Needles Finman Irm Ch26

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CHAPTER 26
Pricing Decisions, Including Target Costing and
Transfer Pricing
PLANNING MATRIX
Enhancing Your
Building Your Basic Knowledge Knowledge, Skills, and
Learning Objective and Skills Critical Thinking
1. Identify the objectives and rules SE 1, 2 E 1, 2 C1
used to establish prices of goods
and services, and relate pricing
issues to the management process.
2. Describe economic pricing SE 3 E 3, 4 C1
concepts, including the auction-
based pricing method used on the
Internet.
3. Use cost-based pricing methods to SE 4, 5 E 5, 6, 7, 8, 9 P 1, 2, 3, C 2
develop prices. 6, 7, 8
4. Describe target costing, and use SE 6, 7 E 10, 11, 12, P 4, 9 C2
that concept to analyze pricing 13 C3
decisions and evaluate a new C4
product opportunity.
5. Describe how transfer pricing is SE 8, 9, 10 E 14, 15 P 5, 10 C5
used for transferring goods and C6
services and evaluating
performance within a division or
segment.
MEMORANDA:
SE: Short Exercises
E: Exercises
P: Problems (Each problem has a User Insight question.)
C: Cases
All questions are in the text with related Learning Objectives (Stop, Think, and Apply).
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
318 Chapter 26: Pricing Decisions, Including Target Costing and Transfer Pricing
SUGGESTED INSTRUCTIONAL STRATEGY

Output Skills Developed:
Technical, Interpersonal
Related Learning Objectives:

3, 4
Instructional Strategies
Learning activity: Discussion, group task
Learning environment: Modified lecture or active; in-class
Learning tool: Textbook assignment Case 2
Steps to Implement
1. Assign Case 2 at least one week before introducing this learning activity in class. Students are to
work on Case 2 individually.
2. Prepare an in-class assignment for groups that include the following tasks:
a. Each group is to take a position on whether corporate headquarters or the foreign division
should set the selling price for the detergent.
b. Each group is to take a position on whether cost-based pricing or target costing should be
used to set the selling price for the detergent.
3. In class, form groups of four to six students, and assign each group a position.
4. After distributing the assignment, allow the groups about ten minutes to develop their arguments.
5. Pair groups that have opposing positions, and allow them to debate their positions for five
minutes.
6. After the debates, ask students to submit a written response identifying which positions they
believe are best and explaining why.
7. Lead a discussion about the dynamics of the debate. Ask each pair of groups to state the position
they believe was best defended. Allow about ten minutes for steps 6 and 7.
Assessment
Technical skills: Give a brief quiz at the end of the period to test recall and comprehension. Ask a
related question on the next examination.
Interpersonal skills: Ask the students one or more of the following questions: How well did your group
interact? How many in the group were prepared for the assignment? How many were fully involved?
What could the group do to improve its performance next time?
Chapter 26: Pricing Decisions, Including Target Costing and Transfer Pricing 319
RESOURCE MATERIALS AND OUTLINES

OBJECTIVE 1: Identify the objectives and rules used to establish prices of goods and
services, and relate pricing issues to the management process.
Summary Statement
A company’s long-run objectives should include statements on pricing policy. Possible pricing policy
objectives include identifying and adhering to both short-run and long-run pricing strategies, maximizing
profits, maintaining or gaining market share, setting socially responsible prices, maintaining a minimum rate
of return on investment, and being customer focused.
For a company to stay in business, the selling price of its product or service must be equal to or lower than the
competition’s price, be acceptable to the customer, recover all costs incurred in bringing the product or service
to market, and return a profit. If a manager deviates from any of these four selling rules, there must be a
specific short-run objective that accounts for the change. Breaking these pricing rules for a long period will
force a company into bankruptcy.
Pricing issues are addressed at each stage of the management process. When planning, managers must
consider how much to charge for each product or service and identify the maximum price the market will
accept and the minimum price the company can sustain. During the year, the product or service is sold at the
specified price or on the auction market and managers monitor performance. When managers evaluate
performance, they evaluate sales to determine which pricing strategies were successful and which failed.
When managers communicate about pricing, analyses of actual and targeted prices and profits are prepared
for use inside the organization.
When making and evaluating pricing decisions, managers must consider both external and internal
factors.
Related Text Illustrations

Figure 1: External and Internal Factors Affecting Pricing Decisions
Lecture Outline
I. Pricing issues are addressed at each stage of the management cycle.
II. Possible pricing policy objectives include the following:
A. Identifying and adhering to both short- and long-run pricing strategies
B. Maximizing profits
C. Maintaining or gaining market share
D. Setting socially responsible prices
E. Maintaining a minimum rate of return on investment
F. Being customer focused
III. Pricing and the management process
A. For a company to stay in business, the selling price of its product or service must
1. Be competitive with the competition’s price
2. Be acceptable to the customer
3. Recover all costs incurred in bringing the product or service to market
4. Return a profit
B. Breaking these pricing rules for a long period will lead to bankruptcy.
IV. When making and evaluating pricing decisions, managers must consider both external and internal
factors.
Teaching Strategy
Introduce pricing by citing an example of a product and asking the students to respond to the question
“What factors does this company need to consider to set a price on this product?” Briefly discuss each
pricing policy objective and rule. Short Exercise 1 or 2 and Exercise 1 or 2 can be used as a basis for
discussion.
OBJECTIVE 2: Describe economic pricing concepts, including the auction-based pricing

method used on the Internet.
Summary Statement
Economic pricing concepts are based on microeconomic theory. A product’s total revenue and total cost
curves are projected and plotted. After an initial loss, the lines cross, and a profit is realized. At some
point, competition causes the revenue and cost lines to approach each other and finally cross again,
causing another loss. Profits are maximized at the point at which the difference between total revenue
and total cost is greatest. Economists use the concepts of marginal revenue and marginal costs to help
determine the optimal price for a good or service.
Because of the increasing amount of business conducted over the Internet by both companies and
individuals, auction-based pricing has become an important pricing mechanism. The Internet allows
sellers and buyers to solicit bids and transact exchanges in an open-market environment. A willing
buyer and seller set an auction-based price in a sales transaction.
New Concepts and Terminology

marginal revenue; marginal cost; auction-based pricing

Figure 2: Microeconomic Pricing Theory
Focus on Business Practice: What’s It Worth to Shop Online?
Focus on Business Practice: How Big a Problem Is Fraud on the Internet?
Lecture Outline
I. Economic pricing concepts are based on microeconomic theory.
A. Profits are maximized when total revenue minus total cost is greatest.
B. On a graph, profits are maximized at the point at which the marginal revenue and marginal
cost curves intersect.
1. Marginal revenue is the increase in total revenue from one additional unit.
2. Marginal cost is the increase in total cost from one additional unit.
II. Significant uncertainty and the necessity of using estimates make the microeconomic approach
difficult to apply.
III. Because of the increasing amount of business conducted over the Internet by both companies and
individuals, auction-based pricing has become an important pricing mechanism.
Teaching Strategy
Use Figure 2 to describe economic pricing concepts. (Some students may not yet have taken or
completed a microeconomics course.) Define marginal costs and marginal revenues. Short Exercise 3,
Exercise 3, or Case 1 or 3 can be used for class discussion of pricing factors.
OBJECTIVE 3: Use cost-based pricing methods to develop prices.

Summary Statement
Managers may use a variety of pricing methods. Two pricing methods based on the cost of producing a
product or service are gross margin pricing and return on asset pricing.
Gross margin pricing is a cost-based pricing method that establishes a selling price at a percentage
above an item’s total production costs. The following formulas are used:
Desired Profit +
Markup Percentage = Total Selling, General, and Administrative Expenses
Total Production Costs
Gross Margin-Based Price = Total Production Costs per Unit + (Markup

Percentage × Total Production Costs per Unit)
Return on assets pricing is a pricing method based on a specific rate of return on assets used in the
generation of a product or service. Assuming that a company has a stated minimum desired rate of
return, the following formula is used to calculate the return on assets–based price:
Return on Assets-Based Price = Total Costs and Expenses per Unit + (Desired Rate
of Return × Cost of Assets Employed per Unit)
Time and materials pricing is a common practice in service businesses. Two primary types of costs are
used in this method: (1) direct materials and parts and (2) direct labor. An overhead rate (which
includes a profit factor) is computed for each of these cost categories.
Although managers may depend on traditional, objective, formula-driven pricing methods to set prices,
they must at times deviate from those approaches and rely on their own experience.

gross margin pricing; return on assets pricing; time and materials pricing

Focus on Business Practice: Pricing a Six-Pack
Figure 3: Cost-Based Pricing Methods: Bookit Company
Lecture Outline
I. In a competitive environment, market prices and conditions influence price, but if prices do not
cover a company’s costs, the company will eventually fail.
II. Gross margin pricing
A. Emphasizes the use of income statement information to determine a selling price.
B. The price is computed using a markup percentage based on a product’s total production
costs.
C. Three ways of determining a price
1. Use Markup Percentage and Gross Margin-Based Price formulas
Desired Profit +
Markup Percentage = Total Selling, General, and Administrative Expenses
Total Production Costs
Gross Margin-Based Price = Total Production Costs per Unit + (Markup
Percentage × Total Production Costs per Unit)
Express the gross margin-based price is to state the formula in terms of a company’s
2.
desire to recover all of its costs and make a profit.
Total Production Costs + Total Selling, General, and
Gross Margin-Based
Administrative Expenses + Desired Profit
Price =
Total Units Produced
3. Determine gross margin-based price on a per unit basis
Gross Margin-Based Price = Direct Materials + Direct Labor + Variable Overhead +
Fixed Overhead+ Selling, General, and Administrative
Expenses + Desired Profit per Unit
III. Return on assets pricing
A. Return on Assets-Based Price = Total Costs and Expenses per Unit + (Desired Rate
of Return × Cost of Assets Employed per Unit)
B. Return on Assets-Based Price = [(Total Production Costs + Total Selling, Genera, an
Administrative Expenses) / Units to Be Produced] +
[Desired Rate of Return × (Total Cost of Assets Employed /
Units to Be Produced)]
IV. Gross margin pricing and return on assets pricing will produce the same selling price, given the
same data.
A. Cost bases include total product costs per unit and total costs and expenses per unit.
B. Managers should select the method that uses the more reliable cost base.
V. Pricing services
A. Most service organizations use a form of time and materials pricing.
B. Use two computations
1. Direct labor
2. Materials and parts
C. Services that do not require materials and parts use only direct labor costs, so professionals
apply a factor that represents all overhead costs to the base labor costs.
VI. Factors Affecting Cost-Based Pricing Methods
A. To set a price, managers should combine their experience with an appropriate pricing
method.
Teaching Strategy
Use Figure 3 and the example of Bookit Company given in the text to demonstrate cost-based pricing
methods. Remind students that if a company is to succeed, the price that is set must cover all costs plus
desired profit margins. The Review Problem in this chapter pertains to gross margin pricing. Short
Exercise 4 or 5 and Exercise 5, 6, 7, 8, or 9 may also be used to illustrate and reinforce this learning
objective.
OBJECTIVE 4: Describe target costing, and use that concept to analyze pricing decisions
and evaluate a new product opportunity.
Summary Statement
Target costing is a pricing method that (1) uses market research to identify the price at which a new
product will be competitive in the marketplace, (2) defines the desired profit to be made on the product,
and (3) computes the target cost by subtracting the desired profit from the competitive market price. To
determine a new product’s target cost, the following formula is applied:
Target Price  Desired Profit = Target Cost
The target cost is the maximum cost to be incurred in designing and manufacturing the product. In other
words, the product is designed and built to a specific cost goal; if the cost goal cannot be met, the
product is not manufactured.
Target costing gives managers the ability to control the costs of a new product in the planning stage of the
product’s life cycle. In contrast, when traditional pricing methods are used, managers cannot set prices
until after production has taken place; the prices are based on an analysis of the actual costs of
development and production plus a profit factor. Because target costing enables managers to analyze a
product’s potential before they commit resources to its production, it enhances a company’s ability to
compete, especially in new or emerging markets. The philosophy underlying target costing is that a
product should be designed and made so that it produces a profit as soon as it is introduced to the
marketplace.
Committed costs are the estimated costs of design, development, engineering, testing, and production
that are engineered into a product or service at the design stage of development. Incurred costs are the
actual costs of making a product. When cost-based pricing is used, it is very difficult to control costs
that occur between the planning stage and the production phase. Because customers are expected to pay
the amount that cost-based pricing identifies, the focus is on sales rather than on design and
manufacture, and efforts at cost control focus on incurred costs after the product has been introduced to
the marketplace. However, controlling costs at this point is difficult. By designing and building a
product to a specific cost goal, target costing controls costs before they are incurred.
At times, the target cost established by target costing cannot be met. In this case, a company should try
to adjust the product’s design and the approach to production. If those attempts fail, the company
should either invest in new equipment and procedures or abandon its plans to market the product.

target costing; committed costs; incurred costs

Figure 4: Comparison of Price Decision Timing
Lecture Outline
I. Target costing involves the following steps:
A. Market research identifies the potential demand for a new product and the maximum price
that customers would be willing to pay for it.
B. The company’s minimum acceptable profit is established.
C. The desired profit is subtracted from the competitive market price to determine the target
cost.
II. Differences between Cost-based pricing and Target pricing
A. The target cost is the maximum cost to be incurred in designing and manufacturing the
product; if the cost goal cannot be met, the product is not manufactured.
B. Cost-based pricing methods focus on controlling incurred costs.
1. Incurred costs occur after the product reaches the marketplace.
C. Target costing focuses on controlling committed costs.
1. Committed costs occur during production.
III. Target costing analysis in an activity-based management environment
A. Find the target cost per unit.
B. Find the projected unit cost.
C. Make a decision.
Teaching Strategy
Refer to Figure 4 to illustrate target costing. Use Exercises 10, 11, 12, or 13 to illustrate and reinforce
this learning objective. Assign Problem 9 or Case 3 or 4 for application of target costing concepts.
OBJECTIVE 5: Describe how transfer pricing is used for transferring goods and services
and evaluating performance within a division or segment.
Summary Statement
A transfer price is the price at which goods are exchanged among an organization’s divisions or
segments. This concept is used by decentralized organizations with production processes that serve
several divisions or segments. By using transfer prices (artificial prices) at the point of transfer,
managers can measure the performance of the division or segment in terms of return on investment.
Thus, transfer prices are internal prices used only for performance evaluation.
There are three basic kinds of transfer prices. A cost-plus transfer price is the sum of costs incurred by
the producing division plus an agreed-on profit percentage. A market transfer price is based on external
market prices. In most cases, a negotiated transfer price is used. A negotiated transfer price is a price
that is reached through bargaining between managers of the selling and buying divisions.

decentralized organization; transfer price; cost-plus transfer price; market transfer price; negotiated
transfer price

Figure 5: Transfer Price Alternatives at Simple Box Company
Exhibit 1: Transfer Price Computation
Exhibit 2: Performance Report Using Transfer Prices
Lecture Outline
I. Transfer price
A. A transfer price is an artificial price at which goods and services are exchanged among a
company’s divisions or segments.
B. Transfer prices are internal prices used only to evaluate the performance of a division or
segment.
C. Three basic kinds of transfer prices
1. Cost-plus transfer price
2. Market transfer price
3. Negotiated transfer price
II. Using Transfer prices to measure performance
A. Because a transfer price contains an estimated amount of profit, a manager’s ability to meet
a targeted profit can be measured.
Teaching Strategy
Discuss the characteristics of transfer pricing. A review of the different types of centers in a
decentralized organization, as well as responsibility accounting reports, is useful in explaining this
concept. Use Exhibit 1 to illustrate one way in which a transfer price can be developed. Short Exercises
8, 9, and 10 pertain to this learning objective.
REVIEW QUIZ
True-False
1. T F Organizations that produce standard items for a competitive market use the same
pricing strategies as organizations that make custom-designed items.
2. T F Social concerns, such as legal constraints and ethical considerations, affect many
companies’ pricing policies.
3. T F Increasing market share by reducing prices below cost can be disastrous unless there is
a specific short-run objective to account for such a move.
4. T F Marginal revenue is the change in total cost resulting from a one-unit change in output.
5. T F In developing prices, organizations must always first determine the cost of producing a
product or service.
6. T F A gross margin–based price is determined by adding total production costs of the
product to the total production costs times the gross margin markup percentage.
7. T F The denominator of the gross margin markup percentage is total selling and
administrative costs.
Multiple Choice
8. An example of a pricing policy objective is to
a. minimize costs.
b. maximize price.
c. minimize losses.
d. maintain or gain market share.
e. do none of the above.
9. The primary objective of return on assets pricing is to

a. earn a profit margin on total costs.
b. earn a profit equal to a specified rate of return on assets.
c. establish a target cost.
d. establish a price based on time and materials.
e. do none of the above.
10. Which of the following organizations would be least likely to use a time and materials pricing
method?
a. Automobile manufacturer
b. Appliance repair shop
c. Home-remodeling specialist
d. Automobile repair business
e. Office cleaning service
11. Which of the following is not a step in target costing?

a. Compute a target cost by adding the desired profit to the expected manufacturing cost.
b. Define the minimum acceptable profit.
c. Identify a competitive market price.
d. Compute a target cost by subtracting the desired profit from the target price.
e. All the above are steps in target costing.
12. Transfer pricing

a. is rarely used in decentralized organizations.
b. has no implication for an organization’s tax liability.
c. is always based on standard costs.
d. is used to calculate the target cost.
e. establishes the price at which goods and services are exchanged among a company’s
divisions or segments.
13. Use of market transfer prices

a. is never acceptable.
b. normally serves only as a basis for negotiation.
c. leaves the selling division unable to sell to outside customers.
d. may cause an internal surplus of materials.
e. does none of the above.
14. When developing a cost-based price, the decision maker must consider
a. competitors’ prices.
b. customers’ expectations.
c. cost of substitute products and services.
d. all of the above.
e. none of the above.
15. Target costing

a. establishes a transfer price.
b. maximizes a product’s cost over its lifetime.
c. begins cost control after the product has been produced.
d. ignores the design phase of a product’s life cycle.
e. reduces costs before they are incurred.
16. Committed costs

a. are identical to incurred costs.
b. occur primarily during the manufacturing stage of a product’s life cycle.
c. are engineered into a product at the design stage of development.
d. occur primarily after the product has been introduced to the marketplace.
e. are identified by all of the above.
17. Which of the following pricing issues is addressed during the evaluation stage of the management
process?
a. Managers consider how much to charge for each product or service and identify the
maximum price the market will accept.
b. Products or services are sold at specified prices.
c. Managers evaluate sales to determine which pricing strategies were successful and which
failed.
d. Reports are prepared for use inside the organization to plan future strategies.
e. None of the above are addressed.
ANSWERS TO REVIEW QUIZ
True-False Multiple Choice

1. F 8. d
2. T 9. b
3. T 10. a
4. F 11. a
5. F 12. e
6. T 13. b
7. F 14. d
15. e
16. c
17. c

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ً ‫ صفحة الباحث العلوي هجانا‬Alaa.aliasrei@gmail.

com ‫@ عالء هحسن شحن‬Aliasrei ‫تلكرام‬

SUGGESTED INSTRUCTIONAL STRATEGY

Related Learning Objectives:

RESOURCE MATERIALS AND OUTLINES

Related Text Illustrations

OBJECTIVE 2: Describe economic pricing concepts, including the auction-based pricing

New Concepts and Terminology

Related Text Illustrations

OBJECTIVE 3: Use cost-based pricing methods to develop prices.

Gross Margin-Based Price = Total Production Costs per Unit + (Markup

New Concepts and Terminology

Related Text Illustrations

New Concepts and Terminology

Related Text Illustrations

New Concepts and Terminology

Related Text Illustrations

9. The primary objective of return on assets pricing is to

11. Which of the following is not a step in target costing?

12. Transfer pricing

13. Use of market transfer prices

15. Target costing

16. Committed costs

ANSWERS TO REVIEW QUIZ

True-False Multiple Choice

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