Pricing for International Markets Factors-05.02.2011

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Pricing for International Markets Factors

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Factors Influencing Pricing Decisions in International Markets Cost Competitions Irregular or Unaccounted Payments in Export Import Purchasing Power Buyers’ Behaviour Foreign Exchange Fluctuations.

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Cost A large number of exporters in initial stages use cost-based pricing, which is hardly the best way to determine price in international markets However, the cost is often a key determinant of the profitability of a firm in marketing the product Firms located in different countries do have significant variations in their cost of production and marketing but the price in international markets is determined by the market forces Therefore, the profitability among international firms varies widely depending upon their costing.

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Competitions The competition is much higher in international markets compared to the domestic markets The competitive intensity and its nature vary widely in international markets In a large number of markets, the competition is from international firms while the local firms or local subsidies of multi-nationals compete only in a few markets.

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Irregular or Unaccounted Payments in Export Import In international trade, a firm is often required to make certain irregular payments that vary widely among the countries Although such irregular payments are unethical, they form an integral part of market access that needs to be taken into account while carrying out costing and market feasibility analysis.

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Purchasing Power Purchasing power of customers varies widely among the countries A firm operating in international markets should take into consideration the buying power of the consumers while making pricing decisions McDonald’s prices its products in international markets depending upon the country’s purchasing power The hamburger prices vary from US$ 1.2 in China to US$ 4.52 in Switzerland

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The theory of purchasing power parity states that in the long run the exchange rate should move towards rates that would equalize the prices of an identical basket of goods and services in any two countries The economist invented the Big Mac Index in September 1986 as a light-hearted guide for cross- country comparison of currencies based on McDonald’s Big Mac, which is produced locally and simultaneously in almost 120 countries The purchasing power parity is calculated by dividing the price of Big Mac in a country with the price in US$.

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Buyer’s Behaviour Buyers from high-income countries are more demanding and knowledgeable, and the buying decision is primarily based on superior performance attributes, whereas the buyers from low-income countries have been reported to make choices based on the price of the products and services.

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Foreign Exchange Fluctuations A firm operating in international markets has to keep a constant vigil on fluctuations of exchange rates while making pricing decisions The currency of price quotation has to be decided by watching its movements over a period.

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Pricing Approaches for International Markets Cost-based Pricing Full Cost Pricing Marginal Cost Pricing Market-based Pricing

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Cost-based Pricing Costs are widely used by firms to determine prices in international markets especially in the initial stages Generally, new exporters determine export prices on ‘ex-works’ price level and add a certain percentage of profit and other expenses depending upon the terms of delivery However, such cost-based pricing methods are not optimum because of the following reasons The price quoted by the exporter on the basis of cost calculations may be too

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vis-à-vis competitors, thus allowing importers to earn huge margins The price quoted by the exporters may be too high, making their goods incompetitive and resulting in outright rejection of the offer.

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Full Cost Pricing It is the most common pricing approach used by exporters in the initial stages of their internationalization It includes adding a mark-up on the total cost to determine price The major benefits of the full cost pricing approach are as follows: It is widely used by exporters in the initial phases of international marketing It ensures fast recovery of investments It is useful for firms that are primarily

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dependent on international markets and register very low or negligible sales in domestic markets It eases operation and implementation of marketing strategies However, the following bottlenecks are also associated with the full cost pricing approach: It often overlooks the prevailing price structure in international markets that may either make the product uncompetitive or prevent the firm from charging higher prices As competitors often use price-cutting strategies to penetrate or gain share in international markets, the full cost pricing approach may result in making the product price uncompetitive in international markets.

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Marginal Cost Pricing In view of the huge size of international markets as compared to the domestic market, export activities are regarded as outlets for the disposal of surplus production that a firm finds difficult to sell in the domestic market As the intensity of competition in international markets is much higher than in the domestic market, competitive pricing becomes a pre-condition for success Therefore, a large number of firms adopt the marginal cost pricing approach for pricing decisions in international markets.

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Marginal cost is the cost of producing and selling one more unit It sets the lower limit to which a firm can reduce its price without affecting its overall profitability The major reasons for adopting pricing costing on marginal cost are as follows: In cases where foreign markets are used to dispose of surplus production, marginal cost pricing provides an alternate market outlet Products from developing countries seldom compete on the basis of brand image or unique value; marginal cost pricing is used as a tool to penetrate international markets

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Marginal cost pricing provides some advantage that the firm would forego if it does not export at the marginal-cost-based price. However, the major limitations of the marginal cost pricing approach are as follows: In case the firm is selling most of its output in international markets, it cannot use marginal cost pricing as the fixed cost also has to be recovered Pricing based on marginal cost may be charged, as dumping in overseas markets is liable to action and subject to investigations Such pricing tends to trigger a price war in

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the overseas market and leads to price under-cutting among suppliers Use of marginal cost pricing with little information on prevailing market prices leads to unrealistically low price quotations.

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Market-based Pricing As developing countries are marginal suppliers of goods in most markets, they rarely have market shares large enough to influence prices in international markets Thus, the exporters in developing countries are generally price followers rather than price setters Besides, the products offered by them are seldom unique so as to enable them to dictate prices In such market situations, pricing decisions by price followers from developing countries involve assessment involve assessment of

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prevailing prices in international markets and a top-down calculation as follows: Establish the current market price for comparative and/or substitutive products in the target market Establish all the elements of the market price, such as VAT, margins for the trade and the importer, import duties, freight and insurance costs, etc. Make a top-down calculation, deducting all the elements of the expected market price of the product (s) in order to arrive at the ‘ex-works’ , ‘ex-factory’ , or ‘ex-warehouse’ price

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Assess if this can be met If not, re-calculate the cost price by finding ways to decrease costs in the factory or organization or to decrease the marketing budget, which also burdens export-market price Estimate total sales over a three-year period, add total planned expenses, including those of the export department and the travelling, and canvassing efforts Make a bottom-up calculation per product item, dividing the supporting budgets over the total number of items to be sold Set the final market price Test the price (through market research).

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Transfer Pricing in International Markets The concept of transfer pricing, which was earlier limited to foreign multinational companies, is becoming increasingly significant for Indian companies as a result of their increasing internationalization Indian firms enter international markets by way of joint ventures, wholly-owned subsidiaries, etc. Companies own distribution systems in international markets, which makes transfer pricing crucial for formulating an international pricing strategy. The price of an international transaction between related parties is called transfer price (figure 1)

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A B C Related Unrelated parties parties Arm’s length price Transfer price Concept of Transfer Pricing

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The objectives of transfer pricing are as follows: Maximizing overall after-tax profits Reducing incident of customs duty payments Circumventing the quota restrictions (in value terms) on imports Reducing exchange exposure, circumventing exchange controls, and restricting profit repatriation so that transfer firms’ affiliates to the parent can be maximized Transferring of funds in locations so as to suit corporate working capital policies ‘Window dressing’ operations to improve the apparent (i.e., reported) financial position of an affiliate so as to enhance its credit ratings.

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The objective of transfer price apparently seems simple allocation of profits among the subsidiaries and the parent company, but the differences in the taxation patterns in various markets makes it a complex phenomenon Transfer prices come under the scrutiny of taxation authorities when it is different from the arm’s length price to unrelated parties Transfer pricing involves the following stake-holders: Parent company Foreign subsidiary or joint venture or any other strategic alliance Strategic alliance partners Home country and overseas managers

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Home country governments Host country government International transactions based on intra-company transfer pricing involves conflicting interests of various stake-holders Therefore, in view of the diverse interests of stake-holders, transfer-pricing decisions become a formidable task The factors influencing transfer pricing include: Market conditions in the foreign country Competition in the foreign country Reasonable profit for the foreign affiliate Home country income taxes Economic conditions in the foreign country

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Import restrictions Customs duties Price controls Taxation in the host country, e.g., withholding taxes Exchange controls, e.g., repatriation of profits.

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Types of Transfer Pricing Market based transfer pricing: It is referred to as arm’s length pricing, wherein the sales transactions occur between the two unrelated (arm’s length) parties Arm’s length pricing is preferred by taxation authorities Transfer pricing comes under the scrutiny of tax authorities when it is different from the arm’s length price to unrelated firms. Non-market pricing: Pricing policies that deviate from market-based arm’s length pricing are known as non-marketing based pricing.

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Pricing at direct manufacturing costs: It refers to the intra-firm transactions that take palace at the marketing cost. A number of transnational corporations have re- invoicing centres at low tax countries (popularly known as tax heavens), such as, Jamaica, Cayman Islands, Bahamas, etc. to co-ordinate transfer pricing around the world These re-invoicing centres are used to carry out intra-corporate transactions between two affiliates of the same parent company or between the parent and the affiliate companies These re-invoicing centres take title of the goods sold by the selling unit and re-sell it to the receiving units

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The prices charged to the buyer and the prices received by the seller are determined so as to achieve the transfer pricing objectives In such cases, the actual shipments of goods take place from the seller to the buyer while the two-stages transfer is shown only in documentation The basic objective of such transfer pricing is to siphon profits away from a high-tax parent company or its affiliate to low-tax affiliates and allocate funds to locations with strong currencies and virtually no exchange controls.

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