AFF02_U4.pdf

U4 PRICING (EXTERNAL SALES) Unit 4: Pricing (External Sales) 4.1 Contents Contents.............................................................................................................. 2 Concept Map........

U4 PRICING (EXTERNAL SALES) Unit 4: Pricing (External Sales) 4.1 Contents Contents.............................................................................................................. 2 Concept Map...................................................................................................... 3 Study Organiser.................................................................................................. 4 4.1 External Sales Environment...................................................................... 4 4.2 Target Costing.......................................................................................... 5 What is target costing?.............................................................................. 5 4.3 Cost Plus Pricing...................................................................................... 6 Limitations of cost plus pricing................................................................. 8 4.4 Variable Cost Pricing................................................................................ 8 Steps in calculating variable cost pricing................................................... 8 4.5 Time and Material Pricing...................................................................... 10 Steps in calculating time and material pricing......................................... 10 4.6 Summary................................................................................................ 13 Minute Paper.......................................................................................... 13 Glossary............................................................................................................ 14 References........................................................................................................ 15 Unit 4: Pricing (External Sales) 4.2 Concept Map This is a diagrammatic representation of what you will be learning in this unit. It shows the links between the learning objectives and key concepts. UNIT 4 Pricing (External 1. Target costing External Sales 2. Cost-plus pricing Determined by 4. Time and material Target selling the market pricing price 3. Variable cost pricing Cost of services Unit 4: Pricing (External Sales) 4.3 Study Organiser Before you begin this unit, please check through your study organiser. It shows the topics that we’ll be covering, the skills you need to acquire (the outcomes) and the activities you’ll do to help you acquire these skills. Topic Outcomes Activities Unit 4: Pricing By the end of this unit, you (External sales) should be able to: 4.1 External Sales  Identify the types of pricing Activity 4.1 Environment for sales to external parties. 4.2 Target Costing  Calculate a target cost when Tutorial Q1 the price is determined by market forces. 4.3 Cost Plus Pricing  Calculate a target selling Tutorial Q2 price using cost-plus pricing. 4.4 Variable Cost Pricing  Establish prices using Tutorial Q3 variable cost pricing. 4.5 Time and Material  Decide the cost of services Tutorial Q4 Pricing provided time and material pricing. You should spend at least 1 week on this unit. To help you, many of the sections indicate approximately how many hours of work you require. Unit 4: Pricing (External Sales) 4.4 4.1 External Sales Environment The main aim of all businesses is to make profit. So in order to do this, businesses are faced with a very important and difficult question as to what price to sell the product or service for? When setting the price for new products, the business must consider other costs like research and development. So it must set the price to meet all the costs and at the same time, earn a reasonable return to continue operating the business. In order to do this, a business has to understand the market forces well in order to set the price. 4.2 Target Costing What is target costing? A target cost is a cost that will provide the desired profit on a product when the seller does not have control over the product’s price. Therefore, target costing is not really a method of setting the price of a product but a system of cost management and Spend at least 2 profit planning. hours on this section. To calculate the target cost, the company decides the selling price. So once the selling price is determined, the target cost is decided by setting the desired profit. The difference between the target price and the desired profit is the target cost of the product. Market price – Desired Profit = Target Profit Example ABC manufactures hair ties. The current market price is $10.00. The business wants to make a profit of $ 4.00 per hair tie. How can the business achieve this objective? EXAMPLE Required a. Calculate the target cost for the hair tie. b. When is target costing particularly helpful in deciding whether to produce a given product. The solution is provided on the following page. Unit 4: Pricing (External Sales) 4.5 Solution a. The target cost formula is: Target cost = Market price – Desired profit In this case, the market price is $10 and the desired profit is $4.00, therefore the target cost is $6.00 ($10.00 – $4.00) b. Target costing is particularly helpful when a company faces a competitive market. In this case, the price is affected by supply and demand, so no company in the industry can affect price. Therefore to earn a profit, companies must focus on controlling costs. 4.3 Cost Plus Pricing In a competitive market the prices are already set by supply and demand. On the other hand, in a less competitive or non- competitive environment, the company may have to set its own price. Now, when the company sets the price, it is commonly a function of the cost of the product or service. Spend at least 2 How much did it cost to buy the product? The typical hours on this section. approach to use is cost-plus pricing. This basically means adding to the cost base a mark-up to determine a target selling price. This mark- up will be determined by how much rate of return on the investment the company wants on its product or service. The cost base includes all costs associated in producing or selling the product or service. The mark- up represents the desired profit. This is illustrated below: Selling Price – Cost = Mark up (Profit) The size of the mark- up depends on the return that the company hopes to generate on the amount it has invested. Once the company has determined its cost base and its desired mark- up, it can add the two together to determine the target selling price. This is expressed below: Cost + Markup = Target Selling price Example Davis Manufacturers Ltd manufactures swimming suits and sells them to the retailers. The market research department believes it Unit 4: Pricing (External Sales) E X A M P L4.6 E has a strong market for this type of suit and it would sell for approximately $100. Davis manufacturers believe it would have the following manufacturing cost: $ Direct material 20 Direct labour 25 Manufacturing overhead 40 Total cost 85 Required Assuming Davis manufacturers uses cost plus pricing, setting the selling price 30% above it costs. What would be the price charged for the swimming suit. (Work out the answer here before checking the solution on the next page.) Unit 4: Pricing (External Sales) 4.7 Solution In this case the selling price would be $110.50 ($85 + [$85 X 30%]). The problem with the $110.50 is that it is unlikely that Davis manufacturers will be able to sell any swimming suits at that price. Market research seems to indicate that it will sell for only $100. One way that Davis manufacturers might consider manufacturing the swimming suit will depend if it has excess capacity and therefore manufacturing will not affect its fixed costs. As long as the company can cover its variable costs it might want to sell at the $110.50. Limitations of cost plus pricing Although cost plus pricing is simple to compute, the cost model does not factor the demand. The sales volume also plays a significant role in determining the cost per unit. This means that when the sales volume is low, the price will be high. The high price is charged to meet the desired return on investment (ROI). 4.4 Variable Cost Pricing In the last section we covered cost plus pricing. Under this approach, all cost incurred is used. This is referred to as full cost pricing. In today’s competitive environment, some companies simply add a mark-up to their variable costs. The cost base includes all variable costs associated with the product, Spend at least 2 hours on this including variable selling and administration costs. Because section. fixed costs are not included in the base, the mark-up must provide for all fixed costs (manufacturing and selling and administrative) and the target ROI. This is particularly useful where there is a lot of uncertainty surrounding cost information. Variable cost pricing is helpful in pricing special orders or when excess capacities exist. Though this may be a useful approach, it is important that we discuss the disadvantages too. Steps in calculating variable cost pricing Step 1 Compute the unit variable cost. Step 2 Compute the mark-up percentage Desired ROI per unit + Fixed Cost per unit = Markup% unit Variable cost Unit 4: Pricing (External Sales) 4.8 Step 3 Set the target price. Variable Cost per unit + (Mark-up % x Variable cost per unit) = Target Selling price Disadvantages Managers may set the price too low and consequently fail to cover their fixed costs. In the long run, failure to cover fixed costs will lead to losses. So to conclude, the business that uses variable cost pricing must adjust its mark- ups to make sure that the price set will provide an adequate return. Example High Productive Producers produce Food processors. The following is the per unit cost available. $ EXAMPLE Direct material 36 Direct labour 24 Variable manufacturing overhead 18 Fixed manufacturing overhead 42 Variable selling and administrative expense 14 Fixed selling and administrative expense 28 Its desired ROI per unit is $30.00 Required Calculate the mark-up percentage and the target selling price per unit using variable cost pricing. Unit 4: Pricing (External Sales) 4.9 Solution The mark-up percentage using variable cost pricing is calculated by including only variable costs in the cost base. Therefore, all fixed costs are excluded from the cost base and added back in the numerator. Desired ROI per unit + Fixed Cost per unit = Markup% unit Variable cost Markup percentage = $30 + ($42 + $28) = 108.7% $36 + $24 + $18 + $14 Variable Cost per unit + (Mark-up % x Variable cost per unit) = Target Selling price Target Selling Price = $92 + (108.7% x $92) = $192.00 4.5 Time and Material Pricing A variation to cost-plus pricing is normally called the time and material pricing approach. This approach sets two pricing rates: a. labour and b. material. Spend at least 2 hours on this The labour rate includes direct labour time and other employee section. costs. The material charge, on the other hand, is based on the direct parts and materials used. A material loading charge is also included for related overhead costs. Time and material pricing is widely used in the service industries especially professional firms such as public accounting, law, engineering, consulting firms as well as construction companies, repair shops and printers. Steps in calculating time and material pricing Step 1 Calculate the labour rate. This is to determine a charge for labour time. This rate includes the direct labour cost for the employees (hourly rate + fringe benefits), Unit 4: Pricing (External Sales) 4.10  selling, administration and overhead costs and an allowance for a desired profit (ROI) per hour of employee time. Step 2 Calculate the material loading charge. The charge for materials include the invoice price for any material used in the job plus a material loading charge. The material charge covers the cost of purchasing, receiving, handling, and storing materials plus any desired profit margin on the materials themselves. The material loading charge is expressed as a percentage of the total estimated costs of parts and materials for the year. Step 3 Calculate charges for a particular job. The charge for a particular job includes the labour charge, the materials charge and the material loading charge. Example Harry Electrical Repair Shop presents the following data for next year. Repair- technicians wages $130,000 EXAMPLE Fringe benefit 30,000 Overhead 20,000 The desired profit margin per labour is $10. The material loading charge is 40% on invoice cost. Harry estimates that 8,000 labour hours will be worked next year. If Harry repairs a TV that takes 4 hours to repair and uses parts costing $50, compute the bill for this job. Solution Total Cost ÷ Total Hours = Per Hour Charge Repair- technicians wages $130,000 ÷ 8,000 = $16.25 Fringe benefit $30,000 ÷ 8,000 = 3.75 Overhead $20,000 ÷ 8,000 = 2.50 $180,000 $22.50 Profit margin 10.00 Rate charged per hour of labour $32.50 Job: Repair TV Labour charges: 4 hours @ $32.50 $130 Material Charges Cost of parts and materials $50 Material loading charge (40% x $50) 20 70 Total price of labour and material $200 Unit 4: Pricing (External Sales) 4.11  Activity 4.1 You will find a brief discussion of these questions in the section Feedback on Activities. 1. What are the two types of pricing environments for sales to external parties? Unit 4: Pricing (External Sales) 4.12 4.6 Summary In this competitive business world one has to be very careful when making decisions as to how to run their business efficiently and effectively. They have to make a wise decision as to what price they are setting for their products and services. A price set too high will result in customers buying from other competitors and a price set too low may not be able to cover all the costs and warrant a good return to the owner. To conclude, the four approaches discussed offered significant benefits though significant costs were involved too. So it is always advisable that a cost benefit analysis be carried out before implementing any of the approaches. Good Job and well done for finishing this unit! If you are on schedule with your readings then it should now be the end of week 13 of the semester. Minute Paper In concise, well-planned sentences, please answer the two questions below: 1. What are the two [three, four, five] most significant [central, useful, meaningful, surprising, disturbing] things you have learned during this unit? _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ Unit 4: Pricing (External Sales) 4.13 2. What key question(s) about this unit still remain in your mind? _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ _________________________________________________________________ Glossary The following are some accounting terms / jargon that you need to master. Please try to define and explain them in your own words. Discuss your definitions with your tutor or email the coordinator if you need to verify your definitions. Jargon / Term Definition 1 Cost-plus pricing 2 Markup 3 Target costing 4 Time and material pricing 5 Variable cost pricing 6 Material loading charge 7 Return on investment 8 Full cost pricing 9 Desired profit Unit 4: Pricing (External Sales) 4.14  Feedback on Activities Activity 4.1 Two types: 1. The company is a price taker; that is, the company does not set the price, but instead the price is set by a competitive market. 2. The company sets the price. This happens most often when the product is specially made for a customer or there are few producers capable of manufacturing a product. References Weygandt J., Kimmel P.,Keiso D., 2015, Managerial Accounting: Tools for business decision making. John Wiley & Sons, Inc., USA. 7th Ed. Unit 4: Pricing (External Sales) 4.15