Unit 5

The pricing of goods and services

Pricing is a process of fixing the value that a manufacturer will receive in the
exchange of services and goods. Pricing method is exercised to adjust the cost of the
producer’s offerings suitable to both the manufacturer and the customer. The
pricing depends on the company’s average prices, and the buyer’s perceived value of
an item, as compared to the perceived value of competitors product.

Every businessperson starts a business with a motive and intention of earning

profits. This ambition can be acquired by the pricing method of a firm. While fixing
the cost of a product and services the following point should be considered:

 The identity of the goods and services

 The cost of similar goods and services in the market
 The target audience for whom the goods and services are produces
 The total cost of production (raw material, labour cost, machinery cost,
transit, inventory cost etc).
 External elements like government rules and regulations, policies, economy,
etc.,

Objectives of Pricing:

 Survival- The objective of pricing for any company is to fix a price that is
reasonable for the consumers and also for the producer to survive in the
market. Every company is in danger of getting ruled out from the market
because of rigorous competition, change in customer’s preferences and taste.
Therefore, while determining the cost of a product all the variables and fixed
cost should be taken into consideration. Once the survival phase is over the
company can strive for extra profits.
 Expansion of current profits-Most of the company tries to enlarge their profit
margin by evaluating the demand and supply of services and goods in the
market. So the pricing is fixed according to the product’s demand and the
substitute for that product. If the demand is high, the price will also be high.
 Ruling the market- Firm’s impose low figure for the goods and services to get
hold of large market size. The technique helps to increase the sale by
increasing the demand and leading to low production cost.
 A market for an innovative idea- Here, the company charge a high price for
their product and services that are highly innovative and use cutting-edge
technology. The price is high because of high production cost. Mobile phone,
electronic gadgets are a few examples.

Pricing Method?
Pricing method is a technique that a company apply to evaluate the cost of their
products. This process is the most challenging challenge encountered by a company,
as the price should match the current market structure and also compliment the
expenses of a company and gain profits. Also, it has to take the competitor’s product
pricing into consideration so, choosing the correct pricing method is essential.

Types of Pricing Method:

The pricing method is divided into two parts:

 Cost Oriented Pricing Method– It is the base for evaluating the price of the
finished goods, and most of the company apply this method to calculate the
cost of the product. This method is divided further into the following ways.

 Cost-Plus Pricing- In this pricing, the manufacturer calculates the cost

of production sustained and includes a fixed percentage (also known
as mark up) to obtain the selling price. The mark up of profit is
evaluated on the total cost (fixed and variable cost).
 Markup Pricing- Here, the fixed number or a percentage of the total
cost of a product is added to the product’s end price to get the selling
price of a product.
 Target-Returning Pricing- The company or a firm fix the cost of the
product to achieve the Rate of Return on Investment.

 Market-Oriented Pricing Method- Under this category, the is determined on

the base of market research

 Perceived-Value Pricing- In this method, the producer establish the

cost taking into consideration the customer’s approach towards the
goods and services, including other elements such as product quality,
advertisement, promotion, distribution, etc. that impacts the
customer’s point of view.
 Value pricing- Here, the company produces a product that is high in
quality but low in price.
 Going-Rate Pricing- In this method, the company reviews the
competitor’s rate as a foundation in deciding the rate of their product.
Usually, the cost of the product will be more or less the same as the
competitors.
 Auction Type Pricing- With more usage of internet, this contemporary
pricing method is blooming day by day. Many online platforms like
OLX, Quickr, eBay, etc. use online sites to buy and sell the product to
the customer.
Pricing- This method is applied when the pricing has to be different for different
groups or customers. Here, the pricing might differ according to the region, area,
product, time etc.
 5.1 Target and minimum pricing.
Target pricing is the process of estimating a competitive price in the marketplace
and applying a firm's standard profit margin to that price in order to arrive at the
maximum cost that a new product can have. A design team then tries to create a
product with the requisite features within the pre-set cost constraint. If the team
cannot complete the product within the cost constraint, the project is
terminated. By taking this approach, a firm can assure itself of earning a
reasonable profit across its product line, without being burdened by any low-
profitability products. However, if the standard profit margin is set too high, it
may not be possible to develop very many products within the cost constraint.

A minimum price is the lowest price that can legally be set, e.g. minimum price for
alcohol, minimum wage
Price floor (minimum price) – the lowest possible price set by the government that
producers are allowed to charge consumers for the good/service
produced/provided. It must be set above the equilibrium price to have any effect on
the market

5.2 Price /demand relationships,

Demand is generally considered to slope downward: at higher prices, consumers
buy less. The point at which the two curves intersect represents the market-clearing
price—the price at which demand and supply are the same. Prices can change for
many reasons (technology, consumer preference, weather conditions).
 Price is dependent on the interaction between demand and supply components of a
market. Demand and supply represent the willingness of consumers and producers
to engage in buying and selling. An exchange of a product takes place when buyers
and sellers can agree upon a price.

Law of demand states: As price of a good increases, the quantity demanded

of the good falls, and as the price of a good decreases, the quantity demanded
of the good rises, ceteris paribus. Restated: there is an inverse relationship between
price (P) and quantity demanded (Qd).

5.3 The pricing of special orders and short-life products,

Pricing of special orders: a product that is being sold for less than its usual price or
the act of selling something for less than the usual price.

Special order pricing is a technique used to calculate the lowest price of a product
or service at which a special order may be accepted and below which a special
order should be rejected. Usually, a business receives special orders from customers
at a price lower than normal.
the example of a special order decision

Suppose Tony's T-shirts is operating at capacity and cannot produce any more T-
shirts. Tony must turn away regular customers to make room for the special order.
In this scenario, the opportunity cost of turning away existing customers must be
considered in the differential analysis.

A Short-term Product means a product traded on the Exchange with physical

delivery that must be presented within a delivery period.
Clothing, laptops, and mobile phones, to name a few, are examples of products with
extremely short life cycles.

The life cycle of the product cycle is the series of phases that a product undergoes
during its lifetime, beginning with the introduction and concluding with the
decline. A product life cycle (PLC) is typically divided into four stages: Introduction,
Growth, Maturity, and Decline. Business owners and marketers utilize the product
life cycle (PLC) to make crucial decisions and formulate plans about advertising
budgets, product prices, and product packaging.

5.4 Pricing in service industries,

For every product, the company has to choose a price. But determining the price
can take many ways. Most importantly, it should follow a predetermined strategy. 3
major pricing strategies can be identified:

 Cost based pricing

 Competition based pricing

 Demand based pricing

Cost based pricing: While in customer value-based pricing, customers’ perceptions of

value are key to setting prices, in cost-based pricing the seller’s costs are the primary

consideration. Costs set the floor for the price that the company can charge.

Therefore, cost-based pricing involves setting prices based on the costs for producing,
distributing and selling the product. In order to make some profit, a fair rate of return

is added to account for efforts and risks.

Some companies, such as Ryanair or Walmart, pursue a low-cost strategy and aim to

offer the lowest prices. This goes along with accepting smaller margins but greater

sales. Other companies, such as Apple or BMW, do not compete based on low prices.

By offering superior customer value, they can claim higher prices and margins — they

pursue a customer value-based pricing strategy. We can see that choosing between

the 3 major pricing strategies is closely related to the overall marketing strategy —

actually it is an integral part of it.

Competition based pricing: competition-based pricing involves setting prices based

on competitor’s strategies, costs, prices and market offerings. In highly competitive

markets, consumers will base their judgments of a product’s value on the prices that

competitors charge for similar products. For instance in the gasoline industry,

competition-based pricing is applied.

Demand based pricing: Demand Based Pricing is a pricing method based on the

customer’s demand and the perceived value of the product. In this method the

customer’s responsiveness to purchase the product at different prices is compared

and then an acceptable price is set.

One of the most appropriate ways that companies price their service is basing the

price on the perceived value of the service to customers. When consumers discuss

value, they use the term in many different ways and talk about myriad attributes or

ferent ways and talk about myriad attributes or components. What constitutes value,

even in a single service category, appears to be highly personal and idiosyncratic,

customers define value in four ways:

 Value is low price

 Value is whatever I want in a product or a service

 Value is the quality I get for the price I pay

 Value is what I get for what I give

5.5 Transfer Pricing
This part of the Chapter describes several transfer pricing methods that can be

used to determine an arm’s length price and describes how to apply these

methods in practice. Transfer pricing methods or methodologies are used to

calculate or test the arm’s length nature of prices or profits. Transfer pricing

methods are ways of establishing arm’s length prices or profits from

transactions between associated enterprises. The transaction between related

enterprises for which an arm’s length price is to be established is referred to as

the controlled transaction. The application of transfer pricing methods helps

assure that transactions conform to the arm’s length standard. It is important to

note that although the term “profit margin” is used, companies may also have

legitimate reasons to report losses at arm’s length. Furthermore, transfer

pricing methods are not determinative in and of themselves. If an associated

enterprise reports an arm’s length amount of income, without the explicit use of

one of the recognized transfer pricing methods, this does not mean that its

pricing should automatically be regarded as not arm’s length and there may be

no reason to impose adjustments.

 o The general economic transfer price rule is that the minimum must be
greater than or equal to the marginal cost of the selling division. In
economics and business management, a marginal cost is equal to the
total new expense incurred from the creation of one additional unit.

Transfer Pricing: Imperfectly Competitive Intermediate Product Market

An imperfect market refers to any economic market that does not meet the
rigorous standards of the hypothetical perfectly—or purely—competitive market.
Pure or perfect competition is an abstract, theoretical market structure in which a
series of criteria are met. Since all real markets exist outside of the spectrum of the
perfect competition model, all real markets can be classified as imperfect markets.

In an imperfect market, individual buyers and sellers can influence prices and
production, there is no full disclosure of information about products and prices, and
there are high barriers to entry or exit in the market.

A perfect market is characterized by perfect competition, market equilibrium, and

an unlimited number of buyers and sellers.
Unit 6
Responsibility Accounting

6.1 Responsibility Accounting

Responsibility Accounting is a system of accounting where specific individuals are

made responsible for accounting in particular areas of cost control. In this accounting
system, responsibility is assigned based on knowledge and skills. If the costs increase,
the person assigned is held accountable and answerable.

Responsibility accounting is a kind of management accounting that is accountable

for all the management, budgeting, and internal accounting of a company. The
primary objective of this accounting is to support all the Planning, costing,
and responsibility centres of a company.

The accounting generally includes the preparation of a monthly and annual budget
for an individual responsibility centre. It also accounts for the cost and revenue of a
company, where reports are accumulated monthly or annually and reported to the
concerned manager for the feedback. Responsibility accounting mainly focuses on
responsibilities centres.

For instance, if Mr X, the manager of a unit, plans the budget of his department, he is
responsible for keeping the budget under control. Mr X will have all the required
information about the cost of his department. In case, if the expenditure is more
than the allocated budget than Mr X will try to find the error and take necessary
action and measures to correct it. Mr X will be personally accountable for the
performance of his unit.

Advantages of Responsibility Accounting:

 It urges the management to acknowledge the company structure and checks

who is accountable for what and fix the problems.
 It enhances attention and awareness of the managers as they have to explain
the variations for which they are responsible.
 It helps to compare the achievements between the pre-planned goals and
actual results.
 It creates a sense of efficiency within individual employees as their work and
achievements will be reviewed.
 It guides the management to plan and structure the future expenditure and
revenue of a company.
 Being a cost control tool, it creates ‘cost consciousness’ among workers.
 Individual and company goals are established and communicated in the best
way.
 It improves and controls the company’s operating activities for an effective
and efficient outcome.
 Simplifies the report structure and guides to prompt reporting.
Disadvantages/Limitations of Responsibility Accounting
1. Generally, a prerequisite for establishing a successful responsibility accounting
system like proper identification of the responsibility center, an adequate delegation
of work, and good reporting are missing, making it difficult to establish this
accounting system.
2. It requires a skilled workforce in each department, which increases its cost.
3. The responsibility accounting system applies only to controllable costs.
4. If the responsibility and objective are not adequately explained, the accounting
system will fail to give good results.

 the Components of Responsibility Accounting:

Inputs and Outputs – refer to the implementation of responsibility accounting

based upon information relating to inputs and outputs. The resources utilized in an
organization, such as the quantity of raw material consumed and labor hours
consumed, are inputs, and the finished product generated is termed outputs.
 Identification of Responsibility Center – The whole concept of responsibility
accounting depends on identifying the responsibility center. The responsibility center
defines the decision point in the organization. Generally, in small organizations, one
person, probably the firm’s owner, can manage the entire organization.
 Target and Actual Information – Responsibility accounting requires target or budget
data and actual data for performance evaluation of the responsible manager of each
responsibility center.
 Responsibility Between Organization Structure and Responsibility Center – A
structure with apparent authority and commitment is required for a successful
responsibility accounting system. Similarly, the responsibility accounting system
must be designed per the organization’s structure.
 Assigning Cost and Revenue to an Individual – After defining the authority–
responsibility relationship, cost, and revenue, which are controllable, should be
given to individuals to evaluate their performance.

USES OF RESPONSIBILITY ACCOUNTING

Responsibility accounting which focuses on managerial levels is an important aid in

the management control process. It has several uses and confers many benefits.
These are listed below: i) Performance Evaluation : This is perhaps the biggest
benefit. With responsibility localized, it is possible to rate individual managers on a
cost basis. When a manager is held responsible for whatever he does, he become
extravigilant. Responsibility accounting system provides the manager with
information that helps controlling operations and evaluating the performance of
subordinates. ii) Delegating Authority : Large business firms can hardly survive
without proper delegation of authority. By its very nature, responsibility accounting
makes it happen.
Decentralisation of power is its keypoint and, hence, delegation of authority follows.
iii) Motivation : Responsibility accounting is the use of accounting information for
planning and control. When the managers know that they are being evaluated, they
are prompted to put their heart and soul in meeting the targets set for them. It acts
as a great stimulus. As a matter of fact, responsibility accounting is based on the
motivating individual managers to maximum performance. The targets provide goals
for achievement and serve to motivate managers to increase revenues or decrease
costs.
iv) Corrective Action : If performance is unsatisfactory, the person responsible must
be identified. It is only after identification of the erring subordinate that the
corrective action can be taken. Under responsibility accounting, as areas of authority
are clearly laid down, such corrective action becomes easier. The control action to be
effective must occur immediately after identification of the causes of the problem.
The longer control action is deferred, the greater the unfavourable financial effect.
v) Management by Objectives : The heads of divisions and departments are assigned
definite objectives before the commencement of the period. They are held
answerable for the attainment of these targets. Shortfalls are punished and excesses
rewarded. Such a system helps in establishing the principle of management by
objectives (MBO) vi) Management by Exception : Performance reporting here, is on
exceptions or deviations from the plan. The idea runs throughout the responsibility
accounting. It helps managers by spending their time on major variances with
greatest potential improvements. The concentration of managerial attention on
exceptional or unusual items of deviation rather than on all is the key to success of
the system. 74 Standard Costing vii) High Morale and Efficiency: Once it is clear that
rewards are linked to the performance, it acts as a great morale booster. Great
disappointment will be caused if an operating foreman is evaluated on the decisions
in which he was not a party.

6.2 Responsibility centers

A responsibility center is an operational unit or entity within an organization, that is

responsible for all the activities and tasks structured for that unit. These centers
have their own goal, staffs, objectives, policies and procedures, and financial reports.
And are used to balance responsibilities related to expenses incurred, revenue
generated, and funds invested to an individual.

In a multinational or large corporation, the organization tasks are divided into a

subtask, and each task is given to various small division or groups. In this context, all
groups in that organization are responsibility centers.
Types of Responsibility Centre:

 Cost Centre- A Cost Centre is a department or a unit which supervises,

allocates, segregates, and eliminates all sorts of the cost related to a
company. The cost center prime work is to check the cost of an organization
and to limit the unwanted expenditure the company may acquire. The cost
can be the determination of both person and location. In multinational
companies, the cost center is authorized to decrease and manage the cost.
 Revenue Centre- This center is accountable for initiating and monitoring
revenue. The management does not have any control over the cost or
investment but can monitor a few of the expenses in the marketing section.
The production of the revenue center is calculated by analyzing the budgeted
revenue with actual revenue and actual marketing expenses with budgeted
marketing expenses.
 Profit Centre-It is a division or department of a company which operates for
the calculation of profit. In an organization, different profit centers are
managed by the managers, who identifies profits on the basis of costs and
incomes. Profit Centre is accountable for all the actions associated with the
sales of goods and production.
 Investment Centre- This center is responsible for both investments and
revenue. The investment manager can control expenses, income, the fund
invested in assets, etc. He also has the authority to form a credit policy, which
has an immediate impact on debt collection.

6.3 MEASURING PERFORMANCE

 The primary purpose of a responsibility accounting is to determine the
individual segment performance of an organization. The managers of
different cost centres of the organisation are responsible to earn acceptable
profit measured in terms of segment margin, or rate of return on sales for the
profit centre. Segment margin represents the amount of income that has
been earned by the particular segment. The manager of an investment centre
is responsible for earning a rate of return on the segment’s investment in
assets. There are various criteria to measure divisional performance such as
profit on turnover, sales per employee and sales growth etc. The most
popular criteria are: 1) Return on Investment (ROI) 2) Residual Income (RI)
14.8.1 Return on Investment Divisional operating profit is generally, used as a
common measure of performance. But divisional profit by itself does not
provide a basis for measuring a divisions 81 performance in generating a
return on the funds invested in the division. For example, Responsibility
Accounting Division A and Division B had an operating profit of Rs.1,00,000
and Rs.80,000 respectively does not necessarily mean that Division A was
more successful than Division B. The difference in profit levels may be due to
the difference in the size of the divisions. Therefore, a suitable measure may
be used to scale the profit for the amount of capital invested in the division.
One common method is Return on Investment (ROI) which will be calculated
as follows : Profit Return on Investment = ——————— × 100 Capital
employed Or Profit Sales ROI = ——— × ——————— Sales Capital
employed If the investment in the Division A and Division B, in the above
example was Rs. 10,00,000 and Rs.5,00,000 respectively, Rs.1,00,000 then
ROI would be 10% (i.e. —————— × 100) Rs. 10,00,000 Rs.80,000 and 16%
( i.e., ————— × 100 ). If investment in respective divisions is considered,
Rs.5,00,000 Division B is more profitable than division A. The ROI of partial
segment must be high enough to provide adequate rate of return for the firm
as a whole. It is always better to require a segment to earn a higher minimum
rate of return on their investment. To improve this rate of return, a segment
can increase its return on sales, increase its investment turnover or do both.
The other way of increasing ROI is to reduce expanses and investment. If a
segment reduces its investment without reducing sales, its ROI will increase.
The ROI for the firm as a whole must not fail to meet the goals of top
management. Though ROI is used widely to measure the segment
performance, it has many limitations. One of the most limitations is that it
can motivate managers to act contrary to the aims of goal congruence. If
managers are encouraged to have a high ROI, they may turn down
investment opportunities that are above the minimum acceptable rate, but
below the current ROI of the divisional performance. For example, where a
division earns a profit 100000 of Rs.1,00,000 for an investment of
Rs.4,00,000, the ROI is 25% ———— × 100 400000 Suppose there is an
opportunity to make an additional investment of Rs.2,00,000 which would
earn a profit of Rs.40,000 per annum. The ROI for additional investment is Rs.
40,000 investment is 20% ————— × 100 Assume that the company
requires a Rs.2,00,000 minimum requires a minimum return of 15 per cent on
its investment, the additional investment clearly qualifies, but it would
reduce the investment centre ROI from 25% to 23.3% Rs. 1,00,000 + Rs.
40,000 i.e. : ———————————— × 100 Rs. 4,00,000 + Rs. 2,00,000
Consequently the manager of the division might decide not to make such an
investment because the comparison of old and new returns would imply that
performance had worsened. The centres manager might hesitate to make
such investment, even though ( ) ( ) ( ) . . . 82 Standard Costing the
investment would have positive benefit for the company as a whole. To over
come this drawback, Residual Income Method is used to evaluate the
acceptability of a project proposal. Illustration 3 Peacock Company Ltd. has
six segments for which the following information is available for the year 31st
March, 2005: I II III IV V VI (Rs. in (Rs. in (Rs. in (Rs. in (Rs. in (Rs. in Lakhs)
Lakhs) Lakhs) Lakhs) Lakhs) Lakhs) Capital employed 1500 1200 3000 2400
4500 6000 Sales 3000 3000 6000 3600 18000 12000 Net profit 150 300 150
720 450 1200 You are required to measure the performance of different
segments. Solution The return on investment can be analysed as follows:
Segments I II III IV V VI Profit/ Sales (Profit ÷ Sales × 100) 5% 10% 2.5% 20%
2.5% 10% Turnover of capital (Sales 2 2.5 2 1.5 4 2 ÷ Capital Employed) ROI
(Profit ÷ Capital 10% 25% 5% 30% 10% 20% Employed × 100)
The above analysis gives the following conclusions regarding the performance
of different segments:
1) The manager of segment I is not showing a satisfactory level of ROI even
though his turnover of capital is not too bad. He must be motivated to
increase his profit sales ratio.
2) Segment II is performing well as profit, sales ratio and turnover of capital,
are relatively good.
3) The performance of segment III is not satisfactory as its profit margin and
capital turnover is Poor.
4) The performance of segment IV is good as its profit margin is high with a
reasonable capital turnover.
5) In respect of segment VI, the manager should be motivated to increase its
profit margin but maintains a very good turnover of capital.
6) The manger of segment VI is performing well comparing to other
segments, as it maintains a good ROI, fairly good capital turnover and
reasonably good profit margin.