Use of Cost-plus Pricing by Companies - Coursework Example

BUSINESS ECONOMICS WORK I. RICH MANUFACTURING 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. Questions: 1. Why do many firms use cost-plus pricing for supply contracts? Many firms use cost-plus pricing for supply contracts as the changes in cost-plus contracts are more likely to become a responsibility of the purchaser of the product. Thus, fluctuations and volatility of labor costs, price for fuel and other resources are the risks of the purchaser of the product rather than supplier/manufacturer. 2. What potential problems do you envision with cost-plus pricing? Cost-plus pricing mitigates the risks of the supplier/manufacturer of the product and therefore, makes him feel more relaxed and less motivated to reduce costs associated with production of the product. Purchaser of the product has to pay for these costs, which incurs increase of the price of the product sold and therefore either decreases his mark up or weakens his competitive position on the market. 3. Should Gina contest the price increase? Explain. Yes, Gina could contest the price increase and thus force Bhagat to keep labour costs at previous level by increasing capital and reducing labor resources involved. 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. Questions: 1. Discuss how PVRs will affect the demand from advertisers. Demand from advertisers will be decreased in result of PVRs as the PVRs enable users to control and manage TV shows they want to watch and when. This will reduce thus reviews of ads. Advertisers will more likely fail to achieve their target audience as people will more skip the advertisement and therefore demand for this type of media will be lowered. 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? The demand for advertising will be calculated by the following formula: Q = 56 - .0002P. V=1; P=280,000-5,000Q. Total revenue should reach maximum, where MR=0. MR = 280,000 – 10,000Q. Assuming that MR=0 and solving for Q will indicate that 28 minutes should be sold for advertising, with the price of $140,000 per minute. Total revenue = Price time *number of minutes = $3, 920 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. In order to calculate “viewer elasticity” it is necessary first to indicate that V1=1, and Q1 = 28. It is supposed that constant price is $140,000 per minute. By changing V to 0.5 it is possible to define that V2 = 0.5, and Q2 = 15. Arc elasticity can be found by using the following formula: [ΔQ/(Q1 + Q2)/2]/[ΔV/(V1 + V2)/2] = ΔQ/(28 + 15)/2]/[ΔV/(1 + 0.5)/2] = 0,9069 Thus, if the number of viewers will change by one percent (either increase or decrease), quantity demanded will change respectively. 3. As more viewers begin using PVRs, what happens to the revenues of the major networks (CBS, NBC, ABC, and FOX)? Increased use of PVRs implies that the revenues of the major networks (such as CBS, NBC, ABC, and FOX) will decrease as the number of ads watched will reduce. 4. Discuss the long-run effects if a significant proportion of the viewers begin adopting these “advertising snipping” systems. In the long-term perspective if a significant portion of the viewers will begin snipping the ads by using these systems, the revenues of commercial networks will fall dramatically and will force them to develop new ways/channels of advertising. 5. What advice would you give the major commercial networks and producers of programming for these networks as more consumers adopt PVRs? Commercial networks and producers for the networks should find new ways of reaching their target audience. There can be applied an example of Youtube channel, where users select the video they want to watch, but advertising is automatically launched before the video starts. Something similar could be integrated to PVRs system. III. 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. 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.) The current average product of labor for PowerGuns Co. can be found by dividing the total product by the input of labor. The total product will be: Q=25*25*40=25 000. Current average product of labor (AP (L)) = Q/L = 25 000/25=1000 In order to compute the current marginal product (MP) of machines with an increase in machines by 1 unit (K=40+1), it is necessary to calculate new output level: Q=25*25*41 = 25625, whereas MP = 25625 – 25000 = 625. b. Does PowerGuns’ production function display increasing, decreasing, or constant returns to scale? Explain. The production function of PowerGuns displays increasing returns to scale. In case of both labour and machines will be increased, the new output level also will increase. For example, if both labour and machines will be increased by 20% (L=30; K=48), the new output level will be Q=25*30*48=36 000 units/month 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? Total Cost of the current production of PowerGuns in a month can be calculated in the following way: TC = (monthly average rate*# of employees) + (monthly rental rate for machines* of machines)  TC = $3000 × 25 + $6000 × 40 = $315,000 The average cost (AC) to produce a shooting gun can be calculated by the following formula: AC = TC/Q = $315000/25000 = $12.6 In order to compute the marginal cost of producing one additional gun it is necessary to compute the marginal cost, whereas K is fixed variable: 25000 + 1 =25*L*40, L = 25.001. The marginal cost of producing one more additional gun will be $3.00 (MC = 0.001 × $3000). d. What is the law of diminishing returns? Does this production display this characteristic? Explain. The law of diminishing returns is the law based on which the marginal product of a variable factor will decline because the use of the factor will be increased. However, this production does not display this characteristics, as the marginal product of K is always 25L, and L=25, therefore 25*25=625, whereas Q increases by 625 units with each unit increase in K. IV. Should a company ever produce an output if the managers know it will lose money over the period? Explain. The company can produce an output even if the managers know it will lose money over the period it in result the company will generate enough revenue to cover the variable costs. When variable costs are covered and there is excess of revenue the company will be able to cover fixed costs as well. V. The Johnson Oil Company has just hired the best manager in the industry. Should the owners of the company anticipate economic profits? Explain. The owners of the Johnson Oil Company should not anticipate economic profits just because they have just hired the best manager in the industry. It is more likely that the manager’s salary will be high due to his professionalism and therefore, generated returns will be paid out to him as financial incentive or remuneration. References: Brickley J, Zimmerman J, and Smith C, (2009), Managerial Economics and Organizational Architecture, McGraw-Hill, (5th edition). Read More