CHAPTER 8
LEARNING OBJECTIVES
1. COMPUTE A TARGET COST WHEN THE MARKET
DETERMINES A PRODUCT PRICE.
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. DETERMINE PRICES USING ABSORPTION-COST PRIC-
ING AND VARIABLE-COST PRICING.
*6. EXPLAIN ISSUES INVOLVED IN TRANSFERRING
GOODS BETWEEN DIVISIONS IN DIFFERENT
COUNTRIES.
CHAPTER REVIEW
External Sales
1. (L.O. 1) Some of the many factors that can affect pricing decisions include:
a. Pricing Objectives
• Gain market share
• Achieve a target rate of return
b. Environment
• Political reaction to prices
• Patent or copyright protection
c. Demand
• Price sensitivity
• Demographics
d. Cost Considerations
• Fixed and variable costs
• Short-run or long-run
2. In most cases, a company does not set prices. Instead the price is set by the competitive market
(laws of supply and demand). These companies are called price takers and price taking often
happens when the product is not easily differentiated from competing products, such as farm
products (corn or wheat) or minerals (coal or sand).
Target Costing
4. Once a company has identified its segment of the market, it does market research to determine
the target price. The 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 the target price, it can
Cost-Plus Pricing
5. (L.O. 2) When the price is set by the company, price is commonly a function of the product or
service. Cost-plus pricing involves establishing a cost base and adding to this cost base a
markup to determine a target selling price. The size of the markup (the “plus”) depends on the
desired return on investment (ROI) for the product line, product, or service. The cost-plus pricing
formula is expressed as follows:
6. The cost-plus 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 the customers pay the price. In
addition, sales volume plays a large role in determining per unit costs. The lower the sales
7. Instead of using both fixed and variable costs to set prices, some companies simply add a markup
Time-and-Material Pricing
8. (L.O. 3) Under time-and-material pricing, 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.
9. 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.
10. To illustrate a time-and-material pricing situation, assume the following data for Rancho Park Golf
Club Repair Service:
Rancho Park Golf Club Repair Service
Budgeted Costs for the Year 2017
Time Material Loading
Charges Charges
Repair service employee wages $26,000 $ 5,000
Administrative assistant salary 1,950 1,000
Step 1: During 2017 Rancho Park budgets 1,300 hours for repair time, and it desires a profit
margin of $6 per hour of labor. Computation of the hourly charges are as follows:
Per Hour
Per Hour Total Cost ÷ Total Hours = Charge
Hourly labor rate for repairs
Repair service employee $26,000 ÷ 1,300 = $20.00
Overhead costs
Step 2: Rancho Park estimates that the total invoice cost of parts and materials used in 2017 will
be $30,000 and it desires a 10 percent profit margin markup on the invoice cost of parts and
materials. The computation of the material loading charge used by Rancho Park during 2017 is as
follows:
Material Total Invoice Material
Loading ÷ Cost, Parts = Loading
Charge and Materials Percentage
Overhead costs
Repair service employee $5,000
Administrative assistant 1,000
Step 3: Rancho Park prepares a price quotation to estimate the cost to fix a set of woods for a
patron. Rancho Park estimates the job will require a half hour of labor and $150 in parts and
materials. Rancho Park’s price quotation is as follows:
Rancho Park Golf Club Repair Service
Time-and-Material Price Quotation
Job: Arnold Palmer, repair of set of woods
Labor charges: half hour @ $31.30 ……………… $ 15.65
Internal Sales
11. (L.O. 4) Divisions within vertically integrated companies normally transfer goods or services to
other divisions within the same company, as well as to customers outside the company. When
Negotiated Transfer Prices
12. The negotiated transfer price is determined through agreement of division managers. Using the
negotiated transfer pricing approach, a minimum transfer price is established by the selling
division, and a maximum transfer price is established by the purchasing division.
Cost-Based Transfer Prices
13. Another method of determining transfer prices is to base the transfer price on the costs incurred
by the division providing the goods. If a transfer price is used, the transfer price may be based on
Market-Based Transfer Prices
14. The market-based transfer price is based on existing market prices of competing goods or
services. A market-based system is often considered the best approach because it is objective
Transfers Between Divisions in Different Countries
*Absorption Cost Pricing
*15. (L.O. 5) Absorption-cost pricing is consistent with generally accepted accounting principles
(GAAP) because it defines the cost base as the manufacturing cost. Both variable and fixed
selling and administrative costs are excluded from this cost base. Thus, selling and administrative
costs plus the target ROI must be provided for through the markup.
The steps in using absorption-cost pricing are as follows:
a. Compute the unit manufacturing cost.
b. Compute the markup percentage using the formula:
Selling and
c. Set the target selling price using the formula:
*Variable-Cost Pricing
*16. Under variable-cost pricing, the cost base consists of all of the variable costs associated with a
product, including variable selling and administrative costs. Because fixed costs are not included
in the base, the markup must provide for fixed costs (manufacturing and selling and administrative)
and the target ROI. Variable-cost pricing is more useful for making short-run decisions because it
displays variable cost and fixed cost behavior patterns separately.
The steps in using variable-cost pricing are as follows:
a. Compute the unit variable cost.
b. Compute the markup percentage using the formula:
c. Set the target selling price using the formula:
*17. (L.O. 6) As more companies “globalize” their operations, an increasing number of transfers are
between divisions that are located in different countries. Companies must pay income tax in
the country where income is generated. In order to maximize income, and minimize income tax,
LECTURE OUTLINE
A. External Sales.
1. Establishing the price for any good or service is affected by the following
factors: pricing objectives, environment, demand, and cost considerations.
2. In the long run a company must price its product to cover its costs and
earn a reasonable profit. In most cases, a company does not set the
MANAGEMENT INSIGHT
At one time, Apple’s iPad represented 75% of tablets being sold. And, about
50% of consumers read newspapers and magazines on their tablets. This
commanding share of the market made Apple feel like it had publishers right
Answer: While it is possible that the companies incur different costs to
provide this service, that would not explain this huge price
B. Target Costing.
1. In a competitive market, the price of a product is greatly affected by
supply and demand. No company in the market can affect the price to a
significant degree.
2. A company chooses the segment of the market it wants to compete in
(its market niche) in a competitive market.
MANAGEMENT INSIGHT
Wal-Mart told jean maker Levi Strauss “the price should be $19 per pair of jeans
instead of $23.” Wal-Mart often sets the price, and the manufacturer has to find
out how to make a profit at that price. Levi Strauss revamped its distribution and
production to improve its overall record of timely deliveries. The chief executive
of Levi Strauss stated “we had to change people and practice.”
What are some issues that Levi Strauss should consider in deciding whether it
should agree to meet Wal-Mart’s target price?
Answer: Levi may be tempted to reduce the quality of its product, or it may be
forced to move more of its operations to low-wage suppliers. A big
concern is that other retailers may complain that Levi is selling its
C. Cost-Plus Pricing.
1. In a noncompetitive environment, the company is faced with the task of
setting its own price, which is commonly a function of the cost of the
product.
4. The cost-plus pricing formula is expressed as follows:
Target Selling Price = Cost + (Markup Percentage X Cost).
Markup Percentage = Desired ROI Per Unit ÷ Total Unit Cost.
5. The cost-plus pricing approach’s major advantage is that it is simple to
compute. However, it does not give consideration to the demand side. In
MANAGEMENT INSIGHT
For nearly 90 years Parker Hannifin calculated the production cost, then added
on a percentage of the cost to arrive at the price. If Parker reduced its production
costs, it also cut the price for the product. This approach made it difficult for the
company to ever substantially increase its profit margins. So the company’s CEO
decided to implement strategic pricing schemes similar to other retailers. It
decided to charge a higher markup for about a third of its products because it
had a competitive advantage.
What kind of help might the sales staff need in implementing this new approach?
Answer: Many customers might object to the price increase, and some might
even threaten to buy a competing product. The company needed to
D. Time-and-Material Pricing.
1. Under time-and-material pricing, the company sets two pricing rates—
one for the labor used on a job and another for the material.
2. 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.
3. Using time-and-material pricing involves three steps:
a. Calculate the per hour labor charge.
4. The charge for labor time is expressed as a rate per labor hour which
includes:
a. The direct labor cost of the employee (hourly rate or salary and
fringe benefits).
5. The charge for materials typically includes a material loading charge
which covers the costs of purchasing, receiving, handling, and storing
materials, plus any desired profit margin on the materials themselves.
6. The material loading charge is expressed as a percentage of the total
estimated costs of parts and materials for the year. The company
determines this percentage by doing the following:
a. Estimating the total annual costs for purchasing, receiving, handling,
and storing materials.
7. The charges for any particular job are the sum of the
a. Labor charge,
SERVICE COMPANY INSIGHT
For many decades, professionals in most service industries have used some
form of hourly based price, regardless of the outcome. Many customers are now
demanding that the bill be tied to actual performance instead of the amount of
hours of work provided.
What implications does this have for a service company’s need for managerial
accounting?
Answer: When service companies billed by the hour, they were better able to
ensure their profitability because labor hours is their primary cost. But
E. Internal Sales.
1. The transfer of goods between divisions of the same company is called
internal sales. Divisions within vertically integrated companies normally
sell goods to other company divisions as well as to outside customers.
2. When companies transfer goods internally, the price used to record the
transfer between the divisions is the transfer price.
a. Negotiated transfer prices.
F. Negotiated Transfer Prices.
1. The negotiated transfer price is determined through agreement of
division managers. It will range between the external purchase price per
unit and the sum of the unit variable cost plus unit opportunity cost.
2. Opportunity cost is the contribution margin per unit of goods sold
externally.
4. Given excess capacity (zero opportunity cost) to the selling division, it
would be in the company’s best interest for the buying division to purchase
goods internally as long as the selling division’s variable cost is less than
the outside price.
6. In the minimum transfer price formula, variable cost is defined as the
variable cost of units sold internally which will differ from the variable cost
of units sold externally in some instances (i.e. reduced variable selling
expenses for internal sales).
a. Market price information is sometimes not easily obtainable.
G. Cost-Based Transfer Prices.
1. One method of determining transfer prices is to base the transfer price
on the costs incurred by the division producing the goods.
2. A cost-based transfer price may be based on full cost, variable cost, or
some modification including a markup.
3. The cost-based approach often leads to poor performance evaluations
H. Market-Based Transfer Prices.
1. The market-based transfer price is based on existing market prices of
competing goods. This system is often considered the best approach
3. If the selling division has excess capacity, the market-based system can
lead to actions that are not in the best interest of the company.
*I. Absorption-Cost Pricing.
1. Absorption-cost pricing uses total manufacturing cost as the cost base
and provides for selling/administrative costs plus the target ROI through
the markup.
2. Absorption-cost pricing involves three steps:
a. Compute the unit manufacturing cost.
3. The markup percentage is computed by dividing the sum of the desired
ROI per unit and selling and administrative expenses per unit by the
manufacturing cost per unit.
4. The target selling price is computed as: Manufacturing cost per unit +
(Markup percentage X Manufacturing cost per unit).
5. Most companies that use cost-plus pricing use either absorption cost or
full cost as the basis because:
*J. Variable-Cost Pricing.
1. Variable-cost pricing uses all of the variable costs, including selling and
administrative costs, as the cost base and provides for fixed costs and
target ROI through the markup.
3. Variable-cost pricing involves the following steps:
a. Compute the unit variable cost.
4. The markup percentage is computed by dividing the sum of the desired
ROI per unit and fixed costs per unit by the variable cost per unit.
6. The specific reasons for using variable-cost pricing are:
a. It is more consistent with cost-volume-profit analysis used to measure
the profit implications of changes in price and volume.
*K. Transfers Between Divisions in Different Countries.
1. An increasing number of transfers are between divisions that are located
in different countries. Differences in tax rates across countries can
complicate the determination of the appropriate transfer price.
2. Companies must pay income tax in the country where they generate the
income. Many companies prefer to report more income in countries with
low tax rates in order to maximize income, and minimize income tax.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Once a company has determined the target price, it can determine its target cost by setting a desired profit.
True False
2. In a competitive, common-product environment the company must set a target selling price using cost-plus
pricing.
True False
3. Under cost-plus pricing, the markup percentage is computed by dividing desired ROI per unit by variable
cost per unit.
True False
4. The labor charge includes the direct labor cost of employees, selling, administrative, and similar overhead
costs; and an allowance for a desired profit per hour.
True False
5. The charges for any particular job are the sum of the labor charge, the materials charge, and the material
loading charge.
True False
6. An appropriate transfer price should assist the company in making proper purchasing decisions.
True False
7. An advantage of the cost–based transfer price approach is that it can increase a division manager’s control
over the division’s performance.
True False
8. The market-based transfer price approach provides a fairer allocation of the company’s contribution margin
to each division than the cost-based approach.
True False
9. In order to maximize income, and minimize income tax, companies can adjust the transfer prices they use
on transfers between divisions located in different countries.
True False
*10. Absorption cost pricing is more consistent with cost–volume-profit analysis used to measure the profit
implications of changes in price and volume.
True False
Multiple Choice
1. The target cost of a product
a. includes product costs but not period costs.
b. is determined before the target price is established.
c. is the difference between the target price and the desired profit.
d. is determined by the target audience.
2. In the cost-plus pricing approach, the markup percentage is computed by dividing the
a. desired ROI/unit by variable cost/unit.
b. desired ROI/unit by total unit cost.
c. total unit cost by desired ROI/unit.
d. selling price/unit by desired ROI/unit.
3. All of the following are steps in the time-and-material pricing approach except calculating the
a. labor charge.
b. material loading charge.
c. manufacturing overhead charge.
d. charges for a particular job.
4. The total contribution margin to a company in the market-based transfer price approach is
a. greater than in the cost-based approach.
b. less than in the cost-based approach.
c. the same as in the cost-based approach.
d. either greater than or less than in the cost-based approach.
*5. Absorption-cost pricing
a. includes all variable costs in the cost base.
b. excludes fixed manufacturing overhead from the cost base.
c. provides the data needed for pricing special orders.
d. uses a markup percentage that covers the desired ROI and the selling and
administrative expenses.
ANSWERS TO QUIZ
True/False
1. True 6. True
Multiple Choice
1. c.