Cost plus pricing for supply contracts

Gina Picaretto is production manager at the Rich Manufacturing Company. Each year her unit buys up to 100,000 machine parts from Bhagat Incorporated. The contract specifies that Rich will pay Bhagat its production costs plus a $5 markup (cost-plus pricing). Currently, Bhagat’s costs per part are $10 for labor and $10 for other costs. Thus the current price is $25 per part. The contract provides an option to Rich to buy up to 100,000 parts at this price. It must purchase a minimum volume of 50,000 parts. Bhagat’s workforce is heavily unionized. During recent contract negotiations, Bhagat agreed to a 30 percent raise for workers. In this labor contract, wages and benefits are specified. However, Bhagat is free to choose the quantity of labor it employs. Bhagat has announced a $3 price increase for its machine parts. This figure represents the projected $3 increase in labor costs due to its new union contract. It is Gina’s responsibility to evaluate this announcement.

1. Why do many firms use cost-plus pricing for supply contracts?

Ans: Estimating the cost of production is very important task for a company. Cost-plus pricing was a popular pricing method because it can do easy calculations of return and risk for a supplier with a very small amount of information. It first calculates the initial cost of production, and then simply adds the profit, so that, total return calculation becomes easy for the company as well as risk exposure is reduced.

Moreover, price increase can easily be justified according to the cost increase. In case of Rich Manufacturing, Bhagat Inc. tried to deviate the risk of price change as well as deviate the accountability for frequent cost increase. Production cost changes commonly because of changing in the price of labors, machinaries, fuels and many other variable costs. In this case, cost-plus contract is shifting the consequences and the exposure of price change to Rich Manufacturing.

2. What potential problems do you envision with cost-plus pricing?

Ans: This is an obsolete and lazy strategy. The supplier becomes very indifferent in reducing their cost. They even do not care about the consumers who will be the ultimate loser. Moreover, cost-plus pricing can no way encourage the supplier to become more efficient and to understand opportunity costs. The supplier is paid a fixed mark-up which is confirming his return at the end of the day. In case of Bhagat, they are free to choose the quantity of labor it employs but Rich has to pay $3 increased price because of the prior specified contract. This will discourage potential buyers to go for a deal with Bhagat Inc.

Another glitch of cost-plus pricing is that it does not care the market competitions. This will keep them either in margin or in preceding sales. Sometimes cost-plus pricing to a commodity could result zero sales if the price was far above the market price.

3. Should Gina contest the price increase? Explain.

Ans: Gina should contest(argue) the price increase if she finds that the supplier is not minimizing costs, particularly if Bhagat Inc does not try to balance higher labor costs by adjusting the mix of inputs they have. Moreover, though Gina signed a contract with Bhagat, it would be tough for her to breach it.

In the short run Bhagat Inc. may not be able to adjust the use of all inputs as the labors are unionized. In the long run they should be able to use less labor and move along the isoquant to the new cost minimizing mix of inputs. Therefore, if Gina wants to go for a long run benefit, she needs to argue with Bhagat Inc. to reduce the cost by adjusting their variable costs. Otherwise, Bhagat Inc. would be so lazy to reduce cost if they receive a $5 mark-up without any sufferings.

From the above figure we found that the Point A is not allowing Bhagat to produce at the proper isoquant. Again, point C is at the isoquant line but it is not the lowest possible cost on that line because of labor price increase. Cost is properly minimized at B, where the isoquant is tangent to the isocost line. The below figure is showing the possibility of Bhagat to reduce its average total cost in the long run.

Q II. Personal Video Recorders (PVRS)-

Personal video recorders (PVRs) are digital video recorders used to record and replay television programs received from cable, satellite, or local broadcasts. But unlike VCRs, which they replace, PVRs offer many more functions, notably the ability to record up to 80 hours of programs and easy programming. A PVR consists of an internal hard disk and micro processor. After the owner installs the hardware, the PVR downloads all upcoming TV schedules to the hardware via a phone or cable connection. Users merely enter the name of the show(s) they want recorded and the system finds the time and channel of the show and automatically records it. Users must subscribe to a cable or satellite system if they wish to record programs off these channels. Besides ease of programming and much larger recording capacity than video tape, PVRs allow the user to watch a prerecorded show while the unit is

recording a new program, pause watching live programs (for example, if the phone rings) and then resume watching the rest of the live broadcast, view instant replays and slow motion of live programs, and skip commercials. In effect, PVRs like older VCRs allow viewers to control when they watch broadcast programs (called “time shifting”). However, PVRs provide much sharper pictures and are much simpler to operate than VCRs, and PVRs allow the user to download the television schedule for the next week. Two companies currently sell the hardware and provide the subscription service: TiVo and ReplayTV. Both firms started in 1997. As of mid 2003. TiVo had nearly 700,000 subscribers and ReplayTV had about 100,000. Companies are developing new technologies that make it even easier for users to “snip” commercials. Cable companies have begun offering a combined cable box and PVR in one unit for a small additional monthly charge. This further simplifies setup and operation and the user gets a single bill.

Answers to the Question II

1. Discuss how PVRs will affect the demand from advertisers.

Ans: The increased usage of PVRs will result in the decrease of demand from advertisers. The value of an advertisement depends on the number of viewers of that who watches the ad but not ofcourse the viewers who are watching the show. Because If there are X number of viewers for a show and all of them skip the ads, then the advertisement will have no effect on the market. In that case, advertisers will shift to some other media or some other marketing procedure. The reason is that the more people use PVRs to record TV shows and skipping commercials, the fewer viewers that commercials can reach which makes the commercials less efficient. Therefore, there would be less demand from the advertisers.

2. Suppose you are in charge of setting the price for commercial advertisements shown during Enemies, a top network television show. There is a 60 minute slot

for the show. However, the running time for the show itself is only 30 minutes. The rest of the time can be sold to other companies to advertise their products or

donated for public service announcements. Demand for advertising is given by:

Qd = 30 – .0002P + 26V where Qd = quantity demanded for advertising on the show (minutes), P = the price per minute that you charge for advertising, and V is the number of viewers expected to watch the advertisements (in millions).

a. All your costs are fixed and your goal is to maximize the total revenue received from selling advertising. Suppose that the expected number of viewers is one million people. What price should you charge? How many minutes of advertising will you sell? What is total revenue?

Ans: The scenario shows a very tight position for a manager of a commercial advertiser to calculate. After doing analysis on Quantity demanded and the price, I can form a strategy.

Firstly I am finding the equation which is,

Quantity Demanded, Qd = 30 – 0.0002P + 26V

Now, if we consider Number of viewers expected to watch, V = 1

We can get a demand of-

Qd = 56 – 0.0002P

or, 0.0002P = 56 – Qd

or, P = ……………………(i)

or, P = 280000 – 5000Qd

It says, when ‘the number of viewer’ is minimized to 1, I get the price per minute (280000 – 5000Qd) for advertising. It is giving me an inverse demand.

We know that,

Marginal Revenue =

Total revenue is maximized at the amount where Marginal Revenue, MR = 0.

The quantity demand function is,

Qd = 56 – 0.0002P

Total Revenue, TR = Qd x P …………………..(ii)

Marginal Revenue is the slope of the total revenue. By deriving TR with Qd we get,

= 280000 – 10000 Qd

or, MR = 280000 – 10000 Qd

Here we can see that Marginal Revenue has the same intercept but two times the value of the slope of demand curve.

If we take Marginal Revenue as zero for finding the optimal number, we get,

MR = 0

Therefore, Q* =

or, Q* = 28

It tells us that I have to sell 28 minutes of advertising to reach the optimal amount.

Now, substituting this optimal value in the demand curve equation (i), we get the optimal price of $140000/min.

Finally, plugging value of P and Q value in the equation (ii) we get the total revenue which is $3920000.

b. Suppose price is held constant at the value from part (a). What will happen to the quantity demanded if due to PVRs the number of expected viewers falls to 0.5 million? Calculate the “viewer elasticity” based on the two points. Explain in words what this value means.

Ans: When price is constant at $140000/min, If expected viewers fall to 0.5 mn, the fall in quantity demanded can be calculated as-

Qd = 30 – (0.0002 x 140,000) + (26 x 0.5) = 15

The minutes I need to sell as optimum is reducing from 28 mins to 15 mins.

So that the first points I had were Qd1 = 28 and V1 = 1, and now the second points are-

Qd2 = 15 and V2 = 0.5.

Now, using a formula,

The viewer elasticity =

=

= 0.91.

Therefore, when I increase or decrease 1% amount of viewers, it gives me 0.91% increase or decrease in the quantity demanded.

3. As more viewers begin using PVRs, what happens to the revenues of the major networks (CBS, NBC, ABC, and FOX)?

Ans: As more viewers begin using PVRs, revenues of the major networks should be decreasing because we know that the Total revenue = Price x Quantity Demand.

When the price remains unchanged, decreasing the quantity demanded will ultimately reduce the Total Revenue. As PVRs becoming widely popular, the number of viewers for ads are falling and it result is a falling of the revenue of the advertisers.

4. Discuss the long-run effects if a significant proportion of the viewers begin adopting these “advertising snipping” systems.

Ans: If a significant proportion of the viewers begin adopting these “advertising snipping” systems, the long-run effects will suggest more companies to shift this television advertising policy. It will severely reduce the revenue of advertising firms.

In that case, major networks (CBS, NBC, ABC, and FOX) needs to shift their current strategy. They can directly charge the viewers for their entertainment, may be with some new scheme or some direct payment methods. So that, viewers will not require to skip advertises as well as major broadcasters might not face drastic decrease in revenue.

5. What advice would you give the major commercial networks and producers of programming for these networks as more consumers adopt PVRs?

Ans: To remain competitive in the changing global market, networks and producers of these networks must have to come up with new strategy. Otherwise survival will be a matter of question. The advice I have for the major commercial networks and producers of programming for these networks is to turn advertisements into more funny and interesting thing that can create attraction and within a fewer time.

The main idea they need to ensure is that viewers should enjoy their advertisements instead of finding them too informative and sluggish. Moreover, like many movies and magazine shows, major network providers may include advertisement as a part of their program. For example, in Batman: The Dark Knight movie, Lieutenant James Gordon first introduced the mobile phone set called Nokia 5800. This phone ultimately got massive market popularity. This kind of innovative ideas may turn the dying advertising industries towards a new track.

Q III. Power Guns-

Suppose the production function of PowerGuns Co. is given by Q = 25LK where Q is the quantity of guns produced in the month, L is the number of workers employed, and K is the number of machines used in the production. The monthly wage rate is $3,000 per worker and the monthly rental rate for a machine is $6,000. Currently PowerGuns Co. employs 25 workers and 40 machines. Assume perfect divisibility of labor and machines.

Answers to the Question III

a. What is the current average product of labor for PowerGuns Co.? What is the

current marginal product of machines? (Assume 1 unit increase in machines.)

Ans: Currently the company employs 25 workers or Labor(L) and 40 machines or Capital(K).

We can say, L = 25 and K = 40

According to the equation, Q = 25LK

So that the current output level, Q = 25 x 25 x 40 = 25000

Average Product of Labor = = = 1000

By keeping the employment of labor constant, we can calculate the marginal product of machine.

Given that, L = 2

Now, if we increase K by 1 unit we get K=40 + 1 = 41

The new output level will be, Q = 25 x 25 x 41 = 25625

Therefore the marginal product of machines = 25625 – 25000 = 625.

b. Does PowerGuns’ production function display increasing, decreasing, or constant

returns to scale? Explain.

Ans: It seems like the production function of PowerGuns displays increasing returns to scale. In this case, when PowerGuns will double their labor and machines, which will be L = 50 and K = 80, we will get the new output level as Q = 25 x 50 x 80 = 100000

Therefore, we are getting a four times more output than before. It is clearly indicating increasing returns to scale.

c. What is the total cost of the current production of PowerGuns in a month? What

is the average cost to produce a shooting gun? Assuming the number of machines

does not change, what is the marginal cost of producing one additional gun?

Ans: We know that the Total Cost = Fixed Cost + Variable cost

In this case, Fixed cost is the cost of machineries or capital and the variable cost is the cost of labors.

So that, Total cost, TC = $3000 x 25 + $6000 x 40 = $315000

Average Cost, AC = = = $12.6

To compute the marginal cost, we need to take K as fixed. Therefore, for 1 extra unit of production, we get the equation-

25000 + 1 = 25 Ã- L Ã- 40 and it gives us the value of Labor, L = 25.001. So the marginal cost of producing one additional gun is, MC = 0.001 Ã- $3000 = $3.00.

d. What is the law of diminishing returns? Does this production display this characteristic? Explain.

Ans: In economics, diminishing returns says us how much the marginal production will decrease as the use of the factor of production is increased. It occurred in the short run when one factor is fixed but in the long run it can be cover up. If we increase one factor of production keeping other variables constant, the overall returns will relatively decrease after a certain point.

Here, this production does not display the required characteristic of law of diminishing return. If we take L fixed at 25, the marginal product of K becomes 25L = 625 and therefore each unit increase in K results 625 units increase in Q.

Q IV. Should a company ever produce an output if the managers know it will lose money over the period? Explain.

Answer to the Question IV

The total cost of production consists of fixed cost and variable cost. In the short run fixed cost seems to be very high whereas output can be increased only by adding more variables. In long run the fixed costs successively reduce and the variable cost depends on the production line. Therefore, it will be possible for the manager to earn profit in long run whereas he knows that it will lose money over the period. Overtime, marginal cost reduces and gives the managers the ultimate benefit in the long-run. So, the firm should operate in the short run as long as it gets enough compensation to cover its variable costs. As we know, the other name of fixed cost is sunk cost. Other than ‘residual value’, there is no remaining to cover-up sunk costs. So, rather closing the production, it will be wise for the manager to continue production as long as he remains above the variable cost line. If he somehow he finds himself below the variable cost covering line, he should stop producing.

The graph is showing how total fixed cost reduces in the long run as the Average Fixed Cost curve goes down.

Q V. The Johnson Oil Company has just hired the best manager in the industry. Should the owners of the company anticipate economic profits? Explain.

Answer to the Question V

Best manager takes higher compensation. Moreover, changing only the manager does not make sure that the Johnson Oil company has efficient poll of employees as a whole. Without a valid ranking process in the industry, there is no good reason to claim someone as the best manager in the industry. And above all, if the best manager cannot show any dramatic charisma in the company, we can surely say that the extra return that company is going to earn will possibly to go to the manager’s pocket as a salary and bonus. Also The Johnson Oil Company has to increment the new manager’s salary periodically otherwise there is a chance for him to shift to another company because of his high demand in the industry. So, there is very few potential of anticipating economic profits for the owner of the company.