Chapter 11: Costing and Pricing

Chapter 9: Costing and Pricing rate vs. price price is more general, for example:

Price = rate * weight

Review of economics basics: monopoly vs. pure competition price at point where marginal cost = marginal revenue. Why? oligopoly and monopolistic competition

For deregulation to work, the ideal structure was pure competition. Question was market entry. "Theory of contestable markets" compared participation of many sellers (of air transport) with "potential competition" (if there were no barriers and no economies of scale).

Example: Railroad from ISU to Boone

Fixed costs Track, locomotive $10,000,000

Variable cost (per year) Car rental @ $400 per year: option 1: 50 cars per year option 2: 500 cars per year option 3: 1,000 cars per year option 4: 10,000 cars per year requires 2nd locomotive @ $2,000,000

What are (& graph each):

1. total costs

2. average costs

3. marginal costs

Cost Concepts: 1 1. Money cost or accounting cost:

a. Cash paid

b. Allocated fixed costs

2. Economic costs: futuristic

a. Opportunity costs

b. Sunk costs

3. Social costs

Easiest to use?

2 Cost vs. activities:

Separable costs: Directly assignable to activity (unit of output)

Example: fuel and driver's time used on a single household moving van trip.

Other examples: (from school, work, home)?

Common costs: Not obviously assignable to one activity, but may be allocated on some "reasonable" basis: dollars per mile, % of separable costs, % of sales.

Common costs may be joint or nonjoint.

Joint (if one unit of output is made, a by-product is also made which might incur more costs): spending 10 gallons to drive a truck from Ames to Des Moines actually means what? Providing one output means that a second output will also be provided. The example is the back-haul.

3 Nonjoint: what portion of the airplane fuel and crew's time is accounted for by my suitcase? (None.) Yet all the passengers and luggage, combined, is moved by the common costs of fuel and crew.

For budgeting, divide costs into fixed (over the short run--which means what?) and variable (those that increase with output).

Note: there is some cross-over between fixed vs. variable and separable vs. common costs. We generally use fixed vs. variable.

Examples of fixed costs: annual property taxes, salaries, interest on long-term loans, annual maintenance (due to time, not amount of use).

Examples of variable costs: fuel, labor time, supplies used up by providing an output, replacement parts that wear out with increased use.

Other examples of variable costs: renting facilities or equipment for a particular use (vehicle, ship, public warehouse); paying a freight bill; paying a garage for maintaining our vehicles.

To "know your costs" for performing a given activity, would you prefer fixed or variable (or both) costs?

Two more kinds of separable costs: marginal and out-of-pocket.

Marginal: change in total costs for one more unit of output.

Out-of-pocket: as it sounds--costs incurred for a given unit of output--but may be applied too narrowly (what is the output-of-pocket cost of one more 10-lb. package) or too broadly (what is the out-of-pocket cost of one more trailer-load) to be useful. But is a reasonable, very short- term measurement of variable costs, and may be used to forecast cash flows.

Railroads and pipelines: up to 50% of costs are fixed; would need to be paid regardless of number of railcars hauled.

Motor carriers: 10% of costs are fixed.

Water carriers: use public right-of-way, keeping fixed costs lower, but equipment investment is high. Similar to motor carriers.

Airlines: public right-of-way and terminals. More like motor carriers.

How much to charge for transportation? If based on costs, use average or marginal costs.

Examples: 1. Specific pricing decisions: new service (FedEx)

2. modifying existing prices 4 3. responding to competitors (in an oligopoly).

Pricing objectives: survival (airline examples--but marginal cost?) unit volume pricing (multiple cars, space available) profit maximization (but how do you know?) Demand curve skimming price (Concorde) market penetration (Vanguard Airlines) sales-based pricing (follows life-cycle) market share objective social responsibility pricing objective.

5 Pricing mistakes: prices too reliant on costs prices not revised with market changes ignore interaction with marketing variables (e.g., promotion) one price for all.

6 Older rate system: product classification, formerly published by Rate Bureaus (sometimes still used within states)

Now discounts from class rates, or exceptions to class rates, or separate commodity rates (for higher volumes, repeated shipments). mileage rates ($1.25 per mile is an example)

LTL, TL, LCL, CL vs. weight groupings multiple-car rates (RR) and Unit-train rates ($100,000)

Incentive rates: higher rate for the first 40,000 lb., lower rate for the remainder of a TL

Per-car; per-truckload; per-containerload rates (e.g., $3,500); similar to AQ

Rates based on product density, or physical volume filled

7 Exempt shipment rates (piggyback, fresh fruit, air freight).

Local vs. Joint

Water-compelled (RR)

Terminal-to-terminal; ramp-to-ramp

Blanket, group rates

Contract rates

Deferred delivery

Corporate Volume rates and Aggregate tender rates

Loading allowance

Released rates

Empty-haul

Rate Making in Practice

Tariffs: the publication showing the rates; a price sheet or rate sheet.

General rates (for a variety of products) vs. Specific rates (as it sounds, for a particular haul or service)

Background:

What if we had a general rate of $.05 per ton-mile? Is that more equitable than a rate of $250 per haul? (The latter is an example of a blanket rate, one type of specific rate.)

Consider differences between points of service (33,000 shipping points in the U.S.), and in commodities being shipped (grain, flour, Ho-Ho's), and in demands for products. If all these differences were accounted for by individual shipping rates, there could be trillions of rates published (in a tariff). OK but awkward.

Therefore, simplify:

1. Shipping and receiving points from 33,000 to only the most important; use a grid system.

a. Measure distance from square to square (using the major shipping point as the basis in each); call this number the rate basis number. 8 2. Substitute "rates" for individual prices. A rate is expressed in dollars (or cents) per hundredweight (cwt).

3. Compare each commodity being shipped with a so-called "average" commodity, in terms of density, stowability, handling, liability. The average product gets a rating of 100 (or 100% of the normal or first-class rating). What would you say about a product with a rating of 45? How about 200?

9 Examples:

1. You have a 10,000 pound shipment of Personal Effects of a Navy Admiral, with a released value between $.50 and 2.00 per pound (what does this mean?) to be shipped from Flint, Michigan to Columbus, Ohio. a. What is the rate basis number (and what does this mean)? Use Table B.2, p. 330. b. What is the class (and what does this mean)? Use Table B.3, p. 331. c. What is the rate? See handout, labeled "Table 13.5" (your textbook omitted the necessary table). d. What is the "price" (the amount of the freight bill)? What if you had 14,000 pounds of this item?

Now you have plastic materials meeting the item 156300 description, in rolls measuring 9 feet in length 2 feet in diameter, to be shipped between two points 525 miles apart. The weight is 40,000 pounds. What is the freight bill? Use Table B.3 and the handout.

You now have 4,000 pounds of reclaimed rubber, to be shipped from Akron, Ohio to Warren, Michigan. How much will you be charged? Use Table B.5, p. 333.