1 The Pricing of Goods and Services

In the world of cost and management accounting, the pricing of goods and services holds
apivotal role in determining the success and profitability of a business. This chapter delves
intovarious aspects of pricing, including target pricing, minimum pricing, price-
demandrelationships, pricing strategies for special orders and short-life products,
pricing in serviceindustries, and the complexities of transfer pricing.

1.1 Target and Minimum Pricing

Target Pricing:

Target pricing is a strategic approach where prices are set based on marketdemand and
competitive forces. It involves identifying the optimal price point that aligns withcustomer
expectations and market dynamics. To implement target pricing effectively, businessesconduct
thorough market research to understand customer behavior, preferences, and
competitorpricing strategies. It also takes into account factors like production costs and
desired profitmargins. This strategy allows businesses to set competitive prices while
maintainingprofitability.

Minimum Pricing:

Minimum pricing is the lowest price at which a product or service must besold to cover variable
costs and avoid financial losses. This is essential for cost management.Determining the
minimum price involves calculating the total variable costs, which typicallyinclude direct
materials, direct labor, and variable overhead. While businesses often aim to setprices above
the minimum pricing threshold to generate a profit, understanding the minimumprice is
crucial for making informed decisions, especially when facing competitive
pricingpressures.

1.2 Price/Demand Relationships

Understanding the relationship between price and demand is crucial for effective
pricingstrategies that maximize revenue and profitability. Key to this understanding is the
concept ofprice elasticity of demand.

Price Elasticity of Demand: Price elasticity of demand measures how sensitive

consumerdemand is to changes in price. It is expressed as a numerical value, indicating the
percentagechange in quantity demanded in response to a one percent change in price.

- High Elasticity: When demand is highly elastic (elasticity > 1), consumers are very
responsiveto price changes. Small price increases can lead to a significant decrease in demand,

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while pricereductions can result in a substantial increase in demand. Companies operating in
markets withhighly elastic demand must be cautious when raising prices and may
benefit from pricereductions to boost sales.

- Low Elasticity: In contrast, inelastic demand (elasticity < 1) indicates that consumers are
lessresponsive to price changes. Price increases may result in only small decreases in demand,
whileprice reductions may not significantly boost sales. Industries with inelastic
demand can potentially raise prices without a significant drop in sales, thereby
increasing revenue andprofitability.

Adjusting Prices Based on Elasticity: Price elasticity of demand guides pricing

decisions.Products or services with highly elastic demand may benefit from lower
prices to increasemarket share and maintain or boost sales volume. For products with
inelastic demand, there maybe opportunities for price increases, leading to higher margins.
Understanding price elasticity of demand, alongside the cost structure, assists
businesses indetermining optimal pricing points that maximize profitability.

1.3 The Pricing of Special Orders and Short-Life Products

Special orders and short-life products require unique pricing strategies to address specific
marketconditions and operational challenges.

Special Orders: Special orders often involve large or non-standard requests from
customers,varying from the typical offerings of a business. Pricing these orders requires
considering factorssuch as production costs, impact on regular sales, and profit margins.

- Pricing Bulk Orders: In the case of bulk orders, companies may offer discounts to
incentivizecustomers to place large orders. The key is to calculate the cost of producing the
additional unitsand ensure that the price covers these costs while providing a reasonable profit.

- Customized Products: Special orders for customized products are more complex. Pricing
mustaccount for the additional costs involved in customization, ensuring the customer covers
theseexpenses while allowing for a profit margin.

Short-Life Products: These are items with limited shelf life or relevance in the market, such
asseasonal products, perishables, or technology products with a short lifecycle. Pricing
strategiesfor short-life products aim to optimize revenue and manage inventory effectively.

- Seasonal Products: Companies often employ pricing strategies like seasonal

discounts orpromotions to sell these products quickly, creating a sense of urgency and
encouraging consumerpurchases during specific times of the year.

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- Perishable Goods: Pricing for perishable goods may involve gradual markdowns as the
expirydate approaches. This strategy seeks to find a balance between minimizing
waste andmaximizing revenue by tracking inventory levels and monitoring consumer behavior.

- Technology Products: Short-life technology products often require tiered pricing,

launchingproducts at premium prices and gradually reducing them as newer models become
available.

Pricing strategies for special orders and short-life products require a deep understanding of
thecost structure, market dynamics, and customer behavior. Tailoring pricing strategies to
thesespecific scenarios ensures businesses make informed decisions that align with their
objectives.

1.4 Pricing in Service Industries

Pricing in service industries differs significantly from pricing tangible goods. It

involvesconsidering factors such as labor costs, overhead, and perceived value. Service
providers mustcraft pricing strategies that reflect the unique characteristics of their offerings.

Labor Costs and Overhead: In service businesses, labor costs and overhead are
significantcomponents of the cost structure. Pricing should ensure that these costs are covered
and provideroom for profit.

Perceived Value: Unlike tangible products, services are intangible, making the
concept ofperceived value central to pricing. Perceived value is how customers assess
the worth of aservice based on their expectations, past experiences, and the quality of service
provided.

- Premium Pricing: Service providers with strong reputations for high-quality service
oftenemploy premium pricing strategies, setting prices at a premium to signify
superior quality.Customers who value top-tier service are willing to pay more for the perceived
value.

- Value-Based Pricing: Value-based pricing aligns the price with the value delivered to
thecustomer. It involves understanding the specific benefits and outcomes a customer receives
andpricing accordingly. For instance, a consulting firm might charge fees based on the
financialimprovements it brings to a client's business.

- Bundle Pricing: Service providers often bundle various services together into
packages,allowing customers to access multiple services at a discounted rate compared to
purchasing eachservice individually. This can be an effective way to increase the
overall value of serviceofferings and encourage customers to buy more.

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- Dynamic Pricing: Some service industries use dynamic pricing, which adjusts prices in real-
time based on factors such as demand, time of day, or other market conditions. This strategy
canmaximize revenue by charging higher prices when demand is high and lower prices during
off-peak times.

Pricing in service industries is multifaceted, often dependent on the nature of the service
offered.Companies must carefully consider their cost structures, competitive landscape, and
customerperceptions to determine effective pricing strategies.

Transfer Pricing

Transfer pricing is a critical consideration for organizations with multiple divisions

orsubsidiaries. It involves determining prices when one division transfers goods or services
toanother within the same organization. Proper transfer pricing ensures fair allocation of costs
andprofits among divisions.

1.5 Transfer Pricing: General Rule for Optimal Transfer PricingThe general rule for optimal
transfer pricing aims to balance divisional autonomy with theorganization's overall
benefit. It prevents suboptimal decision-making by individual divisionsthat might negatively
impact the company

- Marginal Cost Pricing: One common approach is setting transfer prices at the marginal cost
ofthe supplying division, without considering fixed costs. This approach simplifies pricing
andaligns with optimizing divisional performance. It minimizes the potential for profit
manipulationby divisions.

- Negotiated Pricing: Divisions often negotiate transfer prices. This approach allows divisions
toconsider their unique circumstances and reach mutually acceptable agreements.
However,negotiated pricing may lead to suboptimal outcomes if divisions do not fully
understand theorganization's goals.

- Market-Based Pricing: In some cases, external market prices are used as a reference
fortransfer pricing. This method assumes that the price of the transferred goods or services
would besimilar to what the division could obtain on the open market. Market-based pricing is
effectivewhen the market for the product or service is well-established and competitive.

- Cost-Plus Pricing: Cost-plus pricing involves adding a markup to the cost incurred by
thesupplying division, typically including a percentage profit. Cost-plus pricing
ensures thatdivisions are adequately compensated for their contributions.

Optimal transfer pricing depends on various factors, including the nature of the goods or
servicesbeing transferred, relationships between divisions, and the organization's strategic

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objectives. Itrequires a careful balance between divisional autonomy and overall organizational
goals.

1.6 Transfer Pricing: Imperfectly Competitive Intermediate Product Market

In cases where the intermediate product market is imperfectly competitive, determining

transferprices can be challenging due to the absence of perfect competition conditions.

- Imperfect Competition: In an imperfectly competitive market, firms have some degree

ofmarket power, allowing them to influence prices. This can lead to pricing behavior that
differsfrom the competitive market model.

- External Market Prices: In such markets, external market prices may not be readily availableor
may not accurately represent the economic realities of the division. This can make it difficultto
use market-based pricing as a reference.

- Negotiation and Internal Coordination: In cases of imperfect competition, transfer

pricingoften involves negotiations between the divisions involved. Divisions must work
together toensure that the prices set do not harm the overall organization's performance.

- Cost-Based Pricing: When external market pricing is not practical, cost-based pricing, such
ascost-plus pricing, is often used. This method relies on internal cost structures to establish
transferprices, making it less dependent on market dynamics.

Understanding the complexities of transfer pricing in imperfectly competitive markets requires

adeep understanding of the organization's specific circumstances and the nature of the
products orservices being transferred. Balancing the need for fairness and profitability is crucial
for theorganization's success.

2 Responsibility Accounting

2.2 Responsibility Accounting

Responsibility accounting is a management control system based on the principles of

delegatingand locating responsibility.The authority is delegated on responsibility centre and
accounting forthe responsibility centre. Responsibility accounting is a system under which
managers are givendecisions making authority and responsibility for each activity occurring
within a specific area ofthe company. Under this system, managers are made responsible for
the activities of segments.These segments may be called departments, branches or divisions
etc., one of the uses ofmanagement accounting is managerial control. Among the control
techniques “responsibilityaccounting” has assumed considerable significance. While the other
control devices areapplicable to the organization as a whole, responsibility accounting

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represents a method ofmeasuring the performance of various divisions of an organization. The
term ‘division’ withreference to responsibility accounting is used in general sense toinclude any
logical segment,component, sub-component of an organization. Defined in this way, it includes
a decision, adepartment, abranch office, a service centre, a product line, a channel of
distribution, for the operatingperformance it is separately identifiable and measurable is some
what of practical significance tomanagement.

Significance of Responsibility Accounting

The significance of responsibility accounting for management can be explained in the following
way:
Easy Identification:It enables the identification of individual managers responsible for
satisfactory or unsatisfactoryperformance.
Motivational Benefits : If a system of responsibility accounting is implemented, consider-able
motivational benefits areassured.
Data Availability : A mechanism for presenting performance data is provided. A framework of
managerialperformance appraisal system can be established on that basis, besides motivating
managers toact in the best interests of the enterprise.

Ready-hand Information:
Relevant and up to the minutes information is made available which can be used to estimate
future costs and or revenues and to fix up standards for departmental budgets.

Planning and Decision Making: Responsibility accounting helps not only in control but in
planning and decision making too.
Delegation and Control:The twin objectives of management are delegating responsibility while
retaining control areachieved by adoption of responsibility accounting system.

Principles of responsibility Accounting

The main features of responsibility accounting are that it collects and reports planned and
actualaccounting information about the inputs and outputs of responsibility accounting.
Inputs and outputs :Responsibility accounting is based on information relating to inputs and
outputs. The resourcesused are called inputs. The resources used by an organization are
essentially physical in nature such as quantity of materials consumed, hours of labour, and so
on. For managerial control, theseheterogeneous physical resources are expressed in monetary
terms they are called cost. Thus,inputs are expressed as cost. Similarly, outputs are measured in
monetary terms as “revenues”. Inother words, responsibility accounting is based on cost and
revenue data or financial information

Objectives of Responsibility Accounting :

Responsibility accounting is a method of dividing the organizational structure into various

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responsibility centers to measure their performance. In other words responsibility accounting is
adevice to measure divisional performance measurement may be stated as under:
1. To determine the contribution that a division as a sub-unit makes to the total organization.
2. To provide a basis for evaluating the quality of the divisional managers performance.
Responsibility accounting is used to measure the performance of managers and it therefore,
influence the way the managers behave.
3. To motivate the divisional manager to operate his division in a manner consistent with the
basic goals of the organization as a whole.

Responsibility Centre :
For control purposes, responsibility centers are generally categorized into:
1. Cost centres
2. Profit centers

3. Investment centers.
1. Cost Centre or Expense Centre:
An expense centre is a responsibility centre in which inputs, but not outputs, are measured in
monetary terms. Responsibility accounting is based on financial information relating to inputs
(costs) and outputs (revenues). In an expense centre of responsibility, the accounting system
records only the cost incurred by the centre but the revenues earned (outputs) are excluded.
An expense centre measures financial performance in terms of cost incurred by it. In other
words, the performance measured in an expense centre is efficiency of operation in that centre
in termsof the quantity of inputs used in producing some given output. The modus operandi is
to compare actual inputs to some predetermined level that represents efficient utilization. Thr
variance between the actual and budget standard would be indicative of the efficiency of the
division.

2. Profit Centre:A centre in which both the inputs and outputs are measured in monetary terms
is called a profit centre. In other words both costs and revenues of the centre are accounted
for. Since thedifference of revenues and costs is termed as profit, this centre is called profit
centre. In a centre,there are financial measures of the outputs as well as of the input, it is
possible to measure theeffectiveness and efficiency of performance in financial terms. Profit
analysis can be used as abasis for evaluating the performance of divisional manager. A profit
centre as well as additional data regarding revenues. Therefore, management can determine
whether the division was effective in attaining its objectives. This objective is presumably to
earn a “satisfactory profit”.Profit directly traceable to the division and voidable if the division
were closed down. Theconcept of divisional profit is referred to as ‘profit contribution’ as it is
amount of profitcontribution directly by the division.
The performance of the managers is measured by profit. In other words managers can be

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expected to behave as if they were running their own business. For this reason, the profit
centre is good training for general management responsibility .

Measurement of Expenses :Another problem with profit centers may relate to the measure of
certain type of expenses which have to be involved in the computation of profit centres. There
is a scope for difference ofopinion relating to the treatment of those type of expenses which
are not traceable or attributable should be ignored in working out the profit of the division as a
profit centre.
Transfer of Prices :A transfer price is a price used to measure the value of goods and services
furnished by a profitcentre to other responsibility centers within a company. In other words,
when internal exchange of goods and services takes place between the different divisions of a
firm, they have to be expressed in monetary terms. The monetary amount for these
interdivisional exchange transfers is called the transfer prices. The measurement of profit in a
profit centre type or responsibilityaccounting is also complicated by the problem of transfer
prices. The implication of the transfer price is that for the selling division it will be a source of
revenue, where as for the buying division (the division which is receiving, acquiring the goods
and services) it is an element of cost. It will therefore, have a significant bearing on the
revenues, costs therefore, have a significant bearing on the revenues, costs and profits of
responsibility centres. Hence, there is a need for correct determination of transfer prices. The
determination is, however, complicated because of wide variety of alternative methods are
available. They are explained as under :
Types of Transfer Price :
There are two general approaches to the determination of a transfer price :
1. Cost based and

2. Market based, Based on these, there are five basic methods of transfer price :
a) Cost b) Cost plus a normal mark-up c) Incremental cost d) Market price, and
e) Negotiated price
3. Investment Centers
A centre in which assets employed are also measured besides the measurement of inputs and
outputs is called an investment centre. Inputs are accounted for in terms of costs, outputs are
calculated on investment centre. Inputs are accounted for in terms of costs, outputs are
accounted for in terms of revenues and assets employed in terms of values. It is the broadest
measurement, in the sense that the performance is measured not only in terms of profits but
also in terms of assets employed to generate profits.
An investment centre differs from a profit centre in that as investment centre is evaluated on
thebasis of the rate of return earned on the assets invested in the segment while a profit centre
is evaluated on the basis of excess revenue over expenses for the period.

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Controllability :
As is evident from the above description, the notion controllability is prime in a system of
responsibility accounting. A responsibility centre is accountable for controllable factors only. It
is but natural also, since how can one be held responsible for factors beyond one’s control.
Therefore, it is essential to identify which costs are controllable and which costs are not
controllable.

A cost is treated as controllable only when the person responsible for incurring it can exercise
his influence over it. Costs which cannot be so influenced are termed as uncontrollable costs.

Problems in Responsibility Accounting

While implementing the system of responsibility accounting, the following difficulties are likely
to be faced by themanagement:

1. Classification of costs: For responsibility accounting system to be effective a proper

classification between controllable and non controllable costs is a prime requisite. But practical
difficulties arise while doing so on account of the complex nature and variety of costs.
2. Inter-departmental Conflicts: Separate departmental persuits may lead to inter-
departmental rivalry and it may be prejudicial to the interest of the enterprise as a whole.
Managers may act in the best interests of their own, but not in the best interests of the
enterprise.
3. Delay in Reporting: Responsibility reports may be delayed. Each responsibility centre can
take its own time in preparing reports.

4. Overloading of Information: Responsibility accounting reports may be overloading with all

available information. This danger is inherent in the system but with clear instructions by
management as to the functioning of the system and preparation of reports, etc., only relevant
information flow in.

5. Complete Reliance will be deceptive: Responsibility accounting can’t be relied upon

completely as a tool of management control. It is a system just to direct the attention of
management to those areas of performance which required further investigation.