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CHAPTER 5
Pricing calculations

OVERVIEW

PRICING
CALCULATIONS

Maginal
Costing

Cost plus Pricing

Absorption
Costing

Target
Maket Pricing Costing

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COST – PLUS PRICING

SALES PRICE = COST + PROFIT

Which cost should we use to be the BASIS of pricing calculations?

ABSORPTION COSTING MARGINAL COSTING

(Full costing) (Variable costing)

The selling price can be calculated The selling price can be calculated
based on full cost: based on maginal cost:
+ The cost based can be full + The cost based can be variable
manufacturing cost manufacturing cost
+ The cost based also can be full + The cost based also can be all
cost (include manufacturing variable cost (include
and non manufacturing manufacturing and non
expenses) manufacturing expenses)

FULL COST-PLUS PRICING

Unit sales
Total cost Profit
price

Selling,
Full distribution,
Unit sales
manufac- Aministrat- Profit
price
turing cost ion
expenses

COST MARK- Based on full

BASED UP manufacturing
cost

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FULL COST-PLUS PRICING

Unit sales
Total cost Profit
price

Selling,
Full
Unit sales distribution,
manufac- Profit
price Aministrati
turing cost on expenses

Based on full
manufacturing & COST MARK-
non-manufacturing BASED UP
expenses

PRACTICAL POINT
Infact, the sales price must be:
 Low enough to encourage the purchaser to buy, yet

 High enough to make an acceptable profit to producer

This can be achieved using a MARK-UP or a MARGIN. That is

cost – plus pricing method.
NOTE

Margin percentage Mark-up percentage

A margin is the profit A mark-up is the profit
expressed as a percentage Expressed as a
of sales price (sales is percentage of cost (cost is
100%). 100%).

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TEST YOUR UNDERSTANDING 1

Variable production cost per unit £3

Total fixed production costs £12,000
Total other fixed costs £24,000
Number of units 12,000
Calculate the final selling price ofproduct X under the two different full-
cost plus methods if:
(a) The mark-up is 50% on full production cost
(b) The mark-up is 10% on full cost.

TEST YOUR UNDERSTANDING 2

A company with non-current assets of £100,000 and net current

assets of £200,000 requires a 30% ROI. Full cost per unit produced is
£250. There are 1,500 units produced.
What will the selling price need to be?

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TEST YOUR UNDERSTANDING 3

Unit cost = £80 Unitselling price = £100

(a) What markup does this represent?

(b) What margin does this represent?

Calculate selling price if unit cost is £125 using

(a) a gross margin of 10% and

(b) a mark-up of 15%.

MAGINAL COST-PLUS PRICING

Unit sales
Total cost Profit
price

Unit sales Variable

Fixed cost Profit
price cost

Non
Manufactu-
manufactu-
Unit sales ring
ring Fixed costs Profit
price variable
variable
costs
expenses

Based on
variable COST MARK-
manufacturing BASED UP
cost

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MAGINAL COST-PLUS PRICING

Unit sales
Total cost Profit
price

Unit sales Variable

Fixed cost Profit
price cost

Non
Manufactu-
manufactu-
Unit sales ring
ring Fixed costs Profit
price variable
variable
costs
expenses

Based on
variable cost COST MARK-
BASED UP

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TEST YOUR UNDERSTANDING 4

Marginal cost/unit = £81.50

Full cost/unit = £99.50
What would be the sales price if the company

(a) used a 20% mark up on full cost?

(b) used a 50% mark up on marginal cost?

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FULL COST PLUS MARGINAL COST PLUS

PRICING PRICING

ADVANTAGES

• The price is quick and easy to • Simple

calculate. • It avoids the arbitrary
• Can justify price increases if apportionmentand absorption of
costs rise. fixed costs.
• Pricing decisions can be • Very useful for short-term
delegated. decisions, concerning the use of
• If working at normal capacity, excess capacity or one off
it should ensure a profit is contracts.
made

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FULL COST PLUS MARGINAL COST PLUS

PRICING PRICING

DISADVANTAGES

• Profit maximisation may not • May make losses in the long

be achieved as the relationship term if sales price does not
between price and demand is cover fixed costs.
ignored. • May not be relevant to
• No incentive to control costs. businesses with heavy fixed
• Arbitrary absorption of cost base.
overhead into product costs • Profit maximisation may not be
achieved as the relationship
between price and demand is
ignored

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PRICING AND INFLATION EFFECT

 Selling price is determined before delivery of the goods or services
based on Budgeting. The buyer whether agrees to prices based on
actual cost incurred or not.

 The buyer can pay cash imediately or credit.

What is benefit or loss of buyer and supplier if the transaction inccur in high
inflation economic?

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TRANSFER PRICING
A Transfer Price (TP) is the amount charged by one part of an
organisation for the provision of goods or services to another part of the same
organisation.

EXTERNAL
DIVISION A DIVISION B
CUSTOMER

If Division A is a profit centre and it needs a ‘revenue’ from a TP.

Division B realise that Division A does not make the goods for free,
Division B needs a ‘cost’ from a TP.
The TP is therefore a signalling mechanism, hopefully to encourage
divisional managers to act in a way to maximise shareholder wealth (goal
congruence).

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AIMS OF TRANSFER PRICING

o Measure divisional profits
o Measure costs and revenues
o Autonomy to managers
o Encourage goal congruence
o Profit maximisation
Practical
method

Market Cost-plus Two part Dual

Price Price TP Pricing

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MARKET PRICE
In a perfectly competitive market, the optimum TP is the market
price providing the supplying division is operating at full capacity. This
should be reduced for cost savings from internal transfers. This
includes:
 Packaging

 Advertising

 Distribution

 Irrecoverable debts

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COST-PLUS PRICE
Cost-plus TP works in the same way as cost-plus pricing. However
these costs below should be considered for removal from internal sales
price:
+ Packaging

+ Advertising

+ Distribution

+ Irrecoverable debts

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COST-PLUS PRICE
Issues with cost-plus TP:

A predetermined standard cost should be used to prevent

divisional profit being distorted. The TP should be based on total cost
to ensure overheads are recovered by the supplying division.
• However, the supplying divisions fixed costs will then be
perceived as variable by the receiving division.

• The supplying division may also ‘over recover’ its fixed costs. This
may lead the recovering division to outsource purchases when this
is sub-optimal for the overall business.

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TWO-PART TRANSFER PRICING

As the name suggests, the transfer is accounted for in two parts:
• Part 1 = standard variable cost

• Part 2 = periodic fixed charge

This ensures the recovering division is aware of the cost behaviour

patterns of the supplying division.

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DUAL PRICING
Each division records the TP at a different amount to encourage
optimal decision making.
• Supplying division – records revenue at market price or full cost-
plus price.

• Receiving division – records purchases at the supplying divisions

standard variable cost only.

The dual pricing method can be effective in avoiding sub-optimal

decisions but it can be administratively cumbersome

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TEST YOUR UNDERSTANDING 5

Basic situation
MCa = £30 MCb = £55 Sale Price = £120
Div A Div B sell outside
• Div A makes goods at a marginal cost/unit (MCa) of £30
• Div B takes A’s product and turns it into a finished good incurring its
own cost of £55 (MCb).
(a) Does the company make a positive contribution?
(b) What is the minimum TP that A will accept?
(c) What is the maximum TP that B will pay?
(d) What is an acceptable range of TPs?

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TEST YOUR UNDERSTANDING 6

A can sell to external market

Sale Price
MCa = £30 MCb = £55
= £120
Div A Div B
(outside)
(£3) costs
Sales price = £45
(outside)

A wants to maximise its own profits. It can sell externally and/or internally.
(a) What is the net sales price/unit A gets selling externally?
(b) What is the max TP B will pay?
(c) What is the lowest TP A will accept if A is at full capacity?
(d) What is the lowest TP A willaccept if A has spare capacity?

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TEST YOUR UNDERSTANDING 7

A can sell to external market

Sale Price
MCa = £30 MCb = £55
= £120
Div A Div B
(outside)
(£3) costs
Sales price = £45 External supplier
(outside) purchase price = £39

What should each division do to maximise company profitability

(a) If A is at full capacity, what is the situation?
(b) If A has spare capacity, what is the situation?

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TEST YOUR UNDERSTANDING 8

A can sell to external market

Sale Price
MCa = £30 MCb = £55
= £120
Div A Div B
(outside)
(£3) costs
Sales price = £45 External supplier
(outside) purchase price = £26

What should each division do to maximise company profitability

(a) If A is at full capacity, what is the situation?
(b) If A has spare capacity, what is the situation?

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TEST YOUR UNDERSTANDING 9

C and V are two divisions of a company. Division C makes a product,

Mad. Unit production cost and the market price are as follows:
Labour £26
Materials £14
Absorbed fixed cost £8
Total Absorption Cost £48
Prevailing market price £64
Mad is sold outside the company to an external market and also internally
to Division V. Division C incurs an £8 variable selling cost if it sells Mad
outside. Total demand for Mad is sufficient for Division C to manufacture to
capacity.
What is the minimum transferprice the company will set?

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