining strengths of the

buying and selling divisions

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Cost- Based

Negotiated

Motivates Management

Effort

Yes Yes, when based on budgeted costs; less incentive to control costs if

transfers are based on actual costs

Yes

Preserves Subunit Autonomy


No, because it is rule-based

Yes, because it is based on

negotiations between subunits

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Cost- Based

Negotiated

Other Factors No market may exist or

markets may be imperfect or

in distress

Useful for determining full cost of

products; easy to implement

Bargaining and negotiations

take time and may need to be

reviewed repeatedly as

conditions change

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Ideal Transfer PricingIdeal 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

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Minimum Transfer Price The minimum transfer price in many

situations should be:

Incremental cost is the additional cost of producing and transferring the product or service

Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally

Minimum Transfer Price =

Incremental cost per unit incurred up to the point of

transfer +Opportunity Cost per unit

to the selling subunit

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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

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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

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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.

EMBA 5412 Pricing Decisions

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