Rich Manufacturing Saint Leo University MBA 540 Sep 8, 2011 Why do many firms use cost-plus pricing for supply contracts? Firms use cost-plus pricing in order to cover their operating costs. Cost-plus means they can increase the price to their customers with whom they have contracts when the operating costs rise. Operating costs can rise for many reasons and cost-plus pricing allows firms the flexibility to manage operating costs. This flexibility is often needed when the price of a service or good is not known or hard to predict in advance (Magloff, 2011). What potential problems do you envision with cost-plus pricing?
Potential problems may occur if there is no contract between the firm and its customers for cost-pricing. Even in the case of a contract, should the price rise too high, the customer may not renew the contract once it expires. When costs are high, this may prompt customers to search for new suppliers in order to reduce their operating costs. The loss of customers exists when cost-pricing is in place. Customer loyalty may decline when excessive cost-plus pricing. Should Gina contest the price increase? There is a contract in place that stipulates her company will pay the production cost plus five dollars.
As the labor costs are part of production costs, there is little she can do to contest the price. She may attempt to persuade Bhagat to lower their prices or she will not renew the contract but currently she will have to pay the new price. If she negotiates a lower price for her firm, it can be seen as anti-union, an image her company may want to avoid. In that sense, the increased price can be viewed as the price for having a company image that supports unions (if that is important to her company). Is the increase in price more likely to be justified in the short run or the long run? The price is more likely to be justified in the long run.
Eventually, inflation rates and labor cost increase over time and the new cost will average out the keeping pace with the market. The short term effects will be increased costs to maintain a contract with Bhagat. In the short term, it may be beneficial to complete the contract with Bhagat and for long term planning, find another supplier with a more competitive price. She can use the short run cost curves to determine her near term pricing and production requirements. The long run cost curve can be used to determine if a new plant or new supplier is necessary to decrease operating costs.
How will a $3 increase in the price of machine parts affect Gina’s own production decisions? The three dollar increase will be added on to Rich Manufacturing’s product price. In order to lessen customer anger over increased prices, Gina can suggest an increase in the marketing budget to minimize the price increase. She also may want to take into consider the long term plans. For example, if in the long term they can decrease the price while increasing production (perhaps with a new supplier); they may want to absorb the current increase in price instead of passing it on to their customers.
In the short term, money may be lost, but with successful long term planning they can increase profits and maintain customer loyalty (by not increasing price). References Brickley, J. , Smith, C. & Zimmerman, J. (2009). Managerial Economics and Organizational Architecture. (5th Ed. ). New York, NY. McGraw-Hill and Irwin. Magloff, L. (2011). What Is Cost-Plus Pricing Strategy? Demand Media. Retrieved from: http://smallbusiness. chron. com/cost-plus-pricing-strategy-1110. html