Cost based pricing MM – Block III Unit IV – Pricing Prepared By – Pinal Shah

Introduction It focuses on setting prices based on the costs for manufacturing, distributing, and selling the product along with a fair rate of return for its effort and risk. Low cost producers vs high cost producers. i.e. IndiGo – Low cost producer Jet Air, BMW, Apple – high cost producer. higher costs result in higher quality, justifying the high price.

Introduction… Most importantly, To manage the spread between costs and prices-how much the company makes for the customer value it delivers.

Type of costs Fixed - costs that do not vary with production or marketing level. i.e. rent, electricity, interest, and salaries. Variable - that vary directly with the level of production. i.e. raw material, labour. Total costs are the sum of the fixed and variable costs. Ideally, a firm wants to charge a price that will at least cover the total production costs.

Costs at Different Levels of Production 1.Short-Run Average Cost (SRAC) 2.long-run average cost (LRAC) 3.Experience curve (Learning curve)

Short-Run Average Cost Curve (SRAC) Average cost is equal to total cost divided by the number of units produced (output). Average cost is essentially a way to disperse cost evenly across all units of output. There are multiple variations of average cost, including average fixed cost and average variable cost.

SARC Graphically, the SARC curves are u-shaped. The reason for this U is the fact that there are some fixed startup costs that are in place, even if output (quantity) is zero. This accounts for the left half of the U. The right half of the U is caused by law of diminishing returns, where the cost is increasing at a higher rate than the output. Short run costs are assumed to be fixed since there are factors in production that can not be adjusted. The short run average cost curves shows the minimum possible cost of producing at each output level when variable factors are operated in a cost-minimizing fashion.

SARC The Short-Run: The short-run as the period of time over which a firm’s plant size is fixed. The only variable resource is labor and raw materials, meaning that when demand increases for a firm’s product, the firm is able to increase employee work hours, hire more workers and use existing capital more intensively, but it does not have the time to acquire new capital or expand factory size.

SARC and LARC

Worked example of short run production costs

SARC The shape of short run costs (MC, ATC and AVC) are determined by the law of diminishing returns. Since short-run costs are determined by the productivity of the variable resource in the short-run (labor), diminishing returns assures that at first, since a firm can expect to get MORE output for additional units of labor (as fixed capital is used more efficiently) ATC declines as output increases. But beyond a certain point, diminishing returns sets in and the additional output attributable to more units of the variable resource declines. Inevitably, a firm will experience higher and higher average costs as its output continues to grow, since it’s only able to vary the amount of labor used, not capital.

Law of Diminishing returns It is also called law of diminishing returns or principle of diminishing marginal productivity, economic law stating that if one input in the production of a commodity is increased while all other inputs are held fixed, a point will eventually be reached at which additions of the input yield progressively smaller, or diminishing, increases in output.

LARC The long-run is defined as the variable-plant period. A firm can adjust the number of all its inputs: land, labor and capital. One way of thinking about the difference between the short-run and the long-run is imagining the long-run as several different short-runs spread out over a larger range of output. The shape of a typical firm’s short-run and long-run ATC curves may in fact be identical. But there are some very important differences to understand about the short-run costs and long-run costs faced by firms. LARC has three components – Economies of Scale – Constant returns of scale – Diseconomies of scale.

LARC

Economies of scale: As this firm first begins to grow and open new factories, it becomes better and better at what it is producing, is able to get more output per unit of input, and thus experiences lower and lower average total costs as it grows larger. “Scale” is a synonym for size. The bigger the firm’s size, the lower its costs of production: this is called “economies of scale”. Nike and Luigi’s Fine Italian Shoes. Nike makes shoes in giant factories in Indonesia, ships them in giant containers to all corners of the world in shipments containing 100,000 shoes each. Luigi makes shoes in his basement in Milan, has two employees, and ships shoes one at a time to customers around Europe. Who will have a lower average total cost of producing shoes? Luigi or Nike? Clearly, Nike has economies of scale, Luigi does not. If Luigi were to grow his business, chances are his average total costs would decline.

Constant Returns to Scale For the firm above, economies of scale assure that the larger it becomes, the lower its average total costs get. Efficiency in production improves whether through the lower price of inputs achieved through bulk-ordering, its ability to attract and hire skilled managers, the lower per unit cost of shipping larger quantities of products, or other such benefits of being big. At a certain point, however, the benefits of getting larger begin to diminish. This firm’s tenth factory is its minimum efficient scale: The level of total output this firm must achieve to minimize its long-run average total cost. Beyond this level of production, as this firm continues to grow, it will see no further cost benefits; in other words, it will achieve constant returns to scale (size).

Diseconomies of scale When an organization becomes TOO big, it begins to experience inefficiencies. When a firm grows so large that it has factories in all corners of the world, a dozen levels of management, and countless opportunities for corruption and miscommunication, its efficiency decreases and its average total costs begin to increase. In the 1980′s General Motor Company began to lose lots of business to smaller Japanese rivals. The outcome was the gigantic corporation broke up into smaller divisions, which then began to operate as different firms. For a while, GM remained competitive, partially because as a smaller firm, it was more efficient and able to compete on cost with its foreign rivals.

Diminishing returns vs. Diseconomies of scale The principle of diminishing marginal returns to inputs is when more on one input is added, while other inputs are held constant, the marginal product of the input diminishes. Diseconomies of scale or decreasing returns to scale is when the a firm doubles its inputs, output increases by less than double. With diminishing returns, only one input is being changed while holding the other is fixed. But for decreasing returns, both inputs may change.

Experience curve In the 1960's, management consultants at The Boston Consulting Group observed a consistent relationship between the cost of production and the cumulative production quantity. The experience curve is based on the premise that the more you do something, the easier and better you do it. In other words, the more “experience” you have making a product, the faster and cheaper it is to make.

Experience curve Research has shown that as the cumulative number of units of a product rises (cumulative means the total number of units produced since the business was formed,) the cost of producing a unit drops at a predictable rate. For example, as shown in Figure 1, every time production doubles (from 1X to 2X and from 2X to 4X), the cost of making a unit drops by 40 percent (C1 to C2 and from C2 to C4).

Experience curve

To provide a numeric example, with a 40 percent experience curve the cost per unit declines from Rs per unit at 10,000 units of cumulative production to Rs (20 x 40% = 8, = 12) at a cumulative production of 20,000 units (2 x 10,000 units.)

Experience curve As can be observed, the experience curve concept is more applicable to some products than to others, and the rate of reduction varies greatly depending on the product and the business.

Experience curve vs Economies of Scale The experience curve concept is not the same as Economies of Size/scale. Economies of size/scale involve spreading a fixed amount of cost (e.g. facility cost, administration cost, etc.) over an increasing number of units of production. Conversely, the experience curve involves improving skills expertise, and finding new ways of doing things. Also, the experience curve analysis is based on the number of units produced since the business was started. Economies of size is based on the number of units produced during a production period such as a calendar year.

Strategic implication of Experience curve The experience curve has important strategic implications. If a firm is able to gain market share over its competitors, it can develop a cost advantage. Penetration pricing strategies and a significant investment in advertising, sales personnel, production capacity, etc. can be justified to increase market share and gain a competitive advantage.