Accounting 210 Chapter 8 Notes
Accounting 210 Chapter 8 Notes ACCT210
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This 9 page Class Notes was uploaded by Kristin Koelewyn on Saturday March 19, 2016. The Class Notes belongs to ACCT210 at University of Arizona taught by Heather Altman in Spring 2016. Since its upload, it has received 17 views. For similar materials see Managerial Accounting in Accounting at University of Arizona.
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Date Created: 03/19/16
Accounting 210: Chapter 8 Notes Pricing - The price of a good or service is affected by many factors. - Regardless of the factors involved, the price must cover the costs of the good or service as well as earn a reasonable profit. - Pricing Goods for External Sales: o The price of a good or service is affected by many factors. o Company must have a good understanding of market forces. o Where products are unique or clearly distinguishable from competitor goods, prices are set by the company. - Target Costing: o Laws of supply and demand significantly affect product price. o To earn a profit, companies must focus on controlling costs. o Requires setting a target cost that will provide the company’s desired profit. o Target cost: Cost that provides the desired profit when the market determines a product’s price. ▯ Market Price – Desired Profit = Target Cost o If a company can produce its product for the target cost or less, it will meet its profit goal. o First, company should identify its market niche where it wants to compete. o Second, company conducts market research to determine the target price – the price the company believes will place it in the optimal position for the target consumers. o Third, company determines its target cost by setting a desired profit. o Last, company assembles a team to develop a product to meet the company’s goals. ▯ DO IT! Fine Line Phones is considering introducing a fashion cover for its phones. Market research indicates that 200,000 units can be sold if the price is no more than $20. If Fine Line decides to produce the covers, it will need to invest $1,000,000 in new production equipment. Fine Line requires a minimum rate of return of 25% on all investments. Determine the target cost per unit for the cover. o Question: Target cost related to price and profit means that: ▯ a. Cost and desired profit must be determined before selling price. ▯ b. Cost and selling price must be determined before desired profit. ▯ c. Price and desired profit must be determined before costs. ▯ d. Costs can be achieved only if the company is at full capacity. - Cost-Plus Pricing: o In an environment with little or no competition, a company may have to set its own price. o When a company sets price, the price is normally a function of product cost: cost-plus pricing. o Approach requires establishing a cost base and adding a markup to determine a target- selling price. o In determining the proper markup, a company must consider competitive and market conditions. o Size of the markup (the “plus”) depends on the desired return on investment for the product: ▯ ROI = net income ÷ invested assets o Illustration: Thinkmore Products, Inc. is in the process of setting a selling price on its new video camera pen. It is a functioning pen that will record up to 2 hours of audio and video. The per unit variable cost estimates for the new video camera pen are as follows. ▯ In addition, Thinkmore has the following fixed costs per unit at a budgeted sales volume of 10,000 units. ▯ Thinkmore has decided to price its new video camera pen to earn a 20% return on its investment (ROI) of $2,000,000. ▯ Markup = 20% ROI of $2,000,000 ▯ Expected ROI = $400,000 ÷ 10,000 units = $40 ▯ Market Price per Unit= o Compute the markup percentage to achieve a desired ROI of $20 per unit: o Compute the target selling price: o LIMITATIONS OF COST-PLUS PRICING: ▯ Advantage of cost-plus pricing: Easy to compute. ▯ Disadvantages: • Does not consider demand side: o Will the customer pay the price? • Fixed cost per unit changes with change in sales volume: o At lower sales volume, company must charge higher price to meet desired ROI. ▯ Illustration: If budgeted sales volume for Thinkmore’s Products was 5,000 instead of 10,000, Thinkmore’s variable cost per unit would remain the same. However, the fixed cost per unit would change as follows. ▯ Thinkmore's desired 20% ROI now results in a $80 ROI per unit [(20% x $2,000,000) ÷ 5,000]. ▯ Thinkmore computes the selling price at 5,000 units as follows: ▯ At 5,000 units, how much would Thinkmore mark up its total unit costs to earn a desired ROI of $80 per unit. - Variable-Cost Pricing: o Alternative pricing approach: ▯ Simply add a markup to variable costs. ▯ Avoids the problem of uncertain cost information related to fixed-cost-per-unit computations. ▯ Helpful in pricing special orders or when excess capacity exists. o Major disadvantage is that managers may set the price too low and fail to cover fixed costs. o Question: Cost-plus pricing means that: o a. Selling price = variable cost + (markup percentage + variable cost). o b. Selling price = cost + (markup percentage X cost). o c. Selling price = manufacturing cost + (markup percentage + manufacturing cost). o d. Selling price = fixed cost + (markup percentage X fixed cost). - DO IT! Air Corporation produces air purifiers. The following per unit cost information is available: direct materials $16, direct labor $18, variable manufacturing overhead $11, variable selling and administrative expenses $6. Fixed selling and administrative expenses are $50,000, and fixed manufacturing overhead is $150,000. Using a 45% markup percentage on total per unit cost and assuming 10,000 units, compute the target selling price. o Using a 45% markup percentage on total per unit cost and assuming 10,000 units, compute the target selling price. o Vertically integrated companies: ▯ Grow in either direction of its suppliers or its customers. ▯ Frequently transfer goods to other divisions as well as outside customers. - Transfer Price: o Transfer price - price used to record the transfer between two divisions of a company. o Conceptually o Due to practical considerations, companies often use the other two methods. o Illustration: Alberta Company makes rubber soles for work & hiking boots. o Two Divisions: ▯ Sole Division - sells soles externally. ▯ Boot Division- makes leather uppers for hiking boots which are attached to purchased soles. o Division managers compensated on division profitability. o Management now wants Sole Division to provide at least some soles to the Boot Division. o Computation of the contribution margin per unit for each division when the Boot Division purchases soles from an outside supplier. o - No Excess Capacity: o If Sole sells to Boot, ▯ payment must at least cover variable cost per unit plus ▯ its lost contribution margin per sole (opportunity cost). o The minimum transfer price acceptable to Sole is: o From the perspective of the Boot Division (the buyer), the most it will pay is what the sole would cost from an outside supplier. o Can produce 80,000 soles, but can sell only 70,000. o Available capacity of 10,000 soles. o Contribution margin of $7 per unit is not lost. o Minimum transfer price acceptable to Sole: o In this case, the Boot Division and the Sole Division should negotiate a transfer price within the range of $11 to $17. - Variable Costs: o In the minimum transfer price formula, variable cost is the variable cost of units sold internally. o May differ - higher or lower - for units sold internally versus those sold externally. o The minimum transfer pricing formula can still be used – just use the internal variable costs. - Summary: o Transfer prices established: ▯ Minimum by selling division. ▯ Maximum by the purchasing division. o Often not used because: ▯ Market price information sometimes not easily obtainable. ▯ Lack of trust between the two divisions. ▯ Different pricing strategies between divisions. - Cost-Based Transfer Prices: o Uses costs incurred by the division producing the goods as its foundation. o May be based on variable costs alone or on variable costs plus fixed costs. o Selling division may also add markup. o Can result in improper transfer prices causing: ▯ Loss of profitability for company. ▯ Unfair evaluation of division performance. o Illustration: Alberta Company requires the division to use a transfer price based on the variable cost of the sole. With no excess capacity, the contribution margins per unit for the two divisions are: Cost-based transfer price—10,000 units o Cost-based pricing is bad deal for Sole Division – no profit on transfer of 10,000 soles to Boot Division and loses profit of $70,000 on external sales. o Boot Division is very happy; increases contribution margin by $6 per sole. o If Sole Division has excess capacity, the division reports a zero profit on these 10,000 units and the Boot Division gains $6 per unit. ▯ Overall, the Company is worse off by $60,000. o Does not reflect the division’s true profitability nor provide adequate incentive for the division to control costs. - Market- Based Transfer Prices: o Based on existing market prices of competing goods. o Often considered best approach because it is objective and generally provides the proper economic incentives. o It is indifferent between selling internally and externally if can charge/pay market price. o Can lead to bad decisions if have excess capacity. o Why? No opportunity cost. o Where there is not a well-defined market price, companies use cost-based systems. o The Plastics Division of Weston Company manufactures plastic molds and then sells them for $70 per unit. Its variable cost is $30 per unit, and its fixed cost per unit is $10. Management would like the Plastics Division to transfer 10,000 of these molds to another division within the company at a price of $40. The Plastics Division is operating at full capacity. What is the minimum transfer price that the Plastics Division should accept? ▯ A. $10 ▯ B. $30 ▯ C. $40 ▯ D. $70 - Effect of Outsourcing on Transfer Pricing: o Outsourcing - Contracting with an external party to provide a good or service, rather than doing the work internally. o Virtual companies outsource all of their production. o Use incremental analysis to determine if outsourcing is profitable. o As companies increasingly rely on outsourcing, fewer components are transferred internally thereby reducing the need for transfer pricing. - Transfers Between Divisions in Different Countries: o Companies “globalize” their operations o Going global increases transfers between divisions located in different countries. o 60% of trade between countries is estimated to be transfers between divisions. o Different tax rates make determining appropriate transfer price more difficult. o DO IT! The clock division of Control Central Corporation manufactures clocks and then sells them to customers for $10 per unit. Its variable cost is $4 per unit, and its fixed cost per unit is $2.50. Management would like the clock division to transfer 8,000 of these clocks to another division within the company at a price of $5. The clock division could avoid $0.50 per clock of variable packaging costs by selling internally. (a) Determine the minimum transfer price, assuming the clock division is not operating at full capacity. (b) Determine the minimum transfer price, assuming the clock division is operating at full capacity. ▯ Opportunity cost + Variable cost = Minimum transfer price
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