FMAccounting.com » Pricing Decision

What Is An Effective Transfer Pricing System In A Divisional Organization

slang — Tue, 27 Oct 2009 10:00:12 +0000

An effective transfer pricing system in the context of a divisional organization has to satisfy several basic criteria. The challenge is presently no transfer pricing system has been perfect. However, for an effective system of transfer pricing, some of the basic criteria need to be satisfied:

it should encourage divisional managers to actin the best interests of the organization as a whole eg maximise the wealth of the shareholders and achieve goal congruence
facilitate the assessment of management performance by ensuring that one division is not subsidizing another division
support divisional autonomy eg managers should be abl to purchase from the cheapest supplier
the transfer pricing should be deemed to be fair
the system should be clear and understood by all concerned
if appropriate, the system should aim to minimize the tax liability of the company.

Break-Even Pricing And Minimum Pricing Methodologies(Part5)

slang — Tue, 11 Dec 2007 08:49:39 +0000

In this Part 5, we look at two other pricing methodologies which are as follows:

Break-Even Pricing:

For this type of pricing, the price at which the products will break-even is used. This break-even price will then be added a profit mark up.

Simple Illustration:

Fixed Cost $25,000

Variable cost $2.00 per unit

Number of Units produced 4,000

Mark-up is 15% on the break-even price

What will be selling price to the customers?

Solution:

Break-even price

= Fixed Cost + Variable cost/marginal cost

Total Number of units produced

= $25,000+ $8,000

4,000

= $8.25

+ mark up of 15% ($1.24)

= $9.50 which is the selling price to the customer.

Minimum Pricing Methodology:

For this type of pricing, the selling price is the lowest price that a company may sell its product.
Normally the price will be the Total Relevant Costs of Manufacturing.

Useful method in situations where:-

· there is a lot of intense competition, surplus production capacity, clearance of old stocks, getting special orders and or improving market share of the product.

Minimum Price is Incremental costs of manufacturing + Opportunity Costs ( if any)

Simple Illustration:

Assuming the following details of product X:

Material $2.50

Labor( 2 hrs @ $3.00) $6.00

Variable production overhead $2.50

Fixed production overhead $1.20

Total $9.70

Say that the labor is in short supply and is used for other product Y which generates a contribution of $6 per unit and requires 2 hours of the same labor.

Material $2.50

Labor $6.00

Variable production overhead $2.50

Add:

Opportunity cost from labor scarcity:

$6 / 2 hours= $3.00 per hr x 2 hr = $6.00

Minimum price = $17.00

Rate Of Return Or Rate Of Investment Pricing Methodology(Part4)

slang — Tue, 11 Dec 2007 08:16:49 +0000

In earlier Part 2& Part 3 we have covered cost plus pricing & Variable/Marginal Cost Plus Pricing respectively, in this article we look at the Rate Of Return Pricing Metholodgy:

Rate Of Return Pricing:

For this type of pricing, the company needs to specify the rate of return on its capital invested;
Similar to Cost plus pricing,the difference is that the marked up will be based on the target rate of return;
The target rate of return varies with market norm or what management considers a fair return.

Useful method to use:

When a business has invested too much on the project or products

[Note: However, this method is difficult to use where a company has too many product lines or competes in many markets]

Simple Illustration:

Capital invested / employed $2,000,000

Target return 10%

Estimated costs $500,000

Mark up

= 10% x $2,000,000

$500,000

=40%

Variable/Marginal Cost Plus Pricing(Part3)

slang — Tue, 11 Dec 2007 08:11:22 +0000

In earlier Part 2, we discussed the Cost Plus Pricing Methodology, here in this article, we look at the variable or marginal cost plus pricing.

Using the variable or marginal cost plus pricing methodology:-

The selling price is determined by adding a mark up or margin on the total variable costs (marginal cost);
This is based on the assumption that any price above variable cost would generate a certain level of contribution towards meeting fixed costs;
This method is consistent with the marginal costing technique;
When using this pricing method, need to be careful to ensure that it is sufficient to cover all fixed cost and to generate sufficient margin for profit otherwise the long term survival of the business might be at stake;

Useful for contract bidding where competition could be quite intense;

Eliminates the difficulty of computing fixed costs into the products.

Like cost plus pricing, variable or marginal cost plus pricing methodology has it advantages and disadvantages

Advantages Of Variable/Marginal Cost Plus Pricing

As it adopts the margin cost approach, it provides better information as it segregate the variable and fixed costs;
Highlights the importance of contribution;

Disadvantages Of Variable/Marginal Cost Plus Pricing:

For short term pricing decision, it’s alright otherwise needs to be very careful the pricing in the long term can recover fixed costs and generate sufficient profit for the business;
Might be unsuitable for production costs consist a lot of fixed costs.

Simple Illustration Of Variable/Marginal Cost Plus Pricing Methodology:

Let’s look at Product A:

Production cost as follows:

Variable/direct material $1.50

Variable/direct labor $1.50

Variable Production overheads $1.00

Variable Administrative overheads $0.50

Variable Selling overheads $0.10

Total variable costs $4.60

Say required mark up of 65% $3.00

Variable Cost Plus Pricing $7.60

The selling price is determined at $7.60 where the company wants Product A to at least cover its total variable cost and contribute towards recovery fixed costs and profit.

Full Cost Plus Pricing Methodology(Part2)

slang — Tue, 11 Dec 2007 08:00:43 +0000

In the earlier article, we discussed pertaining to the factors which affect pricing and the pricing objectives in relation to the business objective.

This article deals with the various pricing methodology, a businessman/entrepreneur can refer to when pricing a product:

FULL COST PLUS PRICING METHODOLOGY:

Full Cost Plus Pricing:

Traditional method of pricing a product;

Most commonly used method;

Prices are set by adding a percentage of profit ( either a mark up or a margin) to the total cost of the product;

Consistent with the absorption costing technique;

Commonly used by wholesalers, retailers, construction contractors, services, government contractors;

Full Cost Plus Pricing is useful in situation where:

Products are made based on specification by the customers;
Main objective is to make profit after considering fixed costs of the business;
The costs are difficult to estimate in advance;
Expected demand at different price levels is difficult to estimate.

The following are the advantages and disadvantages that we need to consider when using the Full Cost Plus Pricing methodology:

Advantages are:

Easy and simple to understand;
Pricing decisions become standardized;
Adopts a conservative approach that in the long run to at least ensure the recovery of fixed cost of a business; and
Difficult of estimating demands can be avoided.

Disadvantages are:

Tendency to set prices on inaccurate estimates;
Challenges of apportioning the fixed overheads properly into different products
Unsuitable for short term decisions making particularly in situation like surplus production capacity, tendering for contracts price and others;
Ignores competition and price elasticity of demand and
Ignores opportunity costs and relevant costs

Simple Illustration:

Let’s look at Product A:

Production cost as follows:

Variable cost -material $1.50

Variable cost- labor $1.50

Total variable cost $3.00

Fixed cost $3.00

(excludes administrative and selling overheads)

Required 50% mark up on total production cost.

For Full-Cost Plus Pricing:

Total cost = $3.00+$3.00 =$6.00

50% on total/full cost = 50% x $6.00 =$3.00

Hence, Selling price = $6.00+$3.00 =$9.00 per unit.

By pricing at $9.00, the company wants Product A to at least cover its total production cost.

Factors Affecting Pricing(Part 1)

slang — Tue, 11 Dec 2007 07:58:21 +0000

Without proper pricing of a product, there will never be a sale and hence no revenue.

This article discussed the factors which affect pricing and pricing objectives in relation to meeting the overall business strategy.

It is important to understand the factors that can affect pricing. Some of the common factors that affect/determine a firm’s pricing policy include the following:

(1) Costs

- In the long term, a business needs to ensure that its products are priced above their total average cost to achieve profitability. However, in the short-term, it is acceptable to price below total cost if this price exceeds the marginal cost of production – so that the sale still produces a positive contribution to fixed costs.

[ refer to the various types of pricing methodologies]

(2) Competitors

- The pricing of the business will depend whether it is a monopolist or operating under conditions of perfect competition or in between. The chosen price needs to be very carefully considered relative to those of close competitors.

(3) Customers

- The pricing depends on the customer expectations. Ideally, a business should attempt to quantify its demand curve to estimate what volume of sales will be achieved at given prices

(4) Pricing Objectives In Relation To Business Objectives

- Possible pricing objectives include the maximization of profits; achieving a target return on investment; achieving a target sales figure or target market share or just to match the competition, rather than lead the market pricing strategies.