master course on transport systems 2nd semester...
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Master Course on Transport Systems 2nd Semester 2012
Public Transport:Cost-based-Pricing vs. Price-based-Costing
by Prof. Costas Panou
EPFLGroup LITEP
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Outline
1. Background2. Transport Costs3. Equilibrium Model3. Disequilibrium Model3. Pricing Strategies4. Cost-based Pricing5. Price-based Costing
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BackgroundTransport costs are a monetary measure of what the transport provider must pay to produce transportation services. They come as fixed, variable, perceived or external costs.
Any distinction between the above requires consideration of the reference period: short or long terms
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Transport Costs
Definitions:
Total Cost:describes the total economic cost of production. It is made up of:
• Total Variable Cost: varying according to the quantity of a transport service produced (e.g. fuel, labor, etc) and
• Total Fixed Cost: which are independent of the quantity of the produced service (capital, assets, etc)
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Transport Costs
Definitions:
Average (total) Cost:The total cost production required for the production of a service quantity q over that quantity. It can be distinguished in:
• Average Fixed Cost• Average Variable Cost
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Transport Costs
Definitions:
Marginal Cost:is the change in total cost that arises when the quantity produced changes by one unit.
dQdTCMC
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Transport Costs
Relations:between various cost categories
• AFC = Average Fixed Costs
• AVC = Average Variable Costs
• AC = Average (total) Costs
• MC = Marginal Costs
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Equilibrium Model
Profit Maximization
• Profit maximization in competitive markets
• Profit maximization in monopolies
Conditions: 1. p = MR = AR = MC
2.
1. MR = MC
2.
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2
0dQCd t
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2
2
2
dQCd
dQRd t
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Equilibrium Model
Conditions for Profit Maximization
P
Competitive market Monopoly
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Equilibrium Model
Equilibrium Pricing: Assumptions
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Disequilibrium Model
The Market doesn’t Clear
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Disequilibrium Model
How it works
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Disequilibrium Model
Equilibrium is neither unique nor stable
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Pricing Strategies
There is nothing such as “perfect pricing”.
A price is as good as it serves the needs of the strategy for which is chosen.
There exist several pricing strategies for transport services
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Pricing Strategies
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Pricing Strategies
Penetration Pricing
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Pricing Strategies
• Price set to ‘penetrate the market’• ‘Low’ price to secure high volumes• Typical in mass market products – coastal
shipping, low cost airlines, etc.• Suitable for services with long anticipated
life cycles• May be useful if launching into a new market
Penetration Pricing
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Pricing Strategies
Market Skimming
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Pricing Strategies
• High price, low volumes• Skim the profit from the market by charging what the
market can bear• Suitable for services that have short life cycles or which
will face competition at some point in the future• Creates risk-free opportunity for the competition. It is
the wrong policy even if the market is impenetrable. Given enough incentive, a potential competitor will find a way around the strongest protection.
• Examples include: air transport in the 50s, etc.
Market Skimming
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Pricing Strategies
Value Pricing
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Pricing Strategies
Value Pricing• Price set in accordance with
customer perceptions about the value of the product / service
• The worship of premium pricing creates a market for the competitor.
• High profit margins do not yield maximum profits. Total profit is profit margin X turnover.
• Examples of value pricing are status cars, liar jet services, etc.
Companies may be able to set prices according to perceived value.
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Pricing Strategies
Loss Leader
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Pricing Strategies
• Services deliberately sold below cost to encourage sales elsewhere
• Typical in coastal shipping, e.g. offering low tariffs in low demand lines in the hope that pax will be attracted to the firm in high demand lines
• Purchases of higher tariff services more than covers ‘loss’ on low tariff
Loss Leader
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Pricing Strategies
Psychological Pricing
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Pricing Strategies
• Used to play on pax perceptions• Classic example - 9.99 CHF instead of
10.99 CHF!• Links with value pricing – high value
services priced according to what pax THINK should be the price
Psychological Pricing
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Pricing Strategies
Going Rate (Price Leadership)
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Pricing Strategies
Going Rate (Price Leadership)• In case of price leader, rivals have difficulty in
competing on price – too high and they lose market share, too low and the price leader would match price and force smaller rival out of market
• May follow pricing leads of rivals especially where those rivals have a clear dominance of market share
• Where competition is limited, ‘going rate’ pricing may be applicable –find very similar prices in all liner shipping
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Pricing Strategies
Tender Pricing
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Pricing Strategies
Tender Pricing• Many contracts awarded on a tender basis• Transport operators (or carriers) submit
their price for carrying out the work• Purchaser (shipper or forwarder) then
chooses which represents best value• Mostly done in secret and upstream the
supply chain
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Pricing Strategies
Price Discrimination
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Pricing Strategies
Price Discrimination• Charging a different
price for the same service in different markets
• Requires each market to be impenetrable
• Requires different price elasticity of demand in each market.
Prices for rail travel differ for the same journey at different times of the day.
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Pricing Strategies
Destroyer Pricing / Predatory Pricing
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Pricing Strategies
• Deliberate price cutting or offer of ‘free gifts/products’ to force rivals (normally smaller and weaker) out of business or prevent new entrants
• Anti-competitive and illegal if it can be proved
Destroyer Pricing / Predatory Pricing
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Pricing Strategies
Absorption / Full Cost Pricing
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Pricing Strategies
• Full Cost Pricing – attempting to set price to cover both fixed and variable costs
• Absorption Cost Pricing – Price set to ‘absorb’ some of the fixed costs of production
• This is genuine Cost-based Pricing!!!
Absorption / Full Cost Pricing
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Pricing Strategies
Marginal Cost Pricing
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Pricing Strategies
• Marginal cost – the cost of producing ONE extra or ONE fewer item of production
• MC pricing – allows flexibility• Equilibrium economics consider MC pricing optimal• Particularly relevant in transport where fixed costs
may be relatively high• Allows variable pricing structure – e.g. on a flight from
Sydney to Paris – providing the cost of the extra passenger is covered, the price could be varied a good deal to attract customers and fill the aircraft
Marginal Cost Pricing
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Pricing Strategies
• Aircraft flying from Geneva to Brussels – Total Cost (including normal profit) = 15,000 CHF of which 13,000 CHF is fixed cost
• Number of seats = 160, average price = 93.75 CHF
• MC of each passenger = 2,000/160 = 12.50 CHF• If flight not full, better to offer passengers chance
of flying at 12.50 CHF and fill the seats than not fill it at all!
Marginal Cost Pricing: EXAMPLE
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Pricing Strategies
Contribution Pricing
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Pricing Strategies
• Contribution = Selling Price – Variable Costs
• Prices set to ensure coverage of variable costs and a ‘contribution’ to the fixed costs
• Similar in principle to marginal cost pricing• Break-even analysis might be useful in
such circumstances
Contribution Pricing
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Pricing Strategies
Target Pricing
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Pricing Strategies
• Setting price to ‘target’ a specified profit level
• Estimates of the cost and potential revenue at different prices, and thus the break-even have to be made, to determine the mark-up
• Mark-up = [(Revenue/Cost) -1] x 100
Target Pricing
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Pricing Strategies
Cost-plus Pricing
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Pricing Strategies
• Calculation of the average cost (AC) plus a mark-up
• AC = Total Cost / Output (demand)• This is genuine Cost-based Pricing!!
Cost-plus Pricing
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Pricing Strategies
Influence of Elasticity
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Pricing Strategies
• Any pricing decision must be mindful of the impact of price elasticity
• The degree of price elasticity impacts on the level of sales and hence revenue
• Elasticity focuses on proportionate (percentage) changes
• PED = % Change in Quantity demanded / % Change in Price
Influence of Elasticity
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Pricing Strategies
• Price Inelastic:• % change in Q < % change in P• e.g. a 5% increase in price would be met by a
fall in sales of something less than 5% • Revenue would rise• A 7% reduction in price would lead to a rise in
sales of something less than 7%• Revenue would fall
Influence of Elasticity
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Pricing Strategies
• Price Elastic:• % change in quantity demanded > % change
in price• e.g. A 4% rise in price would lead to sales
falling by something more than 4%• Revenue would fall• A 9% fall in price would lead to a rise in sales
of something more than 9%• Revenue would rise
Influence of Elasticity
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Cost-based Pricing
It is the adding up of costs and putting a mark-up on top.
As soon as the service is introduced TOs usually have to:
• start cutting the price• redesign the service at enormous expense• take losses and, often• drop a perfectly good service because it is priced
incorrectly
What is it and why it doesn’t work
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Cost-based Pricing
• Costs have to be recovered and make a profit, BUT:– Pax do not see it as their job to ensure
TOs a profit– They have their own needs to address
and interest to guard
What’s the main Argument
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Cost-based Pricing
• Usually TOs add feature after feature to the service, each priced to yield a profit margin and each driving up the service's price.
• TOs profits soar in the beginning. But the vast majority of pax who need only simple transport become increasingly ready to buy from a competitor
What actually Happens
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Cost-based Pricing
• Cost-driven pricing is the reason that low-cost airlines acquired such a large market share
• When EasyJet brought out their low profit service they immediately took over the airline market – with the advent of other low-cost companies, legacy airlines barely survived
• Cost-driven pricing is also the reason that TOYOTA and NISSAN succeed in pushing the German luxury auto makers out of the U.S. market
Are there known Examples
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Price-based Costing
• The only sound way to price is to start out with what the market is willing to pay
• Then, assume what the competition is likely to charge
• Finally design the service to that price specification
What is it
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Price-based Costing
• To start out with price and then whittle down costs is more work initially
• But in the end it is much less work than to start out wrong and then spend loss-making years bringing costs into line (feeding problems)
• Let alone is far cheaper than losing a market
Where is the catch
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Price-based Costing
• In the real world TOs do not have the ability to determine the optimal price and instead must search for an appropriate price level
• Due to decision making and administrative lags, price, P, adjusts to a target level, P*, with an adjustment time np:
What is the market willing to pay
pnPP
dtdP
*
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Price-based Costing
• The target level price is given by:P∗ = MAX [Up, P·f(demand-supply balance, market share, unit costs)]– where the MAX function prevents the
firm from pricing below unit variable cost Up
What is the market willing to pay
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Price-based Costing
The price discovery process constitutes a hill-climbing heuristic in which the TO should search for better prices in the neighborhood of the current price, using price relative to:• demand-supply balance• market share relative to its target and, of
course,• unit costs
Wrapping up
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For inquiries…
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