Chapter 5

PRICING CALCULATIONS
 Pricing calculations

CHAPTER
05
 Objectives
• Be able to calculate calculate a selling price using
full cost-plus pricing and marginal cost-plus pricing.
• Demonstrate an understanding of the difference
between mark-up and margin and of the
relationship between them.
• Derive the mark up percentage that will achieve a
desired return on the investment in a product.
• Calculate transfer prices for specified sales to
internal customers which take account of
appropriate costs.
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 Topic list

• Full cost-plus pricing

• Mark-ups and margins
• Marginal cost-plus pricing
• Transfer pricing

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 5.1. Full cost-plus pricing
Full costs are fully absorbed production Full costs are production costs and
costs only. some absorbed selling, distribution and
(direct materials, direct labour, production admin OH.
OH)

Unit sales price Unit sales price

= =
Total production cost per unit Total production cost per unit
+ +
Percentage mark-up Other costs * per unit + Percentage
mark-up

Note:
- Setting prices for service, service cost per unit is used instead.
- *other costs include selling, distribution and administration costs.

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 Example 1: Calculate sales price for product A?
• Rachel Ltd has begun to produce product A, for which the
following cost estimat ++m ++es have been prepared.
$ per unit
Variable materials 20.00
Variable labour @ $15 per hour 45.00
Variable production overheads @ $5 per hour 15.00
Variable production cost per unit 80.00

• Fixed production overheads are budgeted to be $100,000

each period. The overhead absorption rate will be based on
25,000 budgeted direct labour hours each period. The
company wishes to add 20% to the full production cost in
order to determine the selling price per unit for product A.
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 Mark-up and Margin percentage

Mark-up Profit as a percentage of full cost

Margin Profit as a percentage of sales price

The percentage profit mark-up or margin:

• do not have to be rigid and fixed.
• can be varied to suit the circumstances.

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Example 2: The difference between mark-
up and margin
1, Product A incurs a total cost of £80 per unit
Sales price is set at total Sales price is set at total
cost plus 20% mark-up cost plus 20% margin
Sales price ? Sales price ?

2, Product A incurs a total cost of £80 per unit and its

selling price is set at £100 per unit.
The mark-up applied to The margin earned by
product A ? product A ?

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 Determining the mark-up to achieve a
required return on investment

• Return on the investment

= Value of the investment (in NCA and WC for
production) x rate of return.
• Percentage of mark-up
= ROI/ Total production cost x 100%
• Selling price per unit
= full cost per unit + percentage mark-up

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Example 3: Pricing to generate a return on
investment
• ZZ Ltd requires an annual return of 30% on the
investment in all of its products. In the
forthcoming year £800,000 will be invested in
non-current assets and working capital to
produce and sell 50,000 units of product Z.
The full cost per unit of product Z is £100.
• Calculate sales price for product Z?

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 Advantages and disadvantages
of full cost-plus pricing
Advantages Disadvantages
1.The price is quick and easy to 1. It ignores potential profit
calculate. maximising
2. Pricing decisions can be delegated 2. It ignores market and demand
to more junior employees. conditions.

3. A price in excess of full cost should 3. It reduces incentives to control

ensure that an organisation working at costs.
normal capacity will cover all its costs
and profit is made.

4. Price increases can be justified as 4. It requires arbitrary absorption of

costs rise. overheads into product costs.

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 5.2. Marginal cost-plus pricing

• Marginal cost-plus pricing is a method of

determining sales prices whereby a profit
mark-up is added to either the marginal cost
of production or the marginal cost of sales.

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 Example 4: Calculating a cost-plus selling price
• Rachel Ltd has begun to produce product A, for which the following cost
estimates have been prepared.
$ per unit
Variable materials 20.00
Variable labour @ $15 per hour 45.00
Variable production overheads @ $5 per hour 15.00
Variable production cost per unit 80.00

• Fixed production overheads are budgeted to be $100,000 each period. The

overhead absorption rate will be based on 25,000 budgeted direct labour hours
each period.
• Variable selling and distribution costs are £3.80 per unit and fixed selling,
distribution and admin costs amount to £30,000 each period.
• The company wishes to add 20% to the marginal cost of sales in order to
determine the selling price per unit for product A.
• Requirement Calculate the selling price per unit of product Y and the profit that
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 Advantages and disadvantages
of marginal cost-plus pricing
Advantages
1. It is a simple and easy method to use.
Disadvantages
1. The full costs might not be
recovered in the long term.

2. It avoids the arbitrary apportionment and 2. Insufficient attention is

absorption of fixed costs that is necessary with paid to demand conditions,
absorption costing. competitors' prices and profit
maximisation.
3. It draws management attention to
contribution and the effect on profit of higher
or lower sales volumes, which is suitable for
short-term decision making.

4. It is used where there is a readily-identifiable

basic variable cost.
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 5.3. Transfer pricing
• A transfer price is the amount charged by one
part of an organisation for the provision of
goods or services to another part of the same
organization
• For example, subsidiary A might manufacture
a component that is used as part of a product
made by subsidiary B of the same company.
The component can also be bought on or sold
to the external market.
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 Aims of a transfer pricing system

• To help in the accurate measurement of divisional performance

(profitability) measurement.
• To provide the supplier with a realistic profit and the receiver with
a realistic cost.
• To give autonomy to managers.
• To encourage goal congruence, whereby the objectives of
divisional managers are compatible with the objectives of overall
company.
• To ensure profit maximisation for the company as a whole.
• A transfer pricing system, if properly established, can check
multinational companies and international groups which may try
to manipulate transfer prices between countries in order to
minimise the overall tax burden. 16
 Practical methods of transfer pricing

• Market price
• Cost-plus price
• Two part transfer price
• Dual price

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 (i) Market price

Division A Division B
Components
Market price

• The external market price is the optimum transfer price

if the supplying division is operating at full capacity.
• Market price is optimal price in perfectly competitive
market
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(ii) Cost plus approach to transfer pricing

• The supplying division determines the transfer

price by adding a profit mark-up to the cost
of the product or service.
• A pre-determined standard cost should be
used rather than actual cost.
• To ensure that overheads are recovered the
supplying division will wish to base the
transfer price on total cost.

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 Example 5: Sub-optimal decision making
• A company has two divisions, S and R. Both divisions manufacture
multiple products. Division S transfers its output of component C
to division R at full cost plus 10%. Division R then incurs further
costs to convert component C into finished product P for sale on
the external market at £40 per unit.
Division S Division R
($ per unit) ($ per unit)
Variable cost 20 15
Fixed cost absorbed 10
Full cost 30

• Requirements: Would the transfers be recommended from the

point of view of:
(a) the company as a whole?
(b) the manager of division R?
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 (iii) Two-part transfer price
• Transfers are charged at a predetermined
standard variable cost.
• A periodic charge for fixed costs would also be
made by the supplying division to the
receiving division (Credit Supplying division,
Debit Receiving division).
• The size of the periodic transfer would be
linked to the quantity or value of goods
transferred.
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 (iv) Dual pricing
• In dual pricing the supplying division is credited
with a different price from that which is
charged to the receiving division.
• This transfer pricing method charges the
receiving division for all transfers at variable or
marginal cost.
• The supplying division is credited with the
market value or with a cost-plus transfer price
in order to provide a profit incentive to make
the transfer. 22
 The economic transfer price rule

• Minimum (fixed by transferring division)

Transfer price ≥ marginal cost of transfer
out division
• Maximum (fixed by receiving division)
Transfer price ≤ net marginal revenue of
transfer in division

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 Exercise 1:
Atlas Company produces two automobile devices:
• The Boot: a high volume item with sales totaling 25,000
units per year
• The Club: a low volume item with sales totaling 5,000
units per year
Each product requires 1 hour of direct labor at the rate of $12
per hour.
Direct materials cost: The Boot: $40 per unit and The Club:
$30 per unit.
Expected annual manufacturing overhead costs $950,000
which are assigned directly to the appropriate activity cost
pool. 24
 Exercise 1 (cont’)
Cost pools Estimated overheads Cost drivers
Setting up machines $300,000 Number of batches
Machining $500,000 Machine hours
Inspecting $150,000 Number of inspections
The Boot The Club
Machine hours per unit 1.4 3
Batch size (units) 500 500
For each 25 units produced, the inspection will be conducted for
quality testing.
Required:
(i) Calculate the budgeted full production cost per unit of each
product using activity based costing.
(ii) Quoted the price of each product. The company has a policy
to price its products at budgeted total cost plus 50% mark-up.
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 Exercise 2:
(i). Jay operates a car valeting service and charges £16 per car. He
incurs a total cost of £10 per car valeted. Calculate the mark-up
and margin earned per car valeted.
(ii). A company requires a 20% annual return on the investment in
product F. The budgeted investment in non-current assets and
working capital for product F for the next year is £90,000. The full
cost per unit of product F is £5.00 and budgeted production and
sales for next year is 36,000 units. Calculate profit margin as a
percentage of the sales price of product F?
(iii). The marginal cost per unit of a product is 70% of its full cost.
Selling prices are set on a full cost-plus basis using a mark-up of
40% of full cost. Which percentage mark-up on marginal cost
would produce the same selling price as the full cost-plus basis
described? 26
SUMMARY

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