An evaluation of a formula method of price determination
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AN EVALUATION OP A FORMULA METHOD OP PRICE DETERMINATION
A Thesis Presented to the Faculty of the School of Commerce The University of Southern California
In Partial Fulfillment of the Requirements for the Degree Master of Business Administration
fcy Benjamin Berry Sherry June 1950
UMI Number: EP43273
All rights reserved IN FO RM A TIO N T O ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion.
Dissertation Publishing
UMI EP43273 Published by ProQuest LLC (2014). Copyright in the Dissertation held by the Author. Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code
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T his thesis, w ritte n by
sherry
■
under the guidance of
h .% 3 ...
..............
F a c u lty C om m ittee,
and app ro ved by a l l its members, has been presented to and accepted by the C o uncil on G ra d u ate S tudy and Research in p a r t ia l f u l f i l l ment of the requirements f o r the degree of
MASTER OF BUSINESS ADMINISTRATION D a te .............
F a c u lty C om m ittee
W-B. Walt E a ;
Rex Has
C hairm an
lton
TABLE OF CONTENTS CHAPTER I.
PAGE
THE PROBLEM AND DEFINITIONS
OF TERMS USED
. .
The p r o b l e m ................... Statement of the problem
2 .........
Importance of the study • •
• .......... .
Definitions of terms u s e d ............
Formula method of pricedetermination
. • . .
Full cost m e t h o d ............... • • • •
2 2 5 3 4
. . .................
4
. . . .
4
Required p r o f i t .............. ...........
5
Accounting profit
5
Alternative method Profit
. . . . .
Pure profit
................... ........................
Material cost • • • • • . .
••
5 6
Conversion c o s t ..........
6
Selling c o s t .........................
6
Normal capacity
...................
Manufacturing overhead
..
...........
P r i c e ...............
II.
1
6 7 7
Organization of the remainder of the thesis
7
REVIEW OF THE L I T E R A T U R E ...................
10
Literature on investigations of the princi ple of full c o s t ...................
10
Literature on investigations of an alterna tive formula method of price determination
12
Ui CHAPTER
PAGE Literature on actual price determination
•
14
Literature on marginal concepts of economic analysis and the function of profits
III.
•
15
17
.
Limitations of previous studies .
•
FULL COST METHOD OF PRICE DETERMINATION- BY MEANS OF A F O R M U L A ..............
19
The constituents of full c o s t ....
19
The computation of profit based on a per centage of full c o s t
*
20
• . •
21
Implied or actual use of capacity as a requirement of price determination
General formula for determining price based on the full cost method
• • • • • • • •
24
Theoretical considerations underlying the full cost m e t h o d ..............
25
Business enterprise organized for the anticipation of profit earnings •
••
.
26
Profit expectations determine the channel ing of resources
• • • • • • • • • • •
The marginal preferences of consumers . *
27 28
Sales value of the marginal product as a measure of consumer preferences’.. . .
31
iv CHAPTER
PACE Profit considered as the residual of total revenues minus total cost .............
51
Prevalence of the full cost method of
IV.
price d e t e r mination ...................
33
In retailing industries • • ...........
33
In manufacturing i n d u s t r i e s ..........
33
S u m m a r y ....................................
35
AN ALTERNATIVE FORMULA FOR PRICE DETERMINATION
37
The constituents of c o s t .................
37
A general alternative formula for pricing •
38
Basis for Knoeppel*s formula
• • • • • •
38
Basis for Churchill!s formula • • • • • •
39
Presentation of Churchill1s formula • • • •
40
Rearrangement of the e l e m e n t s ...........
41
Theoretical considerations underlying the alternative formula • • • . • • • • • • •
42
Pragmatic investigations by Churchill • •
42
Basis for selling cost equaling required profit
43
Basis for not calculating a portion of re quired profit on material cost
. . . .
Basis for the use of normal capacity
. .
44 44
V
CHAPTER
PAGE Justification for considering realized profit as a requirement of business enterprise
• • • • • • • •
.........
Justification in economic theory
•
45
• ..
45
Justification in prevailing business t h o u g h t ..................... ..
43
Justification in considering selling costs independent of costsof production
49
Justification for not calculating per centage profit on material cost and selling costs .......................
51
Justification for the use of normal c a p a c i t y ....................... ..
58
Reconciliation of full cost method and alter native method
...................
58
Restatement of the full cost principle and its mathematical computation • • •
••
59
Computation of the addition for profit or m a r k - u p ..........
59
Implied acceptance of profit, in part, based on conversion cost under the full cost m e t h o d ............. ..
••
60
vi chapter
page
Elimination of material cost and selling cost from the full cost m e t h o d ......
60
Reconciliation of the X% mark-up and the ratio developed by Churchill Summary • • • • « • • V.
• • • • • •
61
...........................
63
THEORETICAL COMPARISON OP PRICES COMPUTED BY THE PULL COST METHOD AND THE ALTERNATIVE METHOD UNDER ASSUMED C O N D I T I O N S ..................
66
Attributes of price • • • • • • • * • .. .........
68
Comparative prices computed by the full cost method and the alternative method under the influence of a changing price level
•• . ♦ •
71
Limitations of both m e t h o d s ................
74
Agreement with the c r i t e r i o n ............
74
Disagreement with the criterion • • • • » • •
74
Cause of disagreement due to fixed indirect cost
• • • • • • • • • • • • •
...............
76
Suggested modification of the alternative method to correct deficiency
.................
80
Comparative prices computed by the full cost method and the alternative method under the influence of a declining price level and declining demand
..............
. . . .
Comparative prices with a declining price level, elasticity of supply greater
81
vii CHAPTER
-
PAGE
than one
. •
82
Comparative prices with a declining price level, elasticity of supply equal to 1*7
85
Comparative prices with a declining price level, elasticity less than one . •
••
80
Table of summary of results • • • • • • « •
91
Agreement with criterion of price • • .
91
Disagreement with criterion of price
•.
...
95
Causes of disagreement due to fixed indirect c o s t s ..........
94
Price computed by full cost method more in agreement with actual theoretical results
94
Causes of more consistent results . . . .
95
Synthesis of full cost method and alternative method
• • • • • « • •
...............
•
Use of alternative method to compute X%
96
for
mark-up of the full cost method . .
••
96
Modification of alternative formula • •
..
97
Limitations of the modified formulas
..
98
.
Basic assumptions « • • • • • • • • • • • Criticism of profit r a t i o .......... Criticism of effective selling effort Summary ..........................
99
. .
100
..
101
• • • • «
101
viii CHAPTER VI.
PAGE
SUMMARY AND C O N C L U S I O N S ............
104
S u m m a r y ...........................
104
C o n c l u s i o n s ............ .........
112
B I B L I O G R A P H Y .............................
118
APPENDIX.
EXAMINATION OP THE ALTERNATIVE FORMULA
BY MARGINAL CONCEPTS
.....................
APPENDIX A.
Hypothetical d a t a ..........
APPENDIX B.
A formula method of pricing applied to pure competition
APPENDIX C.
123
..............
• • • • » • • • • •
153
A formula method of pricing applied to oligopoly and monopolistic competition
APPENDIX E.
131
A formula method of pricing applied to simple monopoly
APPENDIX D.
.121
Summary of appendix • • • • • • • • •
166 173
LIST OF TABLES TABLE I. II.
PAGE Retailers1 Merchandise Ratios - 1939 • • • . Summary of Comparative Prices Computed by the Full Cost Method and the Alternative Method
III.
133
Data for Computation of Marginal Cost, Total Cost not Including Variable Indirect Cost
V.
92
Data for Hypothetical Firm to Compute Variable Unit Cost and Total Unit C o s t ...........
IV.
23
136
Data for Computation of Marginal Cost and Average Expenditure, Total Cost Including Variable Indirect Costs
VI.
• • • • • • • . .
Computation of Marginal Unit Revenue for the Hypothetical Firm Selling Competitively
VII. VIII.
Computation of Total Conversion Costs
...
141 144
• • • • • •
145
Data for Computation of Variable Unit Cost As Determined by Formula Method
X.
•
Data for Computation of Total Unit Cost as Determined by Formula Method
IX.
138
• • • • •
146
Data for Computation of Marginal Unit Cost and Marginal Unit Revenue as Determined by Formula Method
XI.
• • • • • • • • • • • •
Computation of Total Unit Cost and Variable Unit Cost for a Hypothetical Firm that Is
147
X
TABLE
PAGE a Monopolistic Seller "but Buys Competitively
XII.
Computation of Marginal Unit Cost and Marginal Unit Revenue for
XIII.
158
Data
of Table XI
160
Computation of Marginal Unit Revenue of a Hypothetical Firm Confronted with an Inelastic Demand Schedule
• • • • • • • • •
170
LIST OP FIGURES FIGURE
PAGE
1.
Supply Schedule of M a t e r i a l ..................
125
2.
Supply Schedule of Labor
126
•
5.
Schedule of Variable Indirect Costs ........
128
4*
Demand S c h e d u l e ..............................
129
5.
Graph of TUC, VUG and FUC C u r v e s ...........
154
6.
Marginal Cost and Average Expenditure Curves, Pure Competition
7*
...............
159
Marginal Cost and Average Expenditure Curves, Monopsonistic B u y e r .................• • • •
8*
Graph of TUC, VUC, MUC, and MUR Curves, Pure C o m p e t i t i o n ......................... •
9.
148
Graph of TUC, VUC, and FUC Curves of a Mono polist Seller Purchasing Competitively
11.
. •
162
Assumed Inelastic Demand Schedule, Oligopoly and Monopolistic Competition
15.
159
Graph of MUC, MUR, TUC, and VUC Curves; Simple Monopoly
12.
145
Graph of TUC, VUC, MUC, and MUR Curves, In cluding Variable Indirect Cost
10.
140
. •
168
. •
171
Graph of TUC, VUC, MUC, and MUR Curves; Oligopoly and Monopolistic Competition
CHAPTER I THE PROBLEM AND DEFINITIONS OF TERMS USED The problem of price determination confronting the management of an enterprise is one of the most complex in the entire realm of business judgements.
Indeed, the suc
cess or failure of the venture to a large degree depends upon the correct solution of the problem of price determina tion.
At best, the solution may be based upon a reasoned
decision, culminating from exhaustive analysis of many variables; at worse, a guess.
In either event the outcome
may be far from that which was anticipated.
Any methodo
logy then, that may eliminate, or at least, reduce some of the uncertainties inherent in these solutions of price de termination ought to be investigated.
If, as a result of
Inquiry and investigation, a methodology appears to offer a more rational basis for price determination than some methods now generally employed, businessmen would be well advised to use such a method as an aid in the solution of the problem of price determination.
2
THE PROBLEM Statement of the problem*
It was the purpose of this
study (1) to present a formula method of price determination based on the principle of ftfull cost11; (2) to present an alternative formula method of price determination;
(3) to
compare the two formula methods presented and to contrast their respective economic basis; (4) to examine the theoreti cal application of the alternative formula;
(5) to indicate
limitation to the alternative formula method of price deter mination;
(6) in an appendix to explore the prices deter
mined by the alternative formula by means of marginal con cepts to ascertain if generally accepted economic principles were negated. Importance of the study.
For many years many business
men have employed methods of price determination based on the principle of full co3t.
The advent of more accurate means
of cost determination, has, perhaps given greater emphasis to the general adaptation of this method.
However, changing
social concepts operating within the framework of a dynamic economy have caused a change in direction in the philosophy of business enterprise.
The former methods of price deter
mination in many cases, have failed to adequately provide for and give recognition to these changing social concepts.
On the other hand, a small group of authors have offered a method of price determination that superficially appeared to provide adequate expression and recognition of changing social concepts*
Because their suggestions per
taining to price determination are based largely on prag matic considerations, their methods provided for the es sential ingredient of profit motivation in the perpetuation of the business enterprise.
While such means of price
determination have persuasive appeal to the practical busi nessman, he might well hesitate to adopt such methods whole heartedly until they were investigated by disinterested students of economic affairs.
Such an investigation should
contemplate a detailed examination to ascertain if, in the practical application of the alternative formulas for price determination, any serious contradiction to generally ac cepted economic theory was found to exist.
The proponents
of the alternative formula methods did not make this detailed examination.
This study was an investigation and analysis
of the alternative formulas for pricing to determine if the techniques proposed were subject to this criticism.
DEFINITIONS OF TERMS USED Formula method of price determination.
Throughout
this study the term ^formula method” shall be interpreted as indicating a method of price determination of a good or ser vice computed in accordance with an estimated predetermined formula.
The selling price of the good or service will be
computed by the entrepreneur or manager of the individual firm by means of an arbitrary percentage of the accounting concepts of cost of the good or service. Full cost method.
Full cost of a good or service is
considered to mean the accounting concepts of material cost, direct labor costs, manufacturing overhead costs and selling and/or distribution costs.
The sum of these items will be
equal to the ??full cost” of the good or service.
The final
selling price will be equal to the full cost so computed plus an arbitrary percentage of "full cost” added for profit. Alternative method.
The alternative method is a
variation of the full cost method of determining the final selling price of the good or service.
The alternative method
contemplates the computation of the selling price by means of the accounting concept of material cost, direct labor cost and manufacturing overhead cost plus an arbitrary percentage of the direct labor cost and manufacturing overhead cost. Profit.
The word, profit, unqualified by an adjective,
will be considered In Its generic sense.
That is, the re
sidual remaining from the sales revenue when the costs of production have been deducted. Required profit.
Required profit is the residual dif
ference between the sales revenue resulting from the sale of the goods or services offered and the sum of the accounting definition of material cost, direct labor cost, manufacturing overhead cost and the selling cost or distribution cost (if known).
It is approximately equal to the accounting defini
tion of gross profit minus the associated selling costs. Accounting profit.
The term accounting profit is
used
In its^ commonly accepted meaning employed in accounting liter ature and will mean the net profit from operations; the re sidual amount remaining after deducting the expenses of operation and miscellaneous expenses and to which sum Is added miscellaneous income.
Provisions for Federal and State in
come taxes and dividends to stockholders have not been de ducted from the accounting profit. Pure profit. dual remaining after
Pure profit is considered to be the
resi
deducting from the revenue from sales
the Implicit and explicit costs of the firm.
6
Material cost.
The material cost is interpreted to
mean the market price or the lower of cost or market price at the time of transfer of materials to the possession of the enterprise plus incoming freight and other applicable materi al burden cost. Conversion cost.
The conversion cost is the sum of
the direct labor cost and the applicable manufacturing over head computed at normal capacity. Selling cost.
Selling costs are those costs incurred
to increase consumer preference for the good or service. Included in these costs, are the cost efforts that can be attributed to the expanding of the demand schedule confronting the enterprise. Normal capacity.
Normal capacity is that percentage
of total capacity that the enterprise determines it should operate for the forthcoming period, usually a natural business year.
Normal capacity of the individual enterprise should not
exceed its proportionate share of the total capacity of all enterprises engaged in the same industry.
That is to say,
over the natural year, all enterprises of the industry can dispose of a percentage of their total output in accordance with estimated normal demand of consumers for the products or
services.
The individual enterprise should regulate its out
put in accordance with its proportionate share of the per centage of the total output of all enterprises of the indus try that can normally be disposed of through sale to consumers. Manufacturing overhead.
Manufacturing overhead is con
sidered to consist of two items (a) the variable indirect costs associated with the actual capacity at the level of production and (b) the fixed indirect costs computed at normal capacity. Price.
Price is defined as the price of the standard
product F.O.B.
ORGANIZATION OF THE REMAINDER OF THE THESIS In the second chapter, the literature pertaining to the various aspects of the problem will be indicated; the available literature touched upon many pertinent factors associated with the problem but it will be pointed out that the literature examined failed to disclose certain relation ships that ought to have been investigated.
This study was
undertaken In an effort to extend the examination to cover certain particular fields hitherto unexplored. The principles of pricing on full cost will be discus-
sed in Chapter III.
In this chapter, the basic considerations
of this principle will be examined in some detail.
The signifi
cance of marginal concepts and the prevailing practice of busi nessmen regarding marginal concepts will be touched upon. In Chapter IV, an alternative formula for price deter mination will be presented.
The basic principles of this for
mula will be examined rather exhaustively to determine if the basic assumptions are consistent with generally accepted eco nomic theory.
It will be demonstrated that an alternative
formula for pricing does not involve any new or novel concepts but rather a price computed on a rearrangement of the factors of production.
Such rearrangement will be found to be more
nearly consistent with the marginal preferences of consumers that come to focus in the price of a commodity or service. Finally, limitations at the full cost method will be contrasted with the alternative formula method. In Chapter V, the theoretical application of the alter native formula for price determination will be undertaken. It is contemplated that some of the attributes of a price will be presented and a comparison of how well these attributes are satisfied by a price computed on full cost methods and the price computed by means of the alternative formula.
The
price computed by the alternative method will be examined as certain market conditions fluctuate and the contrast between
9 the two methods indicated.
Finally, suggested modifications
to the alternative method will be presented; these modifica tions will take cognizance of a changing price level and the ultimate recovery of implicit and explicit costs. The concluding chapter will present the summary and conclusions of the study and certain limitations of the alter native formula for price determination will be indicated. The Appendix is a technical demonstration.
The prices
determined by the alternative formula method will be examined by means of marginal concepts.
Necessarily, assumed data
and market conditions constitute the basis for such a demon stration.
It will be shown that the alternative method of
price determination by means of formula can be subjected to analysis by means of marginal concepts; such an examination will suggest that the results are thoroughly consistent with those that should be expected by use of this tool of economic analysis*
v
CHAPTER II REVIEW OP THE LITERATURE It is the purpose of this chapter to briefly Indicate the major authoritative literature dealing with full cost methods of pricing,
the limited literature presenting an
alternative formula of price determination and the considerable literature that summarize various findings of independent in vestigations covering aspects of actual price determination will then be presented*
Following this, the principal find
ings of recognized economists in the field of marginal analy sis and the functions of profits will be indicated*
Two
works covering the statistical determination of profits of the corporation will be mentioned*
Finally,
the limitations
of the previous studies will be discussed. Literature on the investigations of the principle of full cost*
Within this field, the principle of full cost in
price determinaion is more implied than actually discussed. Prominent among the authors that give definition to this term are R. L. Hall and C. J* Hitch in Price Theory and Business Behavior*^
^ R. L. Hall and C. J* Hitch, Price Theory and Business Behavior (Oxford, England.: Oxford Economic Papers lumber Two), n*d*, n.p*
11 One publication of the Bureau of Economic Research, Cost and Price Policy^ makes frequent mention of this feature, however. The illustrations in economic textbooks used to demonstrate marginal concepts assume that the data for the prices of the demonstration consist of the factors of production and an addition to the factors of production that will result in a profit.s
Edwin G. Nourse has surveyed the pricing policies
in the industrial field generally.4
A former investigation
by Nourse and Drury in their Industrial Price Policies and Economic Progress5 have offered a penetrating inquiry into this area.
In summary, these findings indicate that implicit
and explicit costs of a product should be recovered in the long-run and in addition, an economic profit should be experi enced depending upon the market conditions confronting the
^ Cost Behavior and Price Policy (New York: National Bureau of Economic Research, Price Studies, Number Four, 1945) 553 pp. 3 Bjfary Jean Bowman and George L. Bach, Economic Analy sis and Public Policy (New Yorks Prentice-Hall, Inc., 1943) §3F pp. 4 Edwin G. Nourse, Price Making in a Democracy (Washing ton, D.C.: The Brookings Institute, 1944J 541 pp. g Edwin G. Nourse and Horace B. Drury, Industrial Price Policies and Economic Progress (Washington, D.C.: The Brookings Institute, 1 9 3 8 ) 4 1 4 pp.
12
enterprise*
Roughly, this principle can be classified as
essentially the full cost method without introducing too much inaccuracy. Literature on investigations of an alternative formula of price determination. narrow.
The literature in this area is very
The writer has been able only to find two authors
that have made contributions in this field.
William L.
Churchill, the author of Pricing for Profit^ and C. E. Knoeppel and his associate, Edgar G. Seybold.
Knoeppel and Seybold
have written two works, Profit Engineering? and Managing for Profit.^ both of which recommend an alternate formula for price determination.
However, closely allied to the idea of
profit managing, the following authors have contributed much valuable information: Pred Shibley,^
Lee H. Bristol,*^
® William L. Churchill, Pricing for Profit (New York: The Macmillan Co., 1932) 271 ry
C. E. Knoeppel, Profit Engineering (New York: McGrawHill Book Company, 1933) 326 pp. Q
C. E. Knoeppel and Edgar G. Seybold, Managing for Profit (McGraw Hill Book Company, 1937) 343 pp. ^ Pred Shibley, New Way to Net Profits (New York: Harper and Brothers, Inc., Publishers, 19281 213 pp. 10
Lee H. Bristol, Profits in Advance (New York: Harper and Brothers, Inc., Publishers, 1932) 180 pp.
13 J. H. Rand*^, and Walter Rauenstrauch-^.
A characteristic of
the^latter six authors was that they had wide experience in the fields of industrial engineering and as business consul tants.
Consequently, their general approach to the subject
of pricing and its corollary, profit, has favored an engineer ing-type of approach.
Their considerations and recommendations
are pragmatic. Closely related to the theoretical considerations of any pricing formula, the aspects of overhead cost are promi nent.
John M. Clark, has, perhaps, offered the most searching
inquiry in this area.
The economic factors of overhead costs
have been rather well explored in Studies in the Economics of Overhead Costs.^-3
Likewise, Business Budgeting and Con
trol-*-^ by J. Brooks Heckert might be selected as a generally accepted standard textbook on the theoretical and practical problems in the distribution of overhead costs.
In a similar
manner, reference to standard works on Cost Accounting pre
^ James H. Rand, Assuring Business Profits (Chicago: Forbes Publishing Company 7 " 192 6 } 245 pp. ^ Walter Rauenstrauch, Successful Control of Profits (Chicago: Forbes Publishing Company, 1926) 245 pp. 13 John M. Clark, Studies in the Economics of OverHead Costs (Chicago: The University of Chicago Press, 1923) 502 pp. J. Brooks Heckert, Business Budgeting and Control (New York: The Ronald Press Company, 1946) 546 pp.
14 sent many methods of determining manufacturing burden rates. Cost Accounting.16 written by John J. Neuner could well be selected as a standard textbook on this phase of cost account ing. Literature on actual price determlnat ion.
In the area
of actual price determination, three works are of outstanding importance; R. L. Hall and C. J. Hitch, authors of Price Theory and Business Behavior1 6 represent the best analysis. In the United States, Cost Behavior and Price Policy1^ pub lished by the National Bureau of Economic Research is, perhaps, the leading work of its kind.
Walten Hamilton has offered
a contribution to this field in Price and Price Policy.16 Donald D. Kennedy has examined the effects of overhead costs occasioned by a shift to machinery.
A factual examination
of these effects in five selected industries was presented ln
Costs and the Shift to Machinery.19
The various
16 John J. Neuner, Cost Accounting (Chicago: Richard D. Irwin, Inc., 1949) 874 pp. 16 R. L. Hall and C. J. Hitch, loc. clt. 17 Cost Behavior and Price Policy, loc. cit. 1® Walten Hamilton, Price and Price Policy (New York: McGraw-Hill Book Company, Inc., 1938) 565 pp. 19 Donald D. Kennedy, Overhead Costs and the Shift to Machinery (Philadelphia: University of Pennsylvania Press, 1928) 100 pp.
15 monographs published by the Temporary National Economics Committee present factual information on many actual practices by business men; The Federal Trade Commission issues, from time to time, reports of business practice coming to the no tice of the Commission. list.
These reports are too numerous to -
Likewise, the decisions handed down by state and
federal courts are a source of fruitful information pertaining to anti-trust suits and unfair trade practices and the relation to price determination.
William L. Chu r c h i l l ^ cited many
cases of actual price determination and the methods employed in the course of his investigations. Literature on marginal concepts of economic analysis and the function of profits♦
The literature on this phase
of economics is extensive and no effort will be made to list all of the standard works on this subject. outstanding contributions are cited. Joan
R o b i n s o n ^ S
A few of the more
Alfred Marshall**-*-,
and Edward H. Chamberlin^S might be selected
as a few of the contributors in this field.
William L. Churchill, loc. cit. 21
Alfred Marshall, Principles of Economics, 8th ed., (New York: The Macmillan Company, 1930T~871 pp. op Joan Robinson, Economics of Imperfect Competition, (London: Macmillan and Co., Ltd., 1934) 352 pp. 23 Edward H. Chamberlin, The Theory of Monopolistic Competition (Cambridge, Massachusetts: Harvard University Press, 1948, 6th ed.) 314 pp.
16
The functions of profits have been examined by many outstanding economists from the time of Adam Smith to the present; the distillation of economic thought along this line has been generally resolved into two streams of thought. One conclusion has been predicted upon the theory of risk. Prank Knight25 and A. G. Hart26 represent the modern pro ponents of this theory.
The second theory of profits has
been predicated upon the consideration that profit is con sidered a reward for one of the factors of production. Herbert Joseph Davenport2*7 has summarized this theory. Henry W. Sweeney2^ has advocated what he termed as St a b i l i z e d accounting," a device by which the balance sheet and operating statements of business enterprises are linked to the varying purchasing power of the dollar.
2 ^ Frank H. Knight, "Profit", Encyclopedia of the Social Sciences, XII, 480-487 p £* Am G. Hart, Anticipations, Uncertainty, and Dynamic Planning (Chicago: University of Chicago Press, 1940) 98 pp. p*7
Herbert Joseph Davenport, Value and Distribution (Chicago: The University of Chicago Press, 1908} 582 pp. 28
Henry W. Sweeney, Stabilized Accounting (New York: Harper and Brothers, Publishers, 1936} 219 pp.
17 Limitations of previous studies.
"Applied*1 economists
such as Knoeppel and Churchill have developed certain alterna tive formula methods of price determination.
Superficially,
these formulas have met one critical standard; according to the authors, they have been used numerous times by practical businessmen with a high degree of success, i.e., the formulas are profit producing.
While the pragmatism of the formulas
can not be tested because of the lack of applicable data and therefore must be accepted on word of the authors, no such prohibition is apparent in examining the underlying principles* to determine if such principles do violence to generally accepted economic theory.
Neither Knoeppel or Churchill in
their published works, performed such an examination. three serious limitations are evident.
Thus
The first limitation
that was apparent was to determine if the methodology of one of the formulas selected for investigation offered any new or novel application of economic concepts.
If this was ans
wered in the affirmative, further investigation should be undertaken to determine if there was any rational basis for the acceptance thereof.
The second limitation was to ascer
tain if the prices that might be determined by the formula could be examined by means of marginal concepts.
It should
be expected that such analysis would produce results that were consistent with predicted results expected of this tool
18 of economic analysis.
Finally, the proponent of the alter
native formula selected for this investigation did not indi cate any limitations to the application of his formula.
It
appeared most unlikely that a formula could be devised for a dynamic economy that would prove universal in application. It was the purpose of this study to explore the three limi tations outlined and attempt to develop an objective apprai sal of the formula method in question.
CHAPTER III FULL COST METHOD OF PRICE DETERMINATION BY MEANS OF A FORMULA Prevalence of the full cost method of price deter mination indicated that this methodology should be examined in some detail.
Accordingly, the principles underlying this
method will be developed.
The full cost methods were given
form and substance in several references and the writer under took to assemble the data and from the data, deduce a general formula that gave expression to the principle.
The formula
developed will be examined in light of the economic theories generally accepted as being the most probable.
Specifically,
the purpose of business enterprise will be examined.
The
marginal preferences of consumers measured in terms of the sales value of the marginal produce will be indicated.
The
functions of profit will be touched upon and the role that profits play in business enterprise will be pointed out. Finally, examples of the use of the full cost method of price determination in retailing establishments and manufacturing industries will be indicated.
THE CONSTITUENTS OF FULL COST Typical of the full cost method of price determination
20 the findings of some Oxford University economists illustrate the principle involved: In some cases this meant computing the full cost of a given commodity, and charging a price equal to cost* In others it meant working from some traditional or con venient price, which had been proved acceptable to con sumers, and adjusting, the quality of the article until its full cost equalled the wgiven" price* Pull cost as used here is defined as follows: "Prime" (or direct) cost per unit is taken as the base, a percentage is made to cover overheads or (on cost or indirect cost), and a further conventional addition (fre quently 10 per cent) Is made for profit* Selling costs commonly and interest on capital rarely are included in overheads; when not so included they are allowed for in the addition for prof its. ■*It can be readily seen that the elements of the full cost method consist of the following basic considerations: 1.
Material cost
2*
Direct labor cost
5*
Overhead or a percentage addition is added to cover overhead
4.
Selling costs (if known)
5*
A percentage addition to cover a profit.
THE COMPUTATION OP PROFIT BASED ON A PERCENTAGE OP PULL COST It should be noted that In the full cost method cited by Hall and Hitch that depended upon the sum of items (1), (2),
^ R. L. Hall and C* J. Hitch, Price Theory and Business Behavior (London: Oxford Economic Papers Number Two, n,d*) n*p.
(5), and (4).
Therefore it is readily seen that the percent
age of the full cost depends upon two things:
First, the nu
merical sum of the items and secondly, the value of the arbi trary percentage to he added.
It Is clear the^, that the
selling price to a consumer will depend upon the full cost of the various elements constituting the cost of the article or service and the addition of an arbitrary percentage added. Frequently the percentage to be added to cover profit is deter mined by the seller in accordance with some previous experi ence or recommendation.
Reference to Table I, page 23, dis
plays several typical percentages to be added to the full cost of articles In the retail trade to obtain this percentage. Subsequent portions of this study will indicate variations of the percentage of profit that are added in cases of manufac turing industries.
But there is another factor that is im
plicit with this method of full cost.
IMPLIED OR ACTUAL USE OF CAPACITY AS A 'REQUIREMENT OF PRICE DETERMINATION In order that industry, using this method can experi ence adequate earnings, the rate at which the stock moves, or the turnover rate, is of major importance.
For:
Operation of an Enterprise. We are ready now for the question: ^How does an enterprise operate?” The answer is: ftBy turning Its working capital” . As explained
22 working capital in its original form is clash* The first actual step in the manufacturing process is taken when a portion of the cash is expended for labor, materials, and supplies* By means of technical processes the labor, materials, and supplies become embodied in a product, During the course of the process the unfinished product is called work-in-process * As soon as it is completed, it is called a finished good* The next step involves delivery of finished products to customers in exchange for accounts receivable. Lastly, accounts receivable are collected and the working capital of the enterprise is again in its original form - cash*.* * The operation of a mercantile establishment involves three rather than four steps since such establishments purchase rather than produce their finished goods inventory.2 If an enterprise computes a percentage for profit on each item sold, the enterprise will experience greater earnings the higher the rate of articles sold, price remaining stable. Similarly, it is known that mercantile establishments fix the mark-up depending upon the estimated rate of turnover of stock*
If the stock does not turn, the percentage of profit
is generally reduced by means of mahk-down, and/or mark-up cancellations, and hence, the selling price, until some con sumer will purchase the article at the reduced price.
Thus
profit is sacrificed in the hope that the f i r m ’s working capital will not be too seriously impaired.
This principle
was illustrated by reference to columns 3 and 4, 5 and 6 of Table I.
The basic elements of full cost listed on page 20
Wilford J. Eiteman, Price Determination Business Practice Versus Economic Theory, (Ann Arbor, Michigan: School of Business Administration, University of Michigan, 1949), p. 7.
TABLE I RETAILERS’ MERCHANDISE RATIOS - 1939 Showing Comparisons Between Profitable and Unprofitable Concerns*
(1)
Types of Retailers
Gross (Per cent Profitable Concerns
Margin of Sales) Unprofit able Concerns
(2)
. M & L Realized (Per cent Profitable Concerns
27.5 55.4 38.0
26.8 48.4 28.0
38.0 124.4 61.4
36.7 93.9 38.9
6.5 12.8 11.0
6.7 14.7 10.8
41.2
36.7
70.2
58.1
29.6
45.4
37.8 18.9 20.0
30.7 15.5 15.7
60.9 23.3 25.0
44.4 18.4 18.6
15.5 10.2 13.8
16.3 9.7 12.6
18.7 24.2
12.4 20.0
23.0 32.0
14.2 25.0
12.0 53.9
10.2 46.5
44.8
38.3
81.3
62.2
27.9
21.3
(4) (5) (6) Mark-up Inventory Turnover of Cost) (Times per Year) Unprofit- Profit- Unprofit able able able Concerns Concerns Concerns
Pood, Beverage, and Restaurant Groups Alcoholic Beverage Stores Bakery Shops Confectionery Stores Dairy and Poultry Product Stores Drinking Places, Taverns and Bars Grocery Stores Grocery and Meat Stores Grocery Stores with Pilling Stations Meat Markets Restaurants and Other Eating Places Etc.
* Compiled from Standard Ratios for Retailing, Dun and Bradstreet, Inc., 1940.
24 should be understood to include the additional requirement of turnover or capacity of the good or service sold.
GENERAL FORMULA FOR DETERMINING PRICE BASED ON THE FULL COST METHOD It was found convenient to reduce the factors of the full cost method to a general formula.
The following Is a
symbolization of the formulas
p =
M
Material cost
L
Direct labor cost
VTC
Variable Indirect cost or overhead
variable
FIC
Fixed indirect cost or fixed overhead
S
Selling cost (if known)
^
The estimated quantity to
yjfc
Percentage addition of full cost to be added to cover profit
P
Price to consumer
(M + L + VIC + FIC + S) §
+
be sold
X%(U + L + VIC + FIC + S) Q,
It was recognized that the above formula was a generalized ex pression of the principle of price determination based upon full cost.
The Introduction of variable Indirect cost at this
stage is justified; such an allowance is a legitimate portion of manufacturing overhead.
The Importance of variable in
direct costs have been stressed by C. Howard Knapp:
25 I believe that one of the most important advances in manufacturing accounting during the past twenty years has been the adoption, fairly generally, of the practice of separating factory overhead into fluctuating, or variable, and fixed overhead*3 However, to further introduce the manifold complications that pertained to variable indirect costs and flexible budgeting would unduly complicate the general formula.
These manifes
tations are omitted.
THEORETICAL CONSIDERATIONS UNDERLYING THE FULL COST METHOD Adam Smith early said: "Price equals the wages of labor, rent of land and profit."4
Classical economists have extended
the meanings of the terms used by Adam Smith and modern indus trial nations have given newer and additional factors to be included in his simple definition.
Essentially, economic
theory maintains that in the long run, total costs implicit and explicit, must be returned to the enterprise if perpetuation is the objective of the business.
In purely competitive enter
prises only the implicit and explicit; costs will be returned and in structures characterized by oligopoly, monopolistic c:
competition and monopoly, a pure profit will be experienced.w
C. Howard Knapp, Proceedings of the Third Annual Institute on Accounting (Columbia: Ohio State University, 1940) pp 22-23. ^ Adam Smith, The Wealth of Nations Dutton and Co., Inc., 19ld Vol. I, p. 91.
(New York: A.P.
5 Mary lean Bowman and George L. Bach, Economic Analysis and Public Policy (New York: Prentice-Hall, Inc., 1943) pp 546-55.
26 Bowman and Bach went on to say, MBut the possibility of gain nevertheless remains a necessary basis to attract men into investments where possibilities of loss are also great.”6 Reputable economists are in general agreement that the antici pation of profits is a sine que non of a private-enterprise capitalistic economy.
It may therefore be accepted as axio
matic the anticipation of profits will be reflected in the prices sought for the product or Service.
Realization of
the profits sought presents a different aspect of this theory. Business enterprise organized for the anticipation of profit earnings.
There is little doubt that business is or
ganized by enterpreneurs primarily for the purpose of experi encing profit earnings.
Johh C. Baker has said:
Top management is responsible for the determination and revision of corporate purposes and objectives in ac cordance with social trends. It must also achieve these ends with profits.? He further elaborated this point: The aim of corporate management and the main test of its success^, is profit - profit considered in the broadest sense with due regard to public interest.® Under the sub-title, The Obj ective of Management, Polts stated that:
6
P. 552.
^ John Calhoun Baker, Directors and Their Functions, (Boston, Mass.: Division of Research, Graduate School of Business Administration, Harvard University, 1945) p. 12. 8 Ibid., p. 130.
27 It is frequently said that the obj ective of management is the making of profit. If by that is meant the assuring of future profits as well as the obtaining of immediate returns, most of us will agree. At least it is true that the modern method of measur ing success or failure of a business is by means of profit or loss resulting from operation.9 With rare exception, it can be assumed that business enter prises are primarily organized for the purpose of realizing anticipated profits from the results of its operations. Profit Expectations determlne the channeling of re sources.
Ignoring for the moment, the complexities of social
objectives, certain motivations of businessmen stand out. A business enterprise commands a certain amount of limited resources, land, labor, capital and entrepreneurship.
In
order to distill these factors of production into an effec tive organization for the purpose of producing a product or service, the anticipation of profits therefrom generally serve to bring the enterprise into being.
Roughly, the enterprise
will continue in being as long as it realizes all or some of the anticipated profits.
Obviously this statement is an over
simplification and it omits adequate consideration to impor tant factors as income distribution, inelastic supply of re sources and a host of other features.
a
Nonetheless, it can
Franklin E. Folts, Introduction to Industrial Management (New York: McGraw-Hill Book Company, 1958) p. 491.
28 serve as a major premise.
This is especially true if the
long-run picture is brought into focus. The anticipated profits of the enterprise, in the main, are furnished by the sales revenue of the consumers.
The im
pact upon the enterprise of changing price levels and enhanced inventory values also may give rise to unexpected gains or losses.
Unless the enterprise was organized to capitalize
upon a fluctuating market (commodity dealers perhaps and specu lators in international exchange, to mention a few), business enterprises are not generally organized to make this type of "windfall” gain or losses.
If then, the anticipated profits
are to be realized through the medium of sales revenue from consumers, it is necessary to examine the principal reasons that impel a consumer to exchange his money or resources for the product or service offered* The marginal preferences of consumers.
Vaughan-*-^
listed seven attributes in describing the nature of consumer demand.
These are summarized as follows: 1.
Effective Demand♦
Effective demand is defined as
the desire, ability and willingness to spend.
All three
attributes are necessary; any one of them alone cannot satisfy a want or affect a market price.
^ Floyd L. Vaughan, Marketing (New York: Farrar and Rinehart, Inc., 1942) p. 22-24.
29 2. experience.
Diminishing Utility*
This is a psychological
As successive units of any article are consumed,
the enjoyment from each one usually becomes less. 3.
Marginal Utility.
Prom the standpoint of the con
sumer it represents the expected enjoyment from a product, usually from an additional unit of the stock which he already has.
How much he is willing to pay for one article in com
parison with another depends upon their relative marginal utilities• 4.Margin of Consumption.
The choice
of one article
in preference to another is a balance in consumption or an effort to
maintain a margin.
assuming the price
That
is to say,each choice,
to be the same,is for. that article which
appeals most strongly to him.
Further, the prospective buyer
may compare anything about to be bought with the most appeal ing combination of goods that could be purchased for the same amount of money. 5*
Present versus Future. People are
often confronted
with the choice between the satisfaction of wants in the present and in the future.
The ability to visualize the
future, or the sense of thrift or frugality, varies among individuals and from one time to another.
Apparently he is
both consuming and saving in the present; actually he is con suming now but lessening his future satisfaction of wants by mortgaging his expectant income.
50 6*
Consumer1s Surplus.
The difference between what
is paid and what would have been paid constitutes a surplus for the consumer or buyer.
This faet makes it possible to
differentiate products by name or appearance or otherwise and to sell them at prices that reflect variations in the consumer’s surplus •
Elastic
rather than difference in cost. and Inelastic Demand.
If the amount
of
i
purchase responds greatly to a change of price, the demand is elastic; if it responds only slightly, the demand is inelas tic.
Important factors in determining whether the demand is
one or the other are the degree of necessity, the extent of habit, the possibility of substitutes, purchasing power, and the savings motive.
The first three of these factors depend
largely upon the physiological and psychological characteris tics of the consumer.
The higher the income of an individual
the less likely he is to curtail or discontinue the purchase of anything when its price advances.
The sensitivity of
quantity purchased to changes in price depends appreciably upon the amount of
the price in the first instance.
additional outlay of a dime would decrease purchases
An to a
lesser extent than that of ten dollars. The factors listed by Vaughan, above, are important and will be extended in the latter portions of this investi gation.
31 Sales value of the marginal produot as a measure of consumer preferences.
Bowman and Bach In Economic Analysis
and Public Policy-*-^ drew an illustration between a manufac ture of scarfs and a firm in the playing-card industry.
It
was supposed that adding another unit would increase the out put of scarfs by 100 at a price of §1.00 per scarf. sales value of the marginal product would be $100.00.
The Adding
another unit to the playing-card industry would increase output by 300 decks of cards at a selling price of 50 cents per pack.
The sales value in this case would be $150.00.
It is apparent that the marginal product of the additional playing cards Is preferable from the consumer point of view. Bowman and Bach go on to say: Since the sales value of the marginal product in any firm Is a measure of the worth to consumers of that product, it is often designated as the economic contribution (italics in the original) of the addi tional unit of input involved in making that marginal product available.12 It Is now clear that there Is a close link between the subjective marginal comparisons made by consumers as pointed out by Vaughan and the value of the marginal product of the firm as Indicated by Bowman and Bach. Profit considered as the residual of total revenues minus total cost.
H
Custom and legal precedent have been
Bowman and Bach, o p . cit., p. 274r275.
12 Ibid., p. 275.
sanctified contract rights in the United States,
Therefore
from the sales revenue of a firm there are certain legal claims that have a prior right over all other claims* Generally these legal claims are classified as the legal liabilities that the firm has undertaken.
Included are wage
claims, purchase claims, interest claims and depreciations* While there is no real legal claim concerning depreciation, it has assumed that status.
Most state laws prohibit the
invasion of the capital assets of the firm by failure to deduct depreciation allowances or providing inadequate de preciation allowances.
Reasonable depreciation must be pro
vided before profits or the residual remaining after satis faction of the legal claims, can be dissipated by dividends. The total cost is represented by the contractual liabilities and the depreciation of fixed assets of the firm.
Prom the
sales revenue these contractual liabilities and depreciation are deducted and the remainder or residual is the accounting profit. A reexamination of the full cost principle of price determination showed that this principle was in no way in con flict with generally accepted economic analysis as outlined. Because of the prevalence of this method, such a conclusion is what might be expected; business practice cannot long exist in variance with economic theory.
53 Prevalence of the full cost method of price determina tion#
Universality might well be applied to this method of
price determination. In retailing industries. is most striking.
In this area, the adherence
An almost slavish devotion to its princi
ples is everywhere present.
Specifically reference should
be made to Table I, page 23 of this study, as evidence of the prevailing practice in the retailing Industries. In manufacturing industries.
Substantiation of the
full cost principle is indicated in the following conclusion reached by the National Bureau of Research* In fields in which no cost accounts, or at best very sketchy ones, exist, the business executive may nevertheless estimate from his own intimate experience the added costs of an increase in output and apply such measures In his pricing and production decisions. More frequently, in all probability, he utilizes a rough rule of thumb, as a retailer does when he adds a uni form mark-up to all items in his store.13 Further illustrations of the full cost principle follow: The list price was obtained by adding to the direct costs 20 cents for overhead and 3% for profit.*^ Churchill, in Pricing for Profit, illustrated a typical exam ple of executive action in the matter of price determination explained by one executive:
13 Cost Behavior and Price Policy (New York: National Bureau of Economic Research, Price Studies, Number Four, 1943) p. 285. 14 The Deering Shoe Company, Policy Formation and Administration (Cambridge, Mass.: Harvard University, Graduate School of Business Administration, 1946) p. 4.
34 ••.our practice is very indefinite and anything but standardized.••.We work about as follows: When a new article or contract is to be priced, the cost de partment first develops and thoroughly checks a complete set of cost data or cost estimates...we add 30 per cent of our total costs and thereby arrive at a price we be lieve we should try to get. If our sales manager’s opinion is that we may expect competition from the X Company and possibly from the Y Company...we add 20 per cent to our costs to arrive at the price we should try to get. Should our information be that competition will be extensive and keen, we add 10 per cent to our costs to establish the price we expect our sales de partment to obtain. Pettengill^-6 listed the following methods of price deter mination in various situations; in some cases special con sideration was apparent in the market situation, and in others, he reaffirmed the prevalence of full cost methods.
These
systems are: (a) No reservation price [auctions, distressed selling, monopsonistic purchasing], [retailing and the like], utilities],
(b) Customary pricing
(c) Prices fixed by law [public
(d) Resale price maintenance, (e) Mark-up for
all overhead and profit added to direct cost, (f) Imitative price [copying another seller’s price], ministrative overhead and profit, producing to order.
(g) Mark-up for ad
(h) Mark-up methods when
In a later portion of Price Economlcs,
he discusses the variants of oligopoly and monopolistic 1practices relating to price.
17
15 william L. Churchill, Pricing for Profit (New York: The Macmillan Company, 1932), p. 92-93. Roger B. Pettingill, Price Economics (New York: The Ronald Press Company, 1948), p. 83-92. 17 Ibid., pp. 162-172.
55 The conclusion reached by Hamilton is pertinent at this point; it related to seven widely different industries: The evidence does not point to an orderly struc ture whose prices have an underlying logic in permuta tions of primary elements each with a precise unit cost. In industry the prices of things have the' rationale of an affair of man, growth and of process .3-8
SUMMARY The full cost method of price determinat ion was ex plored in some detail.
Pull cost was introduced by a de
finition and examination of the constituents that comprised full cost undertaken.
The computation of profit based upon
a percentage of full cost was next examined; the use of capacity in the determination of price, implied, was demonstrated.
either actual or
A general expression in the form
of a formula, based on full cost was presented. Following the presentation of the general formula, the theoretical consideration underlying this method were set forth.
These comprised:
(a) the purpose of business
organization and the effect of profit anticipations upon the channeling of limited resources of a firm,
(b) the mar
ginal preferences of consumers and the related sales value
18
Walton Hamilton and Associates, Price and Price Policies (New York: McGraw-Hill Book Company, Inc., 1958) p. 565.
56 of the marginal product were discussed at some length.
The
relation of economic contribution of the firm and the sub jective judgments of consumers were indicated. The latter portion of the chapter was devoted to examples of actual price determination based p.pon the full cost method. pointed out.
Finally, variants of this method were briefly
CHAPTER IV AN ALTERNATIVE FORMULA FOR PRICE DETERMINATION In this chapter an alternative formula for price deter mination will he examined in some detail.
The constituents
of cost and the computation of wrequiredw profit based on a percentage of some of the factors of production will be indi cated.
The general formula will be presented by means of
symbols.
The theoretical considerations underlying the
alternative method of price determination will be explored. The contrast and limitations of the formula based on full cost and the alternative formula will be pointed out.
THE CONSTITUENTS OF COST In the alternative formula for price determination, the essential constituents of cost are the same as those in the full cost method.
They are as follows:
1.
Material cost represented by symbol M
2.
Direct labor cost represented by symbol L
5.
Overhead or manufacturing Indirect cost represented
by variable indirect cost (VIC) and fixed indirect cost (FIC) 4.
Selling cost represented by S
5.
A percentage addition to cover profit requirement.
38 A GENERAL ALTERNATIVE FORMULA FOR PRICING As mentioned in the review of the literature two general alternative formulas for pricing were discovered. One was 1 offered by C. E. Knoeppel and E. G. Seybold, proponents of price determination based on conversion cost.
The other was
offered by William L. Churchill.^ Basis for Knoeppel's formula.
Knoeppel and Seybold
offered a formula somewhat more sophisticated than Churchill's but their pricing structure was based upon the use of a break even chart.
They assumed that the average business enter
prise should earn 15 per cent on the "net worth content” of the firm.
By use of the breakeven chart, a price was computed.
In the method illustrated by them5 the price so computed in cluded a profit computation that included the selling cost incident to the price. questionable.
The soundness of this procedure was
A further objection was evident because of the
reason given by Eiteman:
**- C. E. Knoeppel and E. G. Seybold, Managing for Profit (New York: McGraw-Hill Book Company, Inc., 1937; 326 pp. 2 William L. Churchill, Pricing for Profit (New York: The Macmillan Company, 1932) 271 pp. 5 Knoeppel and Seybold, o p . clt., pp. 252-256.
39 It is impossible to deny that business managers use breakeven charts, by their nature, almost inevitably suggest that capacity output means maximum profit. If such managers use such charts, It must mean that they accept their implications (whether the implications are right or wrong). If breakeven charts are believed, then manager’s d o n ’t believe in equating marginal cost and revenue. Part of the present study included an examination of prices determined from hypothetical data by means of the tool of marginal analysis*
The prices so computed were the results
of the application of the hypothetical data to an alternative formula.
Because of the theoretical inconsistency that might
be evident as indicated by Eiteman (supra), Knoeppel’s formula was not investigated. Basis for Churchill’s formula.
Churchill's f o r m u l a ^
on the other hand, did not predicate a profit that was com puted on selling costs but made use of other elements of the factors of cost.
Furthermore, the formula was not based on
the use of a breakeven chart.
Thus the theoretical objection
relative to the use of breakeven charts and marginal costs and revenue was avoided.
4
Wilford J. Eitman, Price Determination; Business Practice versus Economic Theory,(Ann Arbor, Michigan; School of Business Administration, University of Michigan, 1949), fn 2, p. 30. ® Churchill, o p . clt., pp. 99-100.
40 PRESENTATION OP CHURCHILL* S FORMULA The following alternative formulas for price determina tion are presented and will be the formulas employed in this investigation. Pricing Formulas Expressed as equations, the economic pricing for mulas are as follows: P a 2 C + . S + M P C
=Price of standard product F.O.B. =Conversion Cost (total mfg. cost less materials in product) C = Normal Profit (100 per cent conv. cost) S = Sales Budget: 1. 2. 3.
To jobbers 50 per cent C To retailers and other mfrs. 100 per cent C To personal consumers 200 per cent C
M =.Materials Cost (at market price at time of transfer to legal possession of customer) + Incoming freight and interest on cost and insurance for period required to be in possession of manufacturer. Price to jobber: P = 2.5C + M Price to retailer or other mfr.: P = 3C + M Price to Personal consumer: P = 4C + M
6 Loc. cit
41 Rearrangement of the elements.
In order to make the
alternative formula comparable to the formula based on full cost, a slight rearrangement of the conversion cost was made in order that the following could be expressed mathematically: The proper profit that must be obtained is equal' to the proper cost of the service rendered. To the manufacturere this means that profit must equal the normal cost of operating his plant in a normal way to produce a normal proportion of its c a p a c i t y , i t Is necessary to include in the conversion cost such pro portion of administrative expenses as may be properly chargeable to manufacturing operations in order that the total of the normal conversion costs may be arrived at,*7 Recasting the alternative formula, substituting for conversion cost at normal capacity as indicated, the following symbolization was developed: Price to jobbers: P =
2.5(L + VIC + PIC) + M Q
Price to retailers and other manufacturers: p =
3.0(L + VIC + PIC ) + M Q *
Price to personal consumer:
r -
7 Ibid., p. 28
4 . 0 (L + VIC + PIC) + M
^
42 THEORETICAL CONSIDERATIONS UNDERLYING THE ALTERNATIVE FORMULA To present the theoretical considerations underlying Churchill’s Alternative formula for price determination, it was necessary to develop the reasons advanced by him and to appraise these reasons and to advance any justification therefore• Pragmatic investigations by Churchill.
Churchill
developed his formulas as a result of many years of investi gation.
The results of his investigations relating to profit
are as follows : If profit must be based upon operating cost, cannot each manufacturer use whatever ration he sees fit? The answer to this question has Involved several years of experimenting, test, and study of many Indus tries. The earlier experiments left it to the manu facturer to decide how much he thought he ought to make, and then ascertained what ratio thl’S amount bore to his operating cost (conversion cost). It soon became apparent, however, that manufacturers had no common con ception of their profit necessities. Studies were then made of the relationship or ratios between conversion cost and net profits of highly successful institutions. These ratios were found to be so consistent as to indi cate a definite profit law. Studies made of non-dividendpaying but mechanically progressive institutions dis closed that their net profits ran close to 50 per cent of their normal conversion cost. These profits were ploughed in and assets increased accordingly, but no cash dividends were paid. Many other tests and comparisons have resulted in two allied conclusions: (a) The normal profits of a manufacturing enterprise must equal its normal conver sion cost; (b) If normal conversion cost is so large
43 as to necessitate prohibitive profit, this may indicate excessive conversion cost, either in fact or by the error of including in such costs items or changes not properly belonging to them.8 A further conclusion develop by him showed that: Further test and comparisons of this basis of profiting disclosed that when normal service costs are determinable, the principle of using such costs as the measure of required profit provides a method and rate for establishing profit objective that is applicable to all forms of profit making activity. On this basis merchants and dealers of all grades, wholesale and retail, can determine what their annual profits should be and thus measure their operating efficiency. Con tractors and personal service corporations that may have little or no investment in permanent assets have a similar yardstick for predetermining their proper earnings Basis for selling cost equaling required profit. Churchill offered the results of his investigations con cerning selling costs and based his formula upon the following: The writer [Churchill] conducted his profit research studies for the purpose of discovering what, if any, general rule controlled or governed the profit making ability of successful corporations. These studies disclosed so many instances where adequate profits were accompanied by equally adequate sales efforts (or sales cost) that out of these Investigations and comparisons was developed an empirical formula. This formula indicates the sales budget necessary to insure the earning of the required profits when the required profit is known. This formula, with its variations as now used is:
8 Ibid., p. 35-6. 9 Ibid., p. 39.
44 Sales costs of products or services sold direct to personal or family consumers equal twice the normal profit required. Products and services sold to retailers and their equivalent {such as other manufacturers, contractors, etc.) for resale to personal or family users or consumers require a selling cost equal to the required profit. Products and services sold to wholesalers for resale to retailers, etc., require a sales budget to 50 per cent of the normal profit requirement.^ Basis for not calculating a portion of required profit on material cost.
This phase of the investigation was stated
by Churchill on the basis of logic rather than as the result of factual f i n d i n g s A
detailed examination of this conten
tion will be undertaken subsequently. Basis for the use of normal capacity.
The computation
of manufacturing burden rate involves, of course, the capacity of the firm.
Increased capacity spreads the variable indirect
cost and the fixed indirect cost over a greater number of units.
Churchill had this to say concerning normal capacity:
What is the proportion of capacity that should be accepted as representing normal? This question needs careful review in each individual case. As already in dicated, the writer has adopted 66.6 per cent as a standard for those industries which operate normally throughout the year. Such industries as vegetable and fruit canning, or those whose goods have a relatively short major selling season, such as jewelry and holiday goods, may require less than average ratios.
10 Ibid., p. 75. Ibid., p. 30-32.
45 In no case has the writer found a ratio higher than 66.6 per cent justified, although from available records he has found one Industry selling as high as 84 per cent of its normal producing capacity.. Such high figures should be suspected as representing tem porary excess of demand over normal supply, with the attendant possibility of early adjustment.**^ The reader will recognize that the basis for Churchill?s pricing formulas was developed by what can be termed a close approximation of the institutional approach.
His findings
represent Inductive rather than deductive reasoning.
It was
therefore proposed to examine his contentions in light of standard economic theory and to attempt to reconcile his findings with the theoretical basis of the full cost principle, pointing out limitations that developed. Justification for considering realized profit as a requirement of business enterprise.
It is perhaps, in this
area that the unsettled debate is most difficult to resolve. This is due to the fact that there are two contending schools of thought pertaining to the theory of profits. Justification in economic theory.
The Survey of
Contemporary Economics had this to say concerning the theory of profits: There are essentially two kinds of profit theory (1) The type of theory which regards profits as a residual, the excess of price over cost; and (2) the theory which
12
Ibid., p/ 54-55.
regards profit as the reward for a factor of production, enterprise, or enterpreneur, in the same way that wages are regarded as the reward for labor, and interest for capital* Both types of theory continue to exist side by side and there is as yet no indication of agreement as to the approach which is the more a p p r o p r i a t e It developed that the residual theory was based upon the risk theory of profits.
It was instructive to trace, briefly, the
development of theory of risk and the relation to pure profits. Adam Smith had said: Ordinary rate of profit varies more or less with certainty or uncertainty of the returns. The ordinary rate of profit always rises more or less with the risk. It does not however seem to rise in proportion with it.-*-4 Poster and Catchings*^ summarized the theory of profits of the enterprise contending that profits were based on risk; risk arising due to the uncertainty of future events.
They
further contended that the businessman is faced with a series of alternative choices, all uncertain as to outcome.
Profits
would temporarily be experienced by the enterprise as a re sult of selection of those risks which turned out to be less uncertain than the alternative choices.
In the long-run the
Howard S. Ellis, editor, Survey of Contemporary Economics (Philadephias The Blakiston Company, 1948), p. 45. 14
Adam Smith, The Wealth of Nations (New York: A.P. Dutton and Co., Inc., 1910*) T] p. 104. lR
William Trufant Poster and Waddill Catchings, Profit (Boston: Houghton MiffIn Company, 1925) pp. 135-48.
47 more fortunate choices tend to be cancelled out by less fortunate choices selected by other businessmen*
Enterprise,
as a whole, tends to make no profits in the aggregate in the long-run. This point of view was supported by Knight in the Encyclopedia of the Social Sciences In support of the second theory of profits outlined by Ellis, Herbert Davenport presented a different point of view: In this sense, profit stands as merely one form of the renumeration of labor and is thereby a subhead under the broader interpretation of the term wages. It points to gain without the intervention of an employer; it Is, then, renumeration to the entrepreneur for entre preneur activity as such. This profit goes, truly, to him who takes the risk, but does not, therefore, go as a compensation for the risk or in proportion to it.17 Pettengill,*^® among others, has pointed out some of the weakness of the risk-theory of profits: If business profits are defined as being equal to opportunity costs for the owners* factors’, then pure profits or losses may be described. This approach tends to Identify profits with payment for risk, an argument that has many weaknesses. Its grain of truth should be used with great care. This examination of the theory of profits clearly indicated, that within the framework of economic theory, the
Prank Knight, ’’Profits/* Encyclopedia of the Social Sciences, X, p. 485. Herbert J. Davenport, Value and Pistribution, (Chicago: The University of Chicago Press, 1908) p. 98. Robert B. Pettengill, Price Economics (New York: The Ronald Press Company, 1948), p. 477.
48 principle that an enterprise should expect to experience a profit based on considerations other than risk and uncertainty has support.
Thus Churchill’s contention that an industry
should experience a required profit is admissible.
Of course,
the amount of required profit or the basis, was yet unanswered. Further support to this theory that profits should be realized was evident when examination of the thoughts of students of business affairs was insrestigated. Justification in prevailing business thought.
That
business enterprises must realize a profit in the long-run was amply supported by students of business affairs as follows; Primarily the creative urge in business takes the form of seeking to develop a successful business enter prise. Success in business is measured by solvency and profits. The most important criterion of ’’creativeness” in the business world, the primary yardstick by which the business leader measures the effectiveness of his work, is the size of his firm’s earnings. This is true of corporation executives as well as owner-managers operating their own enterprises. The executive will use profits in evaluating the results of his leadership, even if he is not an important owner of the business# The mere existence of profits indicated that his work has been well done, though the earnings are distributed to others.19 Chester I. Barnard'indicated the business enterprise was organized for the purpose of rendering service; realized profits were necessary also:
19
Robert A. Gordon, Business Leadership in the Large Corporation, (Washington, D.C.: The Brookings Institute, 1945) p. 308.
49 The possibilities of profit and their realization is some degree are necessary in some economics as condi tions under which a continuing supply of incentives is possible; but the objective purpose of no organization is profit, but service*^0 Similar contentions concerning the realization of profits were stated on pages 26 and 27 of this study* Current economic theory postulated two concepts of the theory of profits; one stated that economic activity would be undertaken because of the anticipation of profits*
The
other maintained that economic activity would be undertaken because of the anticipation of profits and further, that the economic activity should earn a profit as a reward for entrepreneur effort.
The latter theory appeared to have
considerable support by students of business affairs. Justification in considering selling costs indepen dent of costs of production*
It was noted that the alternative
formula for price determination included a positive addition thereto for effective selling effort; that the selling cost or effort should equal the required profit.
This posed two
questions: (1) Could such an assumption be supported in eco nomic theory? and (2) Could any basis be found to support the requirement that selling cost should equal the required profit, as determined by Churchill?
P O
Chester I. Barnard, The Functions of the Executives, Cambridge, Mass.: Harvard University Press, 19507 fn. p. 154.
50 1.
There appeared to be adequate acceptance of the
fact that selling costs are independent of the cost of pro duction*
The conclusion of the Bureau of Economic Research
indicated: Selling costs are defined as costs incurred in the effort to obtain those sales which would not have been made without the impetus lent by the selling ex penditure* In other words, selling costs are to be considered an independent variable which, along with price, the business man can use to vary his volume of sales.21 In this connection, the conclusion of the National Bureau of Economic Research closely followed the analysis of selling cost presented by Chamberlin.^
The alternative formula
separated selling cost from the costs of production.
Churchill
indicated23 that the selling effort should be employed for precisely the same reasons developed by Chamberlin and the Bureau of Economic Research. 2.
None of the cost studies available to the writer
indicated any particular ratio of selling cost to profit. This relationship was not investigated by Independent authori ties and it appeared that the investigations of Churchill were in the nature of an original inquiry.
Only one independent
Cost Behavior and Price Policy (New York: National Bureau of Economic Research, 1943) p. 193. ^ Edward H. Chamberlin, The Theory of Monopolistic Competition (Cambridge, Mass.: Harvard University Press, 1948), pp. 174-183. ^ Churchill, o p . cit., pp. 60-86.
source other than Churchill indicated that this was a practice in at least one industry: w ••.meanwhile spending an amount equal to the profit per can merely for advert!sing Justification for not calculating percentage profit onn material cost and selling costs.
It was previously indi
cated that the full cost method of price determination included a profit calculation based upon a percentage of material cost and selling cost (if known) plus other factors. By way of contrast,
the alternative formula omitted this
profit calculation, profit In this case being computed solely on the conversion cost.
Therefore, if the rationale of
charging a profit by means of a percentage mark-up on material cost and selling cost could be justified, Churchill’s content tion would be weakened.
On the other hand, if the contrary
could be demonstrated, his contention would be strengthened. In fact, abstracting from the full cost method the computation of profit based upon material cost and selling cost would leave only the conversion cost portion of the full cost of the product, on which to calculate any profit at allI The basic considerations relating to the fallacy of charging profit on material cost was pointed out by Knoeppel:
24
# Samuel W* Reyburn, For Top Executives Only (New York The Business Bourse, 1936), p. 57.
52 As an example, take the case of two steel plates of the same size and thickness and, therefore, the same cost on the material market. In one, we lay out and punch 100 holes, while in the other, 10 holes. The ratio of both labor and overhead is 10 to 1, hence, in theory at least, we should receive ten times the profit for the 100 hole job as for the 10 hole job. Why should a vary ing material content govern the profit charge when material in itself has no bearing on the fabrication, while what we do to and with the material (for which the specifications are responsible) has every bearing upon it and should govern the margin of profit, we ask? Profit, therefore, should be added to cost of labor and overhead and not to total cost. We should proceed as if the buyer should say, ,fl will supply you with the material to avoid paying you a profit on it. Although I am willing to give you a proper return on the real work I am asking you to do for me, which is to fabricate this material of mine through the use of your machines, your labor, and your facilitating overhead.!,25 Neuner, in illustrating the inaccuracies of applying overhead based on material cost made the following comment: Although the amount of time used on each of these jobs was approximately the same, and therefore the amount of the expenses consumed on a time basis should also be the same, the resulting expenses applied on a materials cost basis varies widely. Prom a theoretical viewpoint this method of computing manufacturing expenses appli cable to a given job is quite incorrect; but firms using this method argue that, since the cost of the article varies, the selling prices will vary accordingly and on the higher-priced articles the amount of profit should be greater. Therefore, the amount of expenses to be borne by these higher-priced articles should be greater. This is a practical answer, but it is not correct from an accounting viewpoint.26
25 c . E. Knoeppel, Profit Engineering (New York: McGrawHill Book Company, Inc., 1933), p. 196-197.
26 John J. Neuner, Cost Accounting (Chicago: Richard D. Irwin, Inc., 1947), p. 259-260.
53 If the principle of computing a profit on material cost and selling cost were correct, it should be expected that the ratio of material cost and selling cost to profit should vary in proportion thereto, insofar as the profit is related to the dollar amounts involved.
This is not so as demonstrated
by the simple illustration following: Manufacturing Data for Rihgs^ Gold filled Material cost $> 0.50 Labor and manufacturing overhead 1.00 Selling cost 0.75 Pull cost 2.25 Gross profit, 20 per cent of full cost .46 Price # 27 7 T
Solid gold $ 5.00
Platinum $ 25.00
1.00 0.75 6.75 #
1.35 8.10
1.00 0.75 26.75 5.35 $ 32715"
# An extension of the argument presented by C. E. Knoeppel, o p . clt., p. 198. Ratio of material cost to profit Ratio of conversion cost to profit Ratio of selling cost to profit
1.09
3.70
4.68
2.18
0.74
0.19
1.63
0.55
0.14
Assuming the same data but assuming that profit should be equal to the conversion cost, the following obtained: Gold filled Material cost Labor and manufacturing overhead
$> 0.50 1.00
Solid gold
Platinum
$
$ 25.00
5.00 1.00
1.00
54 0.75 6.75
0.75 26.75
1.00 7.75
1.00 27.75
0.50
5.00
25.00
1.00
1.00
1.00
0.75
0.75
0.75
0.75 Selling cost 2.25 Full price Gross profit, 100 per cent conversion cost 1.00 Price 3.25 Ratio of material cost to profit Ratio of conversion cost to profit Ratio of selling cost to profit
It was observed that the ratios in the latter example were consistent; there was no change in the ratios of conversion cost to profit.
Such could be expected because the conversion
cost was the same throughout.
On the other hand, the ratio
of material cost to profit rose in direct proportion to the profit, indicating that the material cost was independent of the profit.
The selling cost ratios on the other hand, re
mained constant.
In terms of the illustration, this consistency
should obtain. On the basis of consistency, profit based on conversion cost only, displayed orderly procedure in relationship to earned profit.
This consistency will always be in harmony
with the changes that take place in the fabrication process. On the other hand, earned profit based upon material cost, conversion cost and selling cost will never be consistent with the costs of fabrication if the full cost principle is
55 used, except by a fortuitous combination of costs*
Thus the
illogic of the full cost principle of including a profit on material cost and selling cost is suggested* There was yet another inconsistency between the price computed by the full cost method*
This inconsistency developed
in considering the two theories of profit previously presented. On one hand, if the risk theory of profit is assumed to be correct, the full cost method of computation of an addition to profit based upon the full cost of the product, could be justified*
That is to say, that profit realization was pre
dicated upon uncertainty in the consumation of future events; obviously the ultimate profit or loss would then have little relation to the constituents of cost and any manner of the computation of the profit addition might be acceptable from the theoretical point of view.
It would appear that there
was little or no relationship between profit realization and the utility values added to the product from the Initial stage of the raw material to the final finished stage. However, accepting the dictum of Davenport, a different conclusion was developed if applied to the full cost method: Demand Utility, marginal utility and subjective worth are primarily categories leading up to the explanation of the demand side of the value equation, as expressed in terms
56 of purchasing power, and as bearing upon the price ad justment of any particular commodity. Marginal utility - a purely individual category and absolute magnitude- is a step toward explaining subjective worth - a purely subjective and individual fact and an absolute feeling magnitude, the cost aspect of marginal utility. Two subjective worths in com parison explain price offer, or refusal price, this latter being merely a demand fact in another aspect. Cost The emergence of value is not dependent upon costof-production influences as a prerequisite, but only there being a supply limited relatively to human desires. But so far as the cost-of-production investigation bears to explain the relative volumes of supply of different oommoditi es, it bears to explain the values of the commoditi es. [Italics not in the original.3 For competitive purposes, cost of production is purely a computation of the individual entrepreneur; for any item or quantum of product, it is the price statement of the compensation necessary to the forthcoming of that product. Outlay costs to the entrepreneur are distributive shares to the recipients; the distributive share of the entrepreneur also - his profit - ls_ cost, to the extent that it is necessary profit. [Italics not In the original/] All productive-distributive compensations come by the same and equal title of contribution to value pro ductivity; but they are the market value (Italics not in the original) of the value contribution rather than the accurate equivalent of the value productiveness; this last varies for each instrument with each entrepreneur, and is nowhere precisely ascertainable by any. Thus if profit was considered part of the entrepreneur^ cost and the costs are the market value thereof, and if the
^
Davenport, o p . cit., pp. 571-572.
57 marginal comparisons mentioned by Vaughan^® $re taken into account, further inconsistencies of the full cost method of price determination appeared to develop as follows* It was assumed that a price of a commodity was deter mined under the full cost method and hence, the profit was an arbitrary percentage of the full cost.
Assuming further that
the material cost of the commodity increased or decreased, the entrepreneur, using the full cost method would be faced with a perplexing situation.
Making the further assumption that
the entrepreneur desired to recoup his costs, i.e., his profit, he must vary the arbitrary percentage applied for his mark-up, But essentially the situation was the same as before the change in the cost of material.
He had done nothing to the
utility value of the commodity to warrant a change of his mark-up percentage.
To adjust the arbitrary percentage for
mark-up to recoup the same profit is clearly inconsistent. On the other hand, assuming that the entrepreneur did not vary the percentage mark-up, then, his cost or his profit would vary according to the change In the material cost, assuming other things to remain equal.
It is equally clear that the
situation had not changed in such a manner as to warrant an increase or decrease of his subjective valuation of his profit.
P8
See pages 28, 29, and 30 of this study.
58 Justification for the use of normal capacity.
In
this respect, Churchill was in close agreement with current accounting procedures.
Two authorities are cited to establish
general acceptance of this principle: Most firms find it necessary to pre-determine burden rates for the purpose of currently determining their product costs. Such rates are based on the re lationship of expected volume to either expected actual costs or the costs justified by the volume - the former providing actual rates; the latter standard rates,29 Therefore when the manufacturers estimates his production, he must work in terms of normal operating conditions; since these methods affect his method of calculating his predetermined rate for manufacturing expenses,3$
RECONCILIATION OP PULL COST METHOD AND ALTERNATIVE METHOD There was little doubt that the prevailing practice of business men who exercise a measure of choice in price detemination, for profit.
employ the full cost principle with mark-up
In contrast, the Investigations and practices
recommended by Churchill effecting price determination have been applied In a limited scope.
It was instructive to compare
the profit computations of the two methods to ascertain if there were areas of agreement between them,
^ J. Brooks Heckert, Business Budgeting and Control (New York: The Ronald Press Company, 1946), p. 366. 30 Neuner, o p . cit.f pp, 256-257,
59 Restatement of the full cost principle and its mathe matical computation*
Price determination by use of the full
cost method was stated as follows, assuming that the selling cost was known: (M + !■ + VIC + FIC + S)
P ~
X%(M + L + VIC + FIC + S)
Qj
Q
the latter portion of the formula represented the percentage addition for profit*
The alternative formula was, presented
as follows.for a manufacturer selling to a retailer: 5.0 (L + VIC + PIC) + M p = Q Computation of the addition for profit or mark-up* Eliminating from both formulas, the costs of the product, the remainder was the computation of profit by both methods and was: ............... , Pull cost method, profit equals Alternative method, profit equals
X$(M + L + VIC + PIC + S) —‘---q -------------—
H
Under the full cost method, multiplication by the per centage mark-up of the elements of material cost and selling costs produced the following: Full cost method, profit equals ** U + . , M k , + ™ It was noted that the expression (L + VIC + PIC) equalled the conversion cost In the alternative method.
60 Implied acceptance of profit, in part, based on conversion cos t under the full cost method*
It was impossible
to escape the conclusion that under both methods that profit, in part, must be based upon conversion cost.
At this stage
of comparison, only two factors remained to reconcile both methods;
(1) The question of profit computation in the full
cost method based upon material cost and selling cost and (2) Reconciliation of
percentage mark-up in the full cost
methods and 1.0, and pragmatic ratio developed by Churchill. Elimination of material cost and selling cost from the full cost method.
The justification of including material
cost and selling cost in the computation of profit has pre viously been explored.
The conclusion concerning material
costs as a basis for profit computation had little justification in fact, if the theory of profits presented by Davenport and the subjective conclusions reached by Knoeppel and Neuner were accepted.
In short, if the theory of profit based upon
the idea that profit was a cost compensation for entrepreneur ship, the value of the material cost going into the product would have no necessary relation to the profit expected.
The
argument was buttressed by KnoeppelTs logical contention that the entrepreneur acted as agent for the consumer insofar as the product related to the material used.
The inconsistencies
of the ratio relationship of material cost to profit was demon-
61 strated. Likewise, it was demonstrated that it was in accordance with accepted economic doctrine to consider the selling costs of a product the effort used to retain or extend the market or demand for the product.
It could be argued that if profit
was a reward for entrepreneurship, the ratio of selling cost to profit employing the full cost method should present a consistent ratio.
That it did not was illustrated.
Subjectively, then, there appeared sufficient justifi cation to eliminate material cost and selling cost from the full cost method.
The profit under the full cost method
would then be reduced to........... 9.t, ? I C ) ^ ^ the elements of full cost, X$*M and X#*S.
eliminating
To recapitulate,
the residual profits were nows • „ . .... Pull cost method, profit equals ,, . Alternative method, profit equals
X$(L + VIC + PIC) —*---- ^ ---------- 1.0(1* + VIC + PIC) ------- g-----------
Reconciliation of the X% mark-up and the ratio developed by Chur chill.
The percentage mark-up under the full
cost method ranges from 10 per cent as indicated on page 20 of this study to 124 per cent as indicated in Table I.
Thus
far, the writer has been unable to discover any mark-up on cost that exceeded those listed in Table I.
Furthermore the
mark-ups listed in Table I related to retailing*
The more
likely range for manufacturing enterprises, based on objective evidence was from about 10 to 30 per cent.
One case was u n
covered where the mark-up added was in the order of 3 per cent (Peering Shoe Company).
This represented an exceptional case
wherein shoes were being manufacturered for the U.S. Army. On the other hand, all of these mark-ups were predicated upon the full cost of the product which included material costs and selling costs.
Eliminating these two costs would explain
why Churchill’s ratio of 1.0 for a manufacturer would be com paratively higher.
How much higher can not be demonstrated
and insofar as this investigation is concerned, the lack of statistical data necessitated acceptance of the ratio dis covered by Churchill because of the lack of contradictory evidence. The reconciliation of the full cost method and the alternative method was complete.
This reconciliation was pre
dicated upon the acceptance of the theory of profits based on the reward for entrepreneurship and certain logical infer ences.
It was recognized that the reconciliation was based
upon premises that rest in areas of serious controversy and the alternative method is not offered as any panacia. Churchill recognized this isl indicated by:
That
63 The application of economic principles does not substitute for Industrial Engineering and Business Management practices, but guides these practices along lines that can insure their effectiveness and guard against their misues. 1
SUMMARY This chapter commenced with the presentation of the 1
constituents of cost pertaining to the alternative method of price determination.
It developed that there was no difference
between these elements and those of the full cost method. alternative pricing formulas were indicated.
Two
For reasons ex
plained in the study, the formula recommended by Churchill was adopted for this investigation.
Churchill’s formula was
presented and a general symbolic representation introduced in order that the alternative formula would be on the same com parative basis as the formula for the full cost method. The investigation next proceeded with the theoretical considerations underlying the alternative formula. basic considerations were presented;
Four
(1) The concept that a
required profit should equal conversion cost (2) The concept that selling cost should equal the required profit (3) The
31
Churchill, op . cit., p. vi.
64 basis for not computing profit on material cost and selling cost and (4) The concept of the use of normal capacity* There was next undertaken the justification for the underlying principles of the alternative formula*
Two theories
pertaining to profits were briefly outlined and the theory that seemed appropriate to the alternative formula was examined. The prevailing ideas of students of business affairs concerning profit realization were indicated.
It was thus demonstrated
that there existed in economic theory and supported by business m e n ’s concepts, the fact that business enterprise ought to realize a profit.
The fact that selling costs were considered
to be independent of the cost of production was pointed out. The justification for not calculating a percentage of profit based on material cost and selling cost was next demon strated.
The demonstration consisted of examining some con
cepts of independent authorities along these lines.
The
inconsistencies resulting from the use of ratios suggested a deficiency when profit was computed using material cost and selling cost under the full cost method.
The Inadequacy of
the full cost method employing material cost and selling cost for profit computation when the price of the material cost varied was touched upon. Churchill’s recommendation concerning normal capacity was found to have ample justification in current cost accounting.
Having presented the justification for item (1),
(2),
(5) and (4), a reconciliation of the profit computation by the full cost method and the alternative method was attempted. By contrasting the matematical addition for profit under the full cost method and the alternative method, certain discre pancies were evident.
These discrepancies were successively
reduced, basing such reduction on the arguments previously presented.
The final reconciliation was carried to a point
wherein the only difference not explained, was the
mark-up
used in the full cost method and the ratio of 1.0 recommended by Churchill.
Part of the difference unexplained was due to
the fact that the X% mark-up based on the full cost method was predicated on the principle that this method required the inclusion of material cost and selling cost (if known) in the full cost.
The lack of any contradictory evidence,
necessitated acceptance of the ratio developed by Churchill from his investigations.
CHAPTER V THEORECTICAL COMPARISON OP PRICES COMPUTED BY THE PULL COST METHOD AND THE ALTERNATIVE METHOD UNDER ASSUMED CONDITIONS In this chapter it is proposed to examined the two methods of price computation under two assumed conditions. In the first condition it will be assumed that a firm will compute prices by the full cost method and by the alternative method under conditions of a rising price level; in the se cond, that the firm will compute prices by the two methods under a declining price level accompanied by a declining demand. To properly evaluate the results of the two situations, it was necessary to describe a norm against which the prices computed by the two formulas could be compared.
Of necessity,
the norm or criterion represented a series of idealized attri butes of a price. Comparison -under the conditions of a changing price level was effected by assuming certain constituents of cost at a price Index equal to 100; employing the formulas pre viously presented,
the resulting price was computed.
Using
the same data but at a price index equal to 200, the resulting price was again computed.
These computed prices were compared
67 to the price computed at an index of 100 adjusted for a general average price rise of 50 per cent.
Agreement and disagreement
with the norm established was pointed out.
The cause for
any disagreement was explored in some detail. The second phase of the investigation involved the computation of comparative prices computed by the full cost and alternative methods under the influence of a declining price level accompanied by a declining demand.
The comparative
prices were computed under three general conditions; a declining price level and demand, assuming an elasticity of supply of greater than one, computation assuming an elasticity of supply of 1.7 and, finally, computation of prices assuming an elas ticity of supply of less than one.
The agreement and dis
agreement with the criterion of price was pointed out and the causesc of any disagreement indicated. Because the prices computed by the full cost method appeared more consistent with actual theoretical results, a synthesis of the two methods was undertaken.
As a result,
certain additional modifications suggested themselves and these modifications, along with the one previously developed were incorporated into a general pricing formula.
68 ATTRIBUTES OP A PRICE In order to further the investigation of the two methods of pricing thus far described, it was necessary to construct a norm by which the prices computed could be gauged.
If a
comparison between the effectiveness of the pricing methods was to be explored, the effectiveness could be judged depend ing on how well the prices were in agreement with the standard. Such a standard or criterion would be ideal and therefore would be valid only insofar as there was agreement as to the criter ion.
Further, the criterion was to apply only from the point
of view of the individual enterprise and therefore would be very limited in scope.
Withal, the standard should be approxi
mately within the realm of reality;
With these severe limi
tation clearly in mind, the attributes of a price from the point of view of an individual enterprise follow* 1.
The price at the market must be of such an amount
that an exchange will take place. 2.
The price must be an amount so as to fulfill the
subjective and objective marginal comparisons of the Income class from which an exchange is sought. 5.
The price must be such that the Implicit and ex
plicit costs are returned to the enterprise in the long run. Costs In this connection are considered the costs outlined
69
by Davenport.^
Bowman and Bach have said this concerning
"costs* in the long run. The long run has been defined as a planning period long enough to permit consideration or reconsideration of the employment of all the agents in an enterprise, of the incurring of all kinds of costs in that enterprise. Long run planning considers all possible alternatives in the combining of productive agents, all possible alternatives in the combining of productive agents, whereas in the short-run planning variations are possible only within the range permitted by the existing "fixed" productive agents* In the long-run, all costs are variable, and long-run adjustments include the entry of new firms into an industry or the withdrawal of firms from it.2 4. in the
The price should reflect the technical progress
industry.
This will be manifest by a relatively slow
rate of price decline. Often these considerations [The optimum rate of technical progress] mean that the improvement ought to be introduced rather slowly, as it gives decisive evi dence of its value, and as the older equipment gradually wears out.^ 5.
Price levels in the
stable, or experience a gentle
long run should remain fairly moderate movement upward or
downward.
1
See pages 56 and 56 of this study
2
Mary Jean Bowman and George L. Bach, Economic Analysis and Public Policy (New Yorks Prentice-Hall, Inc., 1945), p. 12S. 3
Theodore Morgan, Income and Employment Prjentice-Hall, Inc., 1947), p. 47.
(New York:
70 Drastic price level rises or declines bring drastic windfall gains or losses to particular groups within the economy, and are a cause of inefficiency through disrupting business planning* Jknd any considerable price change carries with it the danger of its own continuance and acceleration through arousing speculative anticipations of continuing change in the same d i r e c t i o n . ^ 6.
Prices should not knowningly exploit either the con
sumer or the seller.
Exploitation of the consumer is repre
sented by monopolistic tendencies; exploitation of the seller is characterized by fruitless price wars.
It may also be
accomplished by changing price levels fail to provide revenue to cover the implicit and explicit cost. The effects of most of these practices [unfair competitive tactics] on the functioning of the economy are dramatic and important. They block progress; those with vested interest to protect continuously erect bar riers to prevent the entry of new firms and the competi tion of new and improved products and processes. They lead to high prices and restricted outputs; with these high prices come idle resources and waste, with lowered planes of living for the population as a whole.... Finally, they weaken the bargaining positions of those dealing with the dominant groups, by eliminating alter natives; the tobacco farmer has no really free market in which to sell his tobacco; the buyer of aluminum ingots has no alternative source to which he ean turn for his aluminum.5 While the items (1) through (6) might have been extended almost indefinitely, such extension would result in undue complexity and shortly become cumbersome for the purposes of
4 5
I b i d ., p.
253.
Bowman and Bach, o p .
71 this study.
The items are not necessarily arranged in order
to their priority nor do they pretend to be all inclusive. They were offered as more or less convenient yardsticks by which to measure the results of the two formulas.
They re
presented the major considerations that the individual enter prise should surround his price determination if it is in the position to do so.
COMPARATIVE PRICES COMPUTED BY THE PULL COST METHOD AND ALTERNATIVE METHOD UNDER THE INFLUENCE OP A CHANGING PRICE LEVEL In consideration of this phase of the problem, an individual firm contemplated price determination by means of two formulas.
A highly artificial series of data was assumed;
the elements of cost were fictitious.
It was assumed that
the price index prevailing at the beginning of the period was equal to 100 and at the end of the period, the price index was 200. This would Indicate a price rise, on the average, „ _ , 200 - 100 _ .v . of 50 per cent ( t?q q = 50 per cent). The assumed mark up over cost will be chosen so that the price computed by the full cost method and the alternative method will be equal. It will be further assumed that the selling effort by both formulas produced the same quantity that could be disposed of.
72 Further it was assumed that none of the factors of cost were effected except by the general price rise throughout the period except as indicated.
In a similar manner, the sales
value to the product was assumed to be effected only by the rise in the price level. Price Index = 100 at beginning of period Full cost method ______________
Constituents of cost Alternative per unit________________ method
$ 3.00 0.50 0.10 0.20 0.80
Material (M) Labor (L) VIC FIC Selling cost
$ 4.60
Full cost
(S)
$ 3.00 0.50) 0.10)= #0.80 0.20) 0.80 $ 4.60
Profit computed by full cost method X$6( M + L + VIC + FIC + S) X% = 17.3 per cent Profit, full cost met hod 0.80
0.173 (# 4.60) Profit computed by alternative method 1.0 0 (L + VIC + FIC) (L + VIC + FIC) = $ 0.80 Profit, alternative method 1.00
$ 5.40
($ 0.80) # 5.40
73 Price Index = 200 at end of period Average price rise = 50 per cent Pull cost method $> 3•00 x 0.50 x 0.10 x 0 #80 x
Alternative method
.50 =» # 4.50 .50 = 0.75 .50 = 0.15 0.20 •50 = 1.20 $ 6.80
Material (M) Labor (L) VIC FIC Selling cost(S)
$ 3.00 x 1.50 = $ 4.50 0.50 x 1.50 0.75* 0.10 x 1.50 0.15* 0 .20* 1.20 0.80 x 1.50 $ 6.80
Pull cost *Total equals
$
1.10
Profit computed by full cost method 1.18
0.173 ($ 6.80) Profit computed by alternative method
1.00
(# 1 .10 ) 1.10
Price
$ 7.90
f 7.98 Selling price as per rise in price level | 5.40
2 .70
Price at price index equal to 100 Add 50 per cent increase for rise in price level when price index rose to 200 0.50 (| 5.40)
$ 8.10
Price at end of period
7.98
Price computed by full cost method Price computed by alternative method
f> 5 40
2 70 $ 8 10
7 90
Failure 6*0 methods to reflect rise in price level
$ 0.12
Actual revenue $ 5 . 4 0 x 1.50 x 100= Theoretical revenue, full cost method, $ 7.98 x 100 = Theoretical revenue, alternate method, $ 7.90 x 100 = Excess of implicit and explicit costs over full cost method Excess of implicit and explicit costs over alternative method
---$ 0,20 $ 810.00
$ 810.00
798.00 790.00 _____ 12.00 _____ 20.00
LIMITATION OF BOTH METHODS The limitation of both methods will be indicated under separate captions. Agreement with criterion.
By definition it was assumed
that the prices computed have met the criterion outlined in items (1),
(2), and (4).
fied; i.e., items
(3),
Three items then remained unsatis
(5), and (6).
Disagreement with the criterion.
Examination of the
computation which resulted in the price computed under both methods demonstrated that the prices computed failed to meet the price of the product raised by the increase of 50 per cent because of a changed price level.
The price computed by the
full cost method failed by 12 cents and the price computed by the alternative method failed by 20 cents.
The effect of
75 changing price levels and the relation to economic activity by the individual firm was epitomized by Sweeney: In view, then, of the varying rates of movement between individual price indexes and the general index a price index that is going up may actually be going down in so far as its relation to the general average of prices is concerned. For instance, if the price index of a particular article goes from 100 to 150, It is obviously rising. But if during the same period the general index goes from 100 to 200 the index of the particular article is falling in Its relation to the gen eral average of all prices. For at the beginning of such period the relationship of the individual Index to the general index was 100/100, whereas at the end it is 150/200. On the other hand, an individual index may seem to be falling when it is actually rising. This Is the situation when the price index of a particular article falls from 100 to 75 while the general index is falling from 150 to 100. Because of the foregoing a business management may feel pleased to witness the price of its product rising In cases where c>alarm should be felt because the price is rising less than prices in general. Such a situation means that the Individual product Is losing its ability to command others, and that in so far as that product is concerned the management is not ad vancing toward the goal that the owners of business usually want to reach,* namely, greater general purchas ing power. A similar situation exists where the price of the product is falling at a faster rate than the general index. On the other hand, a management may feel worried to see the price of its product falling when it should feel pleased that the price is falling more slowly than the general index. A business is similarly being bene fited, of course, when its individual index is rising at a faster rate than the general index. In all these cases, as In so many others, it is the relative aspect that is of most importance.®
® Henry W. Sweeney, Stabilized Accounting (New York: Harper and Brothers Publishers, 1936), p. 17.
76 It was evident, in reviewing the computations on pages 72 and 73, that the price computed by the firm did not return the implicit and explicit costs in full.
The full cost
method failed by 12 cents and the alternative method by 20 cents.
This conclusion was based upon the fact that the price
of the product should have risen to $8.10 per unit because of the average general price level rise experienced during the period.
CAUSE OP DISAGREEMENT DUE TO FIXED INDRECT COST In the examples of price determination computed by both methods, all but one of the constituents of cost reflected the average general rise in the price level of 50 per cent. By design, the fixed indirect costs (PIC), did not reflect the increase of the average price rise.
The writer has found no
evidence in the price studies or the pricing practices examined by him that indicated that it was general business practice to base the manufacturing burden other than on original cost of fixed equipment.
Nor was any departure from this procedure
recommended in the accounting literature examined.
Consequently,
it was concluded that prices do not typically include an ad justment that reflect changes in fixed indirect costs as re lated to average price levels.
The same situation cannot be
77 said to exist concerning the other constituents of full cost. It is well known that the Mlast-in, first outtf method of in~ ventory accounting recognize the necessity of reflecting in current revenue, the current prices of materials and supplies. Accordingly, it was assumed that the material cost, the variable indirect costs of
materials would reflect the cur
rent rise in the average price level.
This was a reasonable
assumption when it is considered that the average business is turning over the sums involved in these costs several times during a business year; current revenue derived from these items is more nearly the result of the current cost involved. Pinney summarized this contention as follows: The advocates of the last-in, first-out method contend that it is superior to the first-in, first-out method for two reasons: First, it tends to equalize periodical profits during a cycle of years in which prices rise and fall.... The lifo method may be said to have the advantage of matching current costs against current revenues.... The second principal reason offered in support of the lifo method is that, on a rising market, profits shown under fifo method are necessarily plowed back into inventory, and although such profits are legally avail able for dividends, it may be inexpedient, from the working capital standpoint, to distribute them. The lifo method tends to keep out of the stated profits any amounts which are not realized in the sense of being represented by a net increase in current assets other than merchandise.7
7
H. A. Pinney, Principles of Accounting. Intermediate (New York: Prentice-Hall, Inc., 1946), p. 265-66.
78 Assuming that the implicit cost should contain a profit reward for entrepreneurship in accordance with the theory of profits outlined by Davenport, it was noted that the profit computed by the formulas failed to meet this requirement.
An
illustration will clarify the effects of including a proper allowance for price rise in relation to the fixed indirect costs in order that the profit will be stated in an amount comparable to the general price rise. Price index = 200 at end of period Pull cost method $ 0.20 x 1.50 = $ 0.30
Alternative method Adjustment of PIC for rise in price level - PIC
# 0.20 x 1.50 = $0.30
Additional profit computed by full cost method $ l.SO
0.173 ($ 6.90)'* Additional profit computed by alter native Blethod
1.00 6.90^
($ 1 .20 )**
Pull cost, recomputed
$
1.20 6.90™
$
New Price adjusted ^or Price level
---$ 8.10
$ 8.10
Old Price adjusted for price level ($ 5.40 x 1.50)
$ 8.10
* M = $4.50; L = 0.75; VIC = 0.15; FIC = 1.30; S = 1.20; Total = $ 6.90' 0.75; VIC = 0.15; PIC = 0.30; Total = $ 1.20.
79 By the means outlined, agreement between the prices computed by formula and the price adjusted because of the average general price rise, is manifest.
It was evident that
before this adjustment was made that the price of the product was advancing at a rate slower than the general price level and as Sweeney Indicated, this should be a cause for alarm by the enterprise.
In this case,
the general price level was
unknowingly causing exploitation of the enterprise by re turning to the
enterprise, less than the implicit and explicit
costs.
On the
other hand, the opposite would be true In the
event that the
price level declined and the enterprise would
be exploiting the consumer
by garnering more than its implicit
and explicit costs. Obviously, the Illustration was highly artificial; individual prices probably will not rise in exact proportion to the average price level rise. undoubtedly differ. ciple Involved.
The relative movement would
The example served to clarify the prin
There is a second consideration, however;
how much should the price level, on the average, change before the theoretical adjustment should be made? Sweeney proposed the following in relation to stabilizing the accounts of an enterprise: 1. The general price level must have varied 5%, at least, within the fiscal period under examination;
80 2. Most of the assets, liabilities, and net-worth items that are on the books at the end of the period must have first appeared on the books when the general price level was b%, at least above or below its position at the end of the period.® The writer suggests that the same norm might well be employed when it is desired to theoretically adjust the price of the product in order that the implicit and explicit costs will be returned in full.
This adjustment would be for comparative
purposes only.
SUGGESTED MODIFICATION OF THE ALTERNATIVE METHOD TO CORRECT DEFICIENCY It was observed that the full cost method more nearly satisfied the criterion of the return of the costs of the enterprise than did the alternative method. this were clear.
The reasons for
In the first place, the percentage mark-up
was deliberately chosen so that the prices computed by both methods were the same.
In the second place, the FIC of the
full cost method represented a smaller proportion of the total cost for profit computation than did the FIC as computed by the alternative method.
In short, the basis for the profit
calculation under the full cost method was weighted by the
Q
Sweeney, o p . cit., p. 43.
81 total constituents of cost whereas under the alternative method, only three elements of the constituents of full cost entered into the profit computation.
In this case, the ele-'
ments of the profit computation under the alternative method were influenced more by failure to adjust the PIC than the con stituents of cost under the alternative method, and hence, .the basis for profit computation. Entirely different conclusions might have resulted had the constituents of full cost been in different proportions. Likewise,
if the percentage of mark-up had differed,
the re
sults could have also probably have differed.
COMPARATIVE PRICES COMPUTED BY THE PULL COST METHOD AMD ALTERNATIVE METHOD UNDER THE INFLUENCE OP A DECLINING PRICE LEVEL AND DECLINING DEMAND This phase of the Investigation involved the computation of prices employing the full cost method and the alternative method and the effect on the computation of selling price, assuming a declining price level, accompanied by a declining demand.
In order to use percentage drops in price and output
that had some resemblance to actual conditions obtaining in a dynamic economy, the percentages listed in Table 3, Income
and Employment, ^ were adopted.
It was intended only that the
percentages adapted would be in approximate reality. other cost data was purely hpothetical.
The
The pricing formulas
employed are the same as the ones previously used. Comparative prices w i t h a declining price level, elasticity of supply greater than one.
The following compara
tive prices are based upon the theoretical decline of the price of the product of 12 per cent accompanied by a decline In demand of 74 per cent.
It is assumed that the price in
dex was 100 before the decline. Price per unit assumed equal to $ 9.70; 100 units could be sold at this price when the price index was at 100. Price decline of 12 per cent was assumed and demand reduced to 26 units in lieu of 100. Revenue from sales under reduced price and demand equals | 9.70 x 0.88 x 26 = $ 222.04 Price computed by the alternative formula: P = 3.00(L + VIC + PIC) + M; the cost per unit being (M) (L) VIC PIC
= $ 1.60 = f 1.60 = 0.60 = 0.50
Substituting these values in the alternative formula and
9
Morgan, o p . cit., p . 62
83 reducing the prices, except for PIC, by 12 per cent, the unit selling price by formula was: P =
3.00($ 1.60 x 0.88 + 0.60 x 0.88 + 0.50) + $ 1.60 x 0.88
=
3(# 2.44) + $ 1.41
=
$ 8.73, the selling price per unit computed by formula.
Theoretical revenue from sales, price computed by the alter native formula $ 8.73 x 26 = Actual revenue Excess of implicit and explicit cost over actual revenue
# 226.98 222.04 $
4.94
But if the PIC were adjusted to the decline in price so that the formula would produce a price to just recover Implicit and explicit costs, the following correction to the price com puted by the alternative formula would be: FIC = PIC, adjusted =
$ 0.50 # 0.50 x 0.88 = # 0.44
P = 3.00(# 1.41 * 0.53 + 0.44) + $ 1.41 = $ 8.55, the selling price per unit computed by formula,
but the original price
of $ 9.70 adjusted for
in price
level also equaled $8.55
decline
($ 9.70 x 0.88).Therefore
adjustment of the FIC will bring the theoretical price into agreement with the actual price. The formula for the full cost method was: P a (M + li + VIC + PIC + S) + X%(M + L + VIC + PIC + S)
84 and substituting the hypothetical cost data and adjusting it for the decline in price level produced the following assuming a selling cost of $ 2,70 per unit and a mark-up of 38.6 per cent: 1.60 x 0.88 = (M) 1.60 x 0.88 = (L) 0.60 x 0.88 = VIC 0.50 = PIC
= !I 1.41 = !1 1.41 = 0.53 0.50 =
2.70 x 0.88 = Pull cost
= ! 2.38 ‘ 6.23
Add profit 0.386 ($ 6.23) Price
S
2.41 $ 8.64, the selling price per unit by full cost method
Theoretical revenue from sales, selling price computed by the full cost method: $ 8.64 x 26 = $ 224.64 Actual revenue 222.04 Excess of implicit and explicit costs over actual revenue $ 2.60 But if the PIC were adjusted to the decline in price to that the formula would produce a selling price to just recover im plicit and explicit costs, the following correction to the price computed by the full cost method would be: $ 6.23 0.06 $ 6.17 2.58 $ 8*55
Pull Cost less: FIC, adjusted ($0.50 - 0.50 x 0.88) Pull cost, adjusted Add Profit 0.386 ($ 6.17) Selling Price, adjusted
85 But the original price of $ 9.70 adjusted for decline in price level also equaled $8.55 ($ 9.70 x 0.88).
Therefore adjust
ment of the PIC will bring the theoretical price into agree ment with the actual price. Comparative prices with a declining price levels elasticity of supply equal to 1 . 7 .
The following comparative
prices are based upon the theoretical decline of the price of the product of 25 per cent, accompanied by a decline in demand of 42 per cent.
It was assumed that the price index
was 100 before the decline.
Price per unit equaled $ 9.70;
100 units could be sold at this price when the price index was at 100.
Price decline of 25 per cent was assumed and
demand reduced to 58 units. Revenue from sales under reduced price and demand equals $ 9.70 x 0.75 x 58 = # 421.95 Selling price computed by the alternative formulaj P = 3.00 (L + VIC + FIC) + M; the cost per unit is (M) (L) VIC FIC
= i 1.60 = $ 1.60 = 0.60 = 0.50
Substituting these values in the alternative formula and re ducing the prices, except for FIC, by 25 per cent, the unit selling price by formula was:
86 P = 3.0($ 1.60 x 0.75 + 0.60 x 0.75 + 0.50) + # 1.60 x 0.75 = 3(f 1.20 + 0.45 + CL.50) + # 1.20 = $ 7.58, the selling price per unit computed by formula Theoretical revenue from sales, selling price computed by the alternative formula is: $ 7.58 x 58 = Actual revenue Excess of implicit and explicit costs over actual revenue
# 439.64 421.95 $
17.69
But if the PIC were adjusted to the decline in price so that the formula would produce a price to just recover implicit and explicit costs, the following correction to the price computed by the alternative formula would be: PIC PIC, adjusted
= =
#0.50 # 0.50 x 0.75 = # 0.375
P = 3•00(# 1.20 + 0.45 + 0.375) + # 1.20 * $ 7.28, the selling price per unit computed by for mula j but the original
price of
$ 9.70 adjusted for the decline
In price of the product also equaled $ 7.28 (# 9.70 x 0.75). Therefore the adjustment of the PIC will bring the theoretical price into agreement with the actual price. The formula for the full cost method was: P =*
(M + L + VIC + FIC + S) + X%(M + L + VIC + FIC + S) and
substituting the hypothetical cost data dnd adjusting It for the decline in price of the product produced the following,
87 assuming a selling cost of $ 2.70 per unit and a mark-up of 38.6 per cent: $ 1.60 1.60 0.60 0.50 2.70
x 0.75 = (M) x 0.75 = (L) x 0.75 = VIC = PIC x 0.75 = S Pull cost
= $ 1.20 = 1.20 = 0.45 = 0.50 = 2.02 $ 5.3^
Add profit 0.386 (# 5.37)
2.07 $ 7.44. the selling price =*SB~ per unit by the full cost method
Theoretical revenue from sales, selling price computed by the full cost method is: | 7.44 x 58 = $ 431.52 Actual revenue 421.95 Excess of implicit and explicit costs over actual revenue $ 9*57 But if the PIC were adjusted to the decline in price so that the formula would produce a selling price to just recover the implicit and explicit costs, the following correction to the price computed by the full cost method would be: $ 5.370 0.125 $ 5.245 2.025 $ 7*27+
Pull cost less: Fic, adjusted ($> 0.50 - 0.50 x 0.75) Pull cost, adjusted Add profit 0.386 ($ 5.245) Selling price, adjusted
But the original price of $ 9.70 adjusted for decline in price level also equaled $> 7.28 ($ 9.70 x 0.75).
Therefore the ad
88
justment of the PIC will bring the theoretical selling price Into agreement with the actual price. Comparative prices with a declining price level, elasticity of supply less than one.
The following comparative
prices are based upon the theoretical decline of the price of the product of mand
46 per cent,
of 1per cent.
accompanied by
It was assumed that the
100 before the decline.
a decline in de price index
was
Price per unit equaled # 9.70; 100
units could be sold at this price when the price index was at 100.
Price decline of 46 per cent was assumed and demand
reduced to 99 units. Revenue from sales under the reduced price and demand equals $ 9.70 x 0.54 x 99 = $ 518.56 Selling price computed by the alternative formula: P = 3.00(L + VIC + PIC) + M; the cost per unit is (M) (L) VIC PIC
#1.60 1.60 0.60 0.50
Substituting these values in the alternative formula and re ducing the prices, except for PIC, by 46 per cent, the unit selling price by formula was: P = 3.00(# 1.60 x 0.54 + 0.60 x 0.54 + 0.50) + | 1.60 x 0.54 = 3(0.864 + 0.324 + 0.50) + 0.864
89
= $ 5.90, the selling price computed by formula Theoretical revenue from sales, selling price computed by the alternative formula is: $ 5.90 x 99 = Actual revenue Excess of implicit and explicit costs over actual revenue
$ 584.10 518.56 $>65.54
But if the PIC were adjusted to the decline in price so that the formula would produce a selling price to just recover the implicit and explicit costs, the following correction to the price computed by the alternative formula would be: PIC PIC, adjusted
= | 0.50 = $ 0.50 x 0.54 = $0.27
P = 3.00 ({$ 0.864 + 0.324
+ 0.27) + $ 0.864
= $ 5.24, the selling price per unit computed by formula; but the original price of $ 9.70 adjusted for the decline in price level also equaled $S 5.24 ($ 9.70 x 0.54). Therefore the adjustment of the PIC will bring the theoretical price into agreement with the actual price. The formula for the full cost method was: P = (M + L + VIC + PIC + S) + X%(M + L + VIC + PIC + S) and substituting the hypothetical cost data and adjusting it for the decline in price level produced the following, assuming a selling cost of $ 2.70 per unit and a mark-up of 38.6 per cent:
90 f 1.60 1.60 0.60 0.50 2.70
x 0.54 = (M) = # x 0.54 = (L) = x 0.54 - .VIC = = PIC = x 0.54 = S *==' Pull cost $
0.864 0.864 0.524 0.50 1.458 4.010
Add profit 0.586 (# 4.01) 1.55 Selling price $ 5.56, the selling price per unit by the full cost method Theoretical revenue from sales, selling price computed by the full cost method: # 5.56 x 99 = # 551.44 Actual revenue 518.56 Excess of implicit and explicit eosts over actual revenue $ 52.88 But if the PIC were adjusted to the decline in price so that the formula would produce a selling price to just recover the implicit and explicit costs, the following correction to the price computed by the full cost method would be: f> 4.01 0.25 5.78 1.46 $ 5.24
Pull cost less PIC, adjusted ($ 0.50 - 0.50 x 0.54) Pull cost, adjusted Add profit 0.586 ($ 5.78) Selling price,
adjusted
But the original price of f 9.70 adjusted for decline in price level also equaled $ 5.24 ($ 9.70 x 0.54).
Therefore the ad
justment of the PIC will bring the theoretical selling price into agreement with the actual price.
91
TABLE OP SUMMARY OP RESULTS The results of examination of the effect of changing price levels and changing demand were summarized in Tahle I I • The following conclusions are indicated after review of the results so summarized. 1.
In every instance, the price computed by means of
the full cost method without adjustment for FIC more nearly equaled the actual price, adjusted for the rise or decline of price level. 2.
In every instance, the price computed by means of
the full cost method without adjustment for PIC resulted in a theoretical revenue from sales including the implicit and explicit costs, that more nearly equaled the actual revenue from sales. 5.
The prices computed by the full cost method and
alternative method, when adjusted for the price change effecting the FIC, resulted in a price equal to the actual price.
AGREEMENT WITH CRITERION OP PRICE By definition it was assumed that items (1),
(2) and
(4) of the criterion of price listed on pages 68, 69, and 70 were met. mula.
Items (3),
(5) and (6) were not met by either for
TABLE II SUMMARY OF COMPARATIVE PRICES COMPUTED BY THE FULL COST METHOD AND THE ALTERNATIVE METHOD
Prices resulting from price (3) (1) (2) Actual Before After adjustment adjustment price for FIC for FIC Full cost method Alternative method
$ 7.98* 7.90
| 8.10 8.10
| 8.10 8.10
rise of 50 per cent (4} Excess of Implicit and explicit costs over actual revenue | 12.00* 20.00
Prices.resulting from decline in price and demand; elasticity of supply -- 6.2Full cost method Alternative method
8.64* 8.73
8.55 8.55
8.55 . 8.55
2.60* 4.94
Prices resulting from decline in price and demand; elasticity of supply -• 1.7 Full cost method Alternative method
7.44* 7.58
Full cost method Alternative method
Prices resulting from decline in price and demand; elasticity of supply -■ 0.02 5.56* 5.24 5.24 32.88* 5.90 5.24 65.54 5.24
7.28 7.28
7.28 7.28
9.57* 17.69
* Theoretical result closest to actual result. CO
to
93 DISAGREEMENT WITH CRITERION OP PRICE Both the full cost method and the alternative method, by the nature of their construction, will fail return to the enterprise the implicit and explicit costs.
To the extent
that the actual price fails to accomplish this, it can be expected that in the long run, the enterprise would withdraw from the Industry.
Table II, column 4 indicated the extent
of this discrepancy.
It is evident that the violent fluctua
tions of the price level caused large theoretical losses. These losses can be directly traced to the PIC which would result under the conditions stated, in a large under-absorbed manufacturing burden.
It is well known that the profit of
an enterprise and hence, the implicit and explicit costs will nott be returned by the enterprise to the extent that the u n absorbed manufacturing burden is not absorbed by the sales of the enterprise.
In this case, the drastic reductions
suffered would result In a large unabsorbed manufacturing burden.
In relation to item (6), the prices computed by both
formulas lagged behind the price predicated on the average rise in the general price level and the decline of the general price level.
Thus it was seen that the enterprise
was unknowingly being exploited because the general price
94 level rose and when the price level declined,
theoretical
exploitation of the consumer took place.
CAUSES OP DISAGREEMENT DUE TO FIXED INDIRECT COSTS In every case, it was found that the failure of the formulas to produce a price computation that was in agreement with the actual prices assumed to be experienced by the enter prise could be directly traced to the failure of the formulas to give consideration to the effect of the changing price level on the fixed indirect costs.
That this was true was
demonstrated when adjustment for this brought the computed prices into agreement with the actual prices.
That the actual
prices through the sales revenue failed to return the implicit and explicit costs of the enterprise is irrelevant to the problem.
The central core of the problem was to determine if
the prices computed by formula resulted in a price determina tion that theoretically provided for the Implicit and explicit cost.
PRICE COMPUTED BY THE PULL COST METHOD MORE IN AGREEMENT WITH THE ACTUAL PRICES It was seen that the prices computed by the full cost method without adjustment for PIC produced prices more nearly
95 consistent with the actual prices•
Yet, the prices computed
hy the full cost method, theoretically,
included the implicit
and explicit costs. Causes for more consistent results.
The reason for
this more consistent agreement is as follows.
In the first
place, the mark-up used in the full cost method was designed to produce the same price as determined by the alternative method in order that comparative results could be obtained. Secondly, the computation for the profit addition used in the full cost method was based upon the following consti tuents of costs unit material cost, unit labor cost, unit variable indirect cost, unit fixed indirect cost and unit selling cost; the profit addition for the alternative method was based upon unit labor cost, unit variable indirect cost and unit fixed indirect cost.
Therefore, when the adjustment
for the FIC was combined Into the profit addition for both formulas, the proportionate effect was much greater in the case of the alternative method.
In other words,
the profit
addition for the full cost method was more heavily weighted and consequently, the adjustment for the FIC had less effect on the total result.
96
SYNTHESIS OP PULL COST METHOD AND ALTERNATIVE METHOD It was demonstrated that the full cost method gave more consistent results in price determination.
This was
attributed to the manner of computation of the mark-up em ployed and also to the fact that the PIC, when adjusted had less effect on the more heavily-weighted profit addition. This suggested the following procedure to the writer as a possible guide to businessmen to assist them in practical price determination.
The suggestion would require the design
of a new pricing formula, incorporating the better features of both methods.
The new formula would involve two steps:
(1) Using Churchill’s formulas, a percentage mark-up for sub sequent use in the standard full cost method would be deter mined,
(2) Having determined the mark-up percentage, the
full cost formula would then be used to compute the price. Use of the alternative method to compute X% for mark up of the full cost method.
The following procedure is sug
gested for the computation of X%, employing Churchill’s for mula that applied to selling price to a retailer or other manufacturer: By Churchill’s formula, P = 3,00(L + VIC + FIC) + M: and
(1)
by the full cost method, P = (M + L + VIC + PIC + S) + X %(M + L + VIC + PIC + S)
(2)
97 Assuming that the
price computed by (1) is the
proper price,
this price is.the
price that (2) should produce*
Therefore,
3(h + VIC + PIC) + M = (M + L + VIC + FIC + S) + X%(M + L + PIC + S)
(3)
Solving for X%t . 2(L + VIC + PIC) - S X% = (M + L + VIC + FIC "+~S) Assuming that the
I4 )
ratio developed by Churchill
relating to
selling budget applicable to sales to a retailer or other manufacturer Is correct, then, the selling budget in this case should thing,
equal the required profit or what is
theconversion cost*
In other words,
thesame
S = (L + VIC +
FIC)
(5)
Substituting the value of S in (4) and combining terms, the following empirical value for X% resulted:
x$ -
L + V I C '+ PIC M + 2(L + VIC + PIC)
, t (6)
MODIFICATION OF THE ALTERNATIVE FORMULA Instead of using formula (1) to determine the price, formula (1) is used to determine the value of X% as indicated in (6).
Substituting the value of X% in the full cost formula,
the greater stability of the full cost formula can be adapted for price determination.
The substitution follows, incorporate
98 Ing
(5)for the value of S In
P =
[M + L + VIC +
the full cost method:
PIC + (L + VIC + P I C ) ] + X%[M + L +
VIC +
PIC + (L + VIC + F I C ) ] P =
[M •+ 2 (L + VIC+ PIC) ] + XfolM
+ 2 (L + VIC + PIC)
3
(7 )
Substituting (6) for X%i Price to retailer or other manufacturer P = [M + 2(L + VIC + PIC) 3 + [ [M + 2(L +
V I C ^ 'FIC)
1
VIC + PIC)]
(8)
In a like manner the general formulas for the price to a jobber and the price to a personal consumer were developed. ♦
Price to .1obber P =
[M + 2 ( 1 +
VIC + PIC)] + [ |
-
V
¥
ic)' ]
[M +
2JCD7+ VIC + PIC)]
(9)
Price to personal consumer P =
[M + 2(L +
VIC + FIC)]+ [ m + 2(LV£gVliffiCpiC) 2(L + VIC + P I C ) ]
3t M + (10)
LIMITATIONS OP THE MODIFIED FORMULAS The usefulness of any methodology is largely determined by the basic assumptions on which that methodology are predi cated.
For the purposes of review, those assumptions are
presented, followed by the reasons because of which they were
99
made. Basic assumptions.
These are the major assumptions
underlying the basic structure of the alternative formulas. 1.
An enterprise must recover its implicit and ex
plicit costs in the long run if it is to endure. This doctrine is generally accepted by current eco nomic theory. 2.
Profit is an implicit cost of the enterprise.
This doctrine was presented by Davenport and has about equal acceptance as opposed to the nriskw theory of profit. 3.
Accounting data and theory can estimate rather
accurately the variable indirect costs and the fixed indirect costs• Complete accuracy, of course, cannot be claimed for any particular system of cost accounting.
Nevertheless, the ob
tainable accuracy is useful in assistance of price determination. 4.
The pragmatic investigations of Churchill relating
to the ratio of conversion cost and profit of successful enter prises are considered substantially correct for the purposes of this study. 5.
The pragmatic investigations of Churchill relating
to the ratio of required profit and the selling budget of suc cessful enterprises are considered substantially correct for the purposes of this study.
100 6.
Selling price is based upon the normal capacity
of* the enterprise# To predicate prices on a capacity in excess of normal capacity that the enterprise can reasonably expect to be ab sorbed by effective demand will result in failure of the enter prise to recover its implicit and explicit costs in the long run.
Thus, manufacturing burden computed on a volume in
excess of that that can be disposed of, results in a price consistently lower than the implicit and explicit costs of the enterprise. Criticism of profit ratio.
It was pointed out previously
that the ratio of profit to conversion cost discovered by Churchill was £>ased upon his investigations.
His empirical
relationship was accepted for the purposes of this study. The writer was unable to verify the investigation from inde pendent sources.
Rationally, It would appear that this re
lationship might not hold true for all industries, under all conditions.
Serious objection could be raised on this score;
while it might have been correct in the industries investi gated by Churchill, causal relation was not established.
Oh
the other hand, this matter could be statistically determined and so could be established as a matter of fact.
It would be
important if it could be determined that any ratio existed for the successful firms within an industry.
101 Criticism of effective selling effort.
Again, Churchill
established an empirical relationship between profit of an enterprise and the related selling effort.
The same objec
tion to this relationship could be raised as was pointed out concerning the profit relation.
In addition, it is conceivable
that while effective selling effort could be gainfully used to promote the product at the price computed by the formulas, a point would be reached, at which further selling effort would result in diminishing returns.
Obviously, from this
point on, the increasing cost of selling would thwart the principle.
This point would probably be reached when the
effort was directed to attempting to dispose of more than the normal effective demand could absorb.
In one sense, this
represents a circular type of reasoning. If the above limitations were found to exist in fact as well as in theory, the usefulness of the formulas examined in this study would be greatly impaired.
SUMMARY The first portion of this chapter was devoted to examination of two formula methods of price determination (1) the full cost method and (2) the alternative method.
102 The examination consisted of comparison of the prices as computed by the two formulas under conditions of a changing price level.
The constituents of cost were assumed.
Having computed the prices under a rising price level, agreement and disagreement with a criterion or norm for a price was indicated.
The causes of the disagreement were ex
plored in some detail.
The prices computed by the formulas
were next examining assuming an artificial series of data. In this case, it was assumed that the price of the product was declining, accompanied by a declining demand.
The declin
ing demand was assumed to apply to an industry having an elasticity of supply of more than one, then to an industry having an elasticity of supply of 1.7 and finally, to an in dustry having an elasticity of supply of less than one.
Agree
ment and disagreement with the criterion was indicated. The causes of disagreement were examined and found to have resulted from the same causes explained previously. Results of the prices computed were summarized in Table II. From the results summarized,
it appeared that the prices
computed by the full cost method were consistently closer to the actual results of a price influences by the average general price level solely.
This conclusion suggested that the better
features of both formulas be used to compute a price.
The
103 synthesis of the full cost method and the alternative method was undertaken.
The resulting formulas were (8),
(9), and
(1 0 ). The limitations of the formulas were indicated by reviewing the basic assumption on which they were predicated. Particularly, the profit ratio remained unsettled and the law of diminishing returns theoretically applied to selling effort.
It was pointed out that if the limitations indicated
were found to exist in fact as well as in theory, ness of the formulas would be impaired.
the useful
CHAPTER VI SUMMARY AND CONCLUSIONS SUMMARY The subject of this study was to evaluate a formula method of price determination.
Although businessmen have
customarily been using the ”full cost11 method of price deter mination, this methodology has not proved adequate in some respects.
In order to remedy these deficiencies, an alter
native formula for pricing has been proposed.
The proponents
of the alternative formula have been singularly remiss in failure to examine their alternative formulas in light of current eco^ nomic theory to determine if, any serious contradiction to generally accepted economic doctrine was found to exist.
This
study is an attempt to examine a particular alternative for mula for price determination to ascertain if the techniques proposed were subject to this criticism. Necessarily, the formula pricing methods are stated in terms that require special definition.
The special meanings
to be used were presented in the introductory chapter. Before proceeding with the investigation itself, it was necessary to describe the pertinent literature covering the various aspects of the problem.
There had been published
from time to time, factual data pertaining to the field of actual price determination.
Hall and Hitch are considered to
105 have made outstanding contributions in this area.
Valuable
information has been presented by the Bureau of Economic Research and Hamilton.
Nourse had surveyed the pricing field
generally that came within the sphere of industry.
Various
governmental bodies has published information to the practices of price setting of products by individual companies.
The
existing literature pertaining to price formulas was indicated. It was pointed out that the literature on marginal analysis was extensive. The limitations of previous studies were set forth and finally, the organization of this study presented. Chapter III was the principal concern of the examination of the full cost method of price determination.
The con
stituents of cost and the use of capacity to determine the trend of the enterprise in the economy was presented.
Having
outlined the general considerations of cost, attention was next directed to expressing the full cost method of price determination in terms of a formula. this formula,
The economic reasons for
so commonly used by the practicing businessman
were investigated.
In general it was found that its basis
rested upon the axiom that the implicit and explicit costs of an enterprise should be returned in the long run if the enterprise was to survive in the economy.
Part of the explicit
costs consisted of an addition for profit to return anticipated
106 implicit costs.
The relation of the objective and subjective
marginal comparisons of a consumer and the price of the pro duct were indicated.
The concept that profit was considered
a residual of the total revenues minus the total explicit costs were indicated.
Thus the full cost method of price
determination had adequate support within the framework of economic analysis. The prevalence of the full cost method of price deter mination in the retailing field and manufacturing field was pointed out. An alternative formula was presented in Chapter IV. The purpose of this chapter was to contrast the alternative formula presented! by William L. Churchill In his book, Pricing for Profit, with the full cost method.
Basically it developed
that the essentials of the alternative formula did not differ from those relating to the full cost method.
The principal
difference lay in the use of the constituents of cost to determine the price of a product and the concept
that an enter
prise should earn a profit over and above that equivalent to Minterest one investment.”
The general formula was presented
and for comparative purposes the elements were rearranged so that parallels could be drawn with the full cost
method. The
rearrangement in no way altered the alternative formula. alternative formula differed from the full cost method of
The
107 price determination in three ways:
(1) It was asserted by
Churchill that his pragmatic investigations of successful corporation led him to the conclusion that business in order to be successful, must earn a "required* profit equivalent to the conversion cost of the product.
Conversion cost was
defined as the direct labor plus the related manufacturing overhead,
(2) Churchill contended that his investigations
led to the conclusion that in order to collect the required profit, a selling effort equivalent to the must be made.
squired" profit
(3) Additionally, he contended that the selling
effort necessary to collect the required profit when sales were made to a jobber was found to be equal to only 50 per cent of the required profit; sales to retailers or other manu facturers required a selling effort of 100 per cent and if sales were made to .personal consumers, the selling effort should equal 200 per cent of the required profit.
With these
basic contentions of Churchill in view, the theoretical con siderations underlying the alternative formula were explored. It was necessary to establish that current economic theory did not preclude the hard fact that business enterprise was entitled to a profit.
The alternative formula did not permit
a taking of profit on either the cost of materials nor the selling effort.
In this respect, the full cost method sanc
tioned this concept.
It was next necessary to establish the
108 basis for the computation of manufacturing overhead predi cated on ttnormalw capacity.
The justification for the
assumptions made by Churchill, while not necessarily proved by independent investigation, were not precluded from con sideration in the light of current economic thought and logical inference. A reconciliation between the full cost method and the alternative method was undertaken.
By presenting the full
cost formula, and abstracting therefrom the cost of materials and selling effort (if known), the full cost method was placed on exactly the same footing as the alternative method, i.e., the profit addition under the full cost method was based upon a percentage mark-up of conversion cost, the same basis es tablished for the alternative method.
The chief difference
lay in the percentage mark-up to be applied.
In the alter
native formula, the percentage mark-up was 100 per cent of conversion cost and in the full cost method an unknown per centage.
In manufacturing industries, the percentage was
rarely over
about 30 per cent although
in one caseit was as
little as 3
per cent and in another as
high as 124per cent.
On the other hand, under mark-up was
the full cost
method, thepercentage
a percentage of the full cost, including material
and labor and manufacturing overhead, while in the alternative method, the percentage mark-up was based on the direct labor
109 and manufacturing overhead, an obviously smaller base. Chapter V presented the theoretical comparisons between prices computed by the full cost method and the alternative method under different conditions.
In both instances, the
same constituents of cost were employed and the mark-up under the full cost method designed to produce the same ultimate price as computed by the alternative method.
Thus a comparison
could be drawn between the two prices computed under the same conditions.
These prices were compared at the beginning and
end of a rise in the general price level of 50 per cent, assuming that the volume of sales did not vary and that all elements of cost were subject to the average general price rise of 50 per cent except for the fixed indirect costs, which value was determined on the original costs involved. This situation was idealized;
it was appreciated that the
elements of cost would unlikely vary exactly as the general price rise but the.t each element of cost would be subject to its own dynamics and only remotely related to the rise in the average general price level. of theoretical illustration,
Nonetheless, for the purposes
the conditions were assumed to
be valid. In a similar manner, comparative prices were computed under the conditions of a declining price level, accompanied by a declining demand.
The results of the investigation were
110 summarized in Table II and the following conclusions drawn. In every instance, the full cost method computed a price that was more nearly equal to the price of the product increased or decreased by the assumed average rising general price level or the average declining price level. surrounding the investigation,
In the situation
the full cost method gave a
better result insofar as price determination was concerned than did the alternative method. The causes of this were carefully traced and it was determined that the cause was solely due to the computation involved in the formulas concerning the fixed indirect costs which were assumed to be predicated on original cost and therefore were unaffected by the average general price rise or decline.
An adjustment was made for this variation and
both formulas produced identical results that were In agree ment with the theoretical price of the product adjusted for the rise or decline of price level. The conclusions suggested to the writer that the greater stability of the full cost method could be incorporated into the alternative price formula.
In order to accomplish
this, a series of new formulas, identified in this study by (8),
(9) and (10), were computed.
This computation was
accomplished by computing X%, the percentage mark-up used in the full cost formula, by means of the alternative formula.
Ill The theoretical computation expressed in terms of the direct labor cost (L), the material cost
(M), the variable indirect
cost (VIC) and the fixed indirect cost (PIC) was presented* The X% percentage mark-up expressed in terms of (M),
(L),
(VIC), and (PIC) was Incorporated in the general expression for the full cost formula. The Appendix and the subsequent sections were a technical demonstration involving an analysis of one of Churchillfs pricing formulas by means of marginal concepts.
This examina
tion was necessary to determine if this alternative formula for pricing could be analyzed by means of marginal concepts and to ascertain if there would be any significant departure from the analysis predicated by marginal.concepts.
If it
developed that there were any significant departures from the results theoretically expected, there would be a major reason for the rejection of Churchill’s formulas on this ground alone. On the other hand, if the results of the pricing structure were in substantial agreement with the expected results indi cated by marginal analysis, this fact alone would not be suf ficient to validate the alternative formulas.
This examination,
therefore, was somewhat negative in approach but nevertheless, was a requisite of the study.
112 CONCLUSIONS The conclusions of this study are summarized in the following paragraphs* This investigation was concerned with the comparative analysis of two formulas used for price determination.
The
full cost formula is a method of price determination frequently used by businessmen.
The alternative formulas developed by
William L. Churchill offered a method of price determination differing in certain essentials from the full cost formula. The economic basis for the full cost method is quite clear.
It consisted primarily of the determination of the
total of the components of cost which included material cost, labor cost, variable indirect costs, fixed indirect cost and selling cost (if known).
To this total was added a percentage
of the total to cover profit addition. had complete support in economic theory.
Its economic basis Particularly the
arbitrary or customary addition for profit could be considered thoroughly consistent with the risk theory of profits; thus, the economic concept that implicit and explicit costs of an enterprise would be returned in the long run, provided the choice of alternative actions open to the entrepreneur were wisely selected was evident.
In addition, the full cost
method has had the sanction of business for many years.
113 Traditional acceptance by businessmen has made its use virtually impregnable. In contrast, the alternative formulas developed by Churchill were markedly different at first examination.
The
first principle difference was the requirement that an enter prise should realize a profit.
It was found that there was
justification for this concept in the framework of current economic thought.
The second principle difference was the
effect of selling costs as related to profit.
That is to say,
Churchill contended that the required profit as computed by his formulas could be earned by the effectiveness of the related selling effort.
While there was sufficient basis for
considering selling costs of an enterprise independent of the other constituents of cost, no justification could be uncovered in current economic theory that supported the con tention that the selling effort should be equal to the required profit.
Turning, therefore, to the investigations of Churchill,
it was developed that this portion of his formula was the results of investigations conducted by him and was therefore empirical in nature.
These investigations were pragmatic
rather than theoretical.
Only one independent source was
found that indicated that the investigations by Churchill relating to this aspect of his formulas, had support in the business world.
On the other hand it could be argued that if
114 selling costs were In fact independent of the other constituents of cost, selling costs should not be included as a part on which to compute profit as is done in the full cost method* It was clear that while there was no positive affirmation of the Idea that selling costs should equal the required profit, at least, this idea was not precluded from consideration. The problem on the inclusion of the cost of materials as part of the base on which profit is computed in the full cost method could be refuted on the basis of logical inference. If then, the cost of material and the selling cost were abstracted from the full cost formula, the remaining portion of the total cost on which to compute profit was the conversion cost.
Conversion cost was the same basis for
computing profit proposed by the alternative formulas.
In
light of these findings it was seen that the only real differ ence between the full cost method and the alternative method was the question of the percentage of mark-up to be applied to the conversion costs.
Churchill contended that this mark
up should be 100 per cent in all cases.
The basis for the
profit computation in the full cost method having been theore tically reduced by the abstraction of the material cost and the selling cost, obviously, would be using a percentage mark up much lower than It should.
The reason that the mark-up was
so low was due to the reduction of the base on which it was computed.
115 It was clearly demonstrated that under the theoretical influence of a changing price level, the full cost
method
predicated prices that were more satisfactory than the same constitutents of cost applied to the alternative formula. In these cases It was patent that the full cost method pro vided a more adequate vehicle for the enterprise to recover its implicit and explicit costs. traced, Invariably, in both formulas.
The reasons for this were
to the fixed indirect costs appearing By making a proper adjustment to the fixed
Indirect costs, both formulas furnished a price equivalent to the theoretical price affected by a changing average general price of the product. The writer then presented three variants of Churchill’s formulas.
The variants of the alternative formulas were com
puted as follows: The full cost formula was equated to the alternative formula and the equation solved for X%.
The price
resulting from the formula was based upon the full cost for mula, using the percentage mark-up, X%, calculated above.
It
was recognized that the modified formula was a technical deviseto exclude untoward influences that might otherwise distort the price as computed by the alternative formula. The limitations of the alternative or modified alter native formulas depended on how valid one considered the basic assumption to be.
The application of unlimited selling costs
116 would be restrained by the law of diminishing returns. Limitation was also implied if Davenport’s contention that part of the implicit cost of an enterprise was a reward for entrepreneur activity, was not accepted. In the field of purely speculative enterprise, economy realities would appear to nullify Churchill’s empirical for mulas.
While it is theoretically possible to apply the
formulas to this type of enterprise, the element of speculation and the estimated revenue from sales would appear to bear little or no relation to the utility value added to the pro duct by labor and overhead expenses. was pointed out in the appendix,
In a similar manner, it
and in Chapter V, markets
whose elasticity of supply was one or less, resulted In the greatest disparity between the market price and the price computed by the alternative formulas. In the appendix,
the examination of the price structure
by means of marginal concepts was a negative approach.
That
is to say, significant departure from the analysis predicted by marginal concepts would tend to invalidate the alternative formulas; substantial agreement would by no means affirm the alternative formulas.
It was demonstrated that there was
substantial agreement between the results predicted by marginal concepts and the actual analysis of prices computed by the alternative formulas, assuming hypothetical cost data and
demand information. The results of the evaluation presented left many areas unexplored.
However,
the results suggested that there was
considerable justification for the use of the alternative formulas and their derived modifications as a substitute for the full cost method.
Independent verification of the ratio
developed in the formulas of Churchill was lacking.
Such a
verification is possible but extended beyond the scope of this study.
A statistical analysis, independent of the
investigations of Churchill, is indicated and it is suggested that such a verification confirming or modifying the empirical formulas be undertaken.
B I B L I O G R A P H Y
BIBLIOGRAPHY Bain, Joe S., Pricing, Distribution, and Employment. Henry Holt and Company, 1948. 496 pp.
New York:
Baker, John Calhoun, Directors and Their Functions. Boston: Division of Research, Graduate School of Business Admini stration, Harvard University, 1945. 144 pp. Bowman, Mary Jean and George Leland Bach, Economic Analysis and Public Policy. New York: Prentice-Hall, Inc., 1943. 935 pp. Bristol, Lee Hastings, Profits in Advance. New York: Harper and Brothers, Publishers, 1932. 180 pp. Chamberlin, Edward H., The Theory of Monopolistic Competition. Cambridge, Mass.: Harvard University Press, 1948. 314 pp. Churchill, William L., Pricing for Profit. Macmillan Company, 1932. 271 pp.
New York: The
Clark, J. Maurice, Studies in the Economics of Overhead. The University of Chicago Press, 1923. 502 pp.
Chicago
Davenport, Herbert Joseph, Value and Distribution. Chicago: The University of Chicago Press, 1908. 582 pp. Eiteman, Wilford J., Price Determination: Business Practice Versus Economic Theory. Ann Arbor, Michigan: School of Business Administration, University of Michigan, Bureau of Business Research, Report no. 16, 1949. 39 pp. Finney, H. A., Principles of Accounting. Intermediate. Third edition; New York: Prentice-Hall, Inc., 1946. 873 pp. Folts, Franklin E . , Introduction to Industrial Management. New York: McGraw-Hill tk>ok Company, 1938. 565 pp. Foster, William Trufant and Waddill Catchings, Profits. Boston: Houghton Miffin Company, 1925. 465 pp. Ghiselli, Edwin E. and Clarence W. Brown, Personnel and Indus trial Psychology. New York: McGraw-Hill Book Company, Inc., 1948. 475 pp. Gordon, Robert Aaron, Business Leadership in the Large Corpora tion. Washington, D . C . : The Brookings Institute, 1945. 369 pp.
119 Greenberg, David B., and Henry Schindall, A Small Store and Independence, New York: Greenberg, Publisher, 1945. 243 pp. Hall, R. L. and C. J. Hitch, Price Theory and Business Behavior. Oxford, England: Oxford Economic Papers no. 2, n.d., n.p. Hamilton, Walton, Price and Price Policy, New York: McGrawHill Book Co., 1938. 565 pp. Hart, Albert Gailard, Anticipations, Uncertalnty, and Dynamic Planning. Chicago: University of Chicago Press, 1940. 98 pp. Heckert, J. Brooks, Business Budgeting and Control. The Ronald Press Company, 1946. 546 pp.
New York:
Kennedy, Donald Dwight, Overhead Costs and the Shift to Machinery. Philadelphia: University of Pennsylvania Press, 1928. 100 pp. Knoeppel, C. E . , Profit Engineering. New York: McGraw-Hill Book Company, Inc., 1933. 326 pp. Knoeppel, C. E . , and Edgar G. Seybold, Managing for Profit. New York: McGraw-Hill Company, Inc., 1937. 343 pp. Marshall, Alfred, Principles of Economics. New York: The Macmillan Company, 1930. Morgan, Theodore, Income and Employment. Hall, Inc., 1947. 280 pp. Neuner, John J. W . , Cost Accounting. Irwin, Inc., 1947. 874 pp.
Eighth edition, 871 pp.
New York: Prentice-
Chicago: Richard D.
Nourse, Edwin G . , Price Making in a Democracy. Washington, D . C . : The Brookings Institute, 1944. 541 pp. Nourse, Edwin G. and Horace B. Drury, Industrial Price Policies and Economic Progress. Washington, D . C . : The Brookings Institute, 1938. 314 pp. Rand, James H., Assuring Business Profits. Publishing Company, 192 6. 245 pp.
Chicago: Forbes
Rautenstrauch, Walter, Successful Control of Profits. Forbes Publishing Company, 1926. 245 pp.
Chicago:
120 Reyburn, Samuel W., For Top Executives Only* Business Bourse, 1936. 382 pp.
New York: The
Shibley, Fred W . , New Way to Net Profits. New York: Harper and Brothers, Publishers, 1928. 213 pp. Smith, Adam, The Wealth of Nations. and Company, 1910. 441 pp.
New York: A. P. Dutton
Sweeney, Henry W . , Stabilized Accounting. , New York and London? Harper and Brothers, Publishers, 193 6. 219 pp. Vaughan, Floyd L., Marketing. Inc., 1942. 639 pp.
New York: Farrar and Rinehart,
Waite, Warren C. and Ralph Cassady, Jr., The Consumer and the Economic Order. New York: McGraw-Hill Company, Inc., 1939. 389 pp. PUBLICATIONS OF LEARNED ORGANIZATIONS Cost Behavior and Price Policy. New York: National Bureau of Economic Research, Price Studies, Number Four, 1943. 353 pp. Ellis, Howard S., editor, “Profits,“ Survey of Contemporary Economics, American Economic Association. Philadelphia: Blakiston Company, 1948. 490 pp. Knapp, C. Howard, Proceedings of the Third Annual Institute of Accounting. Ohio State University, 1940. n.p. ENCYCLOPEDIA ARTICLES Knight, Frank H . , “Profit,11 Encyclopedia of the Social Sciences, XII, 480-487.
A P P E N D I X
EXAMINATION OF ONE OF THE ALTERNATIVE FORMULAS BY MARGINAL CONCEPTS In the appendix sections A, B, C, L, and E, the alternative formula for pricing will be explored by means of marginal concepts.
The modifications indicated in the
preceding chapter will not be introduced in the alternative formula.
The modifications were essentially a technique
adapted for the purpose of compensating for external forces that otherwise would unduly distort the usefulness of the alternative formula without this modification.
The useful
ness of the modified alternative formula depended entirely on the validity of the alternative formula itself and was merely another expression of the same ideas and concepts. If the price structure resulting from the use of the alternative formula is analyzed by means of marginal concepts, it will be determined if there is any significant departure from the results predicted by marginal analysis. developed from the Investigation,
If It
that there were significant
departure from the results theoretically expected, this then would be a major cause for the rejection of Churchill’s for mulas on this ground alone.
On the other hand, if the results
were in substantial agreement,
this fact alone would not be
sufficient reason for validation of the alternative formulas.
122 Therefore, this examination, while negative in approach, is, nevertheless, a sine que non of this study. Appendix A presents an array of data, hypothetical in nature, of the elements of cost of an enterprise and the demand confronting that enterprise.
This data will he fitted
to the alternative formula that is presented and the marginal costs and associated marginal revenue curves ascertained.
A P P E N D I X
A.
HYPOTHETICAL DATA Assumed hypothetical d ata.
It will be assumed that
the firm with which this investigation is concerned is a manufacturing enterprise producing one commodity for sale to retailers and that the price of the commodity will be determined by the pricing formula: P = 3C + M where P is the price, C is the conversion cost and M is the material cost.
It is clear that the cost of the material
and part of the conversion cost, i.e., direct labor, are two of the factors of production for which the firm must bid in a competitive or monopsonistic market.
On the other
hand the price of the commodity will be subject to a demand schedule that can be represented by a horizontal line as in a purely competitive market or as a line sloping downward from the left to the right as would be expected in a mono poly or monopolistic competition.
It will be assumed that
the firm has certain fixed costs and some indirect variable costs• Supply schedule of material.
It was assumed that the
inputs of material are such that one unit of material will be required for one unit of the finished product.
The required
material may be varied from twenty units to one hundred units
124 without difficulty.
The bid price of the material require
ments will vary in accordance with the graphic presentation in Figure 1.
It will be noted that if the material supply
is purely competitive, the prevailing market price of $1.60 will obtain throughout each successive increment up to the requirement of one hundred units, represented by S m i • Curve
of Figure 1 indicates that the bid price will
increase proportionately as more and more units of material are required for the firm.
On the other hand, curve Sm 3 Sm 3
of the same figure indicates that the price of each unit of material will increase at a rate faster than the rate of demand of the firm. Supply schedule of labor. supply is depicted.
In Figure 2, the labor
It was also assumed that one unit of
labor Input was required to complete one unit of finished good.
In a manner similar to the material supply, it will
be observed that the curve S^ i Sl i Indicates a constant price of $1.60 per unit of labor as the labor requirements for increased production are successively increased. and S ^ S i ^ vary in.the same manner for labor cost as the corresponding curves varied for material costs in Figure 1.
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127 Fixed and indirect variable costs.
In this instance,
it is assumed that the fixed costs equal $ 50.00 and will remain fixed throughout the entire range of production. In Figure 3, an assumed graphic representation of indirect variable costs is shown.
It will be noted that such costs
are assumed to increase at a faster rate than the increase of the rate of production. The demand schedule.
It will be assumed that the
firm faces one of three demand schedules.
In referring to
Figure 4 D 3 D 3 can be chosen to represent the demand schedule in a purely competitive market.
That is to say, the market
price will be the same regardless of the output of this firm.
Curve DgDg represents a condition wherein the quan
tity sold will vary in direct proportion to a decrease in price asked.
represents the demand schedule general
ly faced by a n ologopolist or the demand faced by a firm engaged in monopolistic competition.
Summary.
The initial data, hypothetical in nature,
pertaining to the cost components of a fictitious enter prise was presented. • This data consisted of an assumed supply schedule of material, labor, and the associated
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Thusfar, the assumptions made for the hypothetical firm in this study follow the theoretical behavior leading to marginal concepts. Computation of marginal costs.
Table IV indicates
the marginal cost of the hypothetical data without considera tion of the variable indirect costs arising from within the firm.
The cost per unit of input will consist of the
material and labor cost per unit.
It was assumed that a com
petitive price of $1.60 per unit prevailed.
The fixed cost
of $50.00 was added to obtain the total cost and is listed in column 6 of Table IV.
The marginal cost per increase
of ten units of input was computed by the difference between successive total costs per increase of production of ten units The average expediture in column 8 was computed by dividing the sum of the labor and material cost per increase of ten units of production by the total input at that level.
Thus
it was observed that the marginal cost and the average reve nue were equal.
Such a result is expected.
Reference is made to Table V, where the same data was employed but included the variable indirect costs of the firm.
The source was Table III.
A different result developed
It was noted that the Indirect variable costs associated with an increase in input were assumed to Increase in accordance
TABLE IV DATA FOR COMPUTATION OF MARGINAL GOST, TOTAL COST NOT INCLUDING VARIABLE INDIRECT COST
(1) Input
(2) Material
(5) Labor
(4) Total M and L
(5) Fixed cost
(6) Total cost
(7) Marginal cost
(8) Average Expenditure
20
#32.00
$32.00
$64.00
$50.00
$114.00
30
48.00
48.00
96.00
50.00
146.00
$32.00
$32.00
40
64.00
64.00
128.00
50.00
178.00
32.00
32.00
50
80.00
80.00
160.00
50.00
210.00
32.00
32.00
60
96.00
96.00
192.00
50.00
242.00
32.00
32.00
70
112.00
112.00
224.00
50.00
274.00
32.00
32.00
80
128.00
128.00
256.00
50.00
306.00
32.00
32.00
90
144.00
114.00
288.00
50.00
338.00
32.00
32.00
100
160.00
160.00
320.00
50.00
370.00
32.00
32.00
H 03 03
137 with Figure 3.
This appeared to be a realistic assumption
confronting most firms and in most cases these variable in direct costs will increase as a discrete series, not in "smooth curve manner" with the increase in production. Figures 6 and 7 are the graphs of the data in columns 6
and 8 of Table IV and column 3 and 4 of Table V.
Figure 6
indicates an agreement with expectbd results using the data in Table IV.
However, the graph of Table V indicates some
thing quite different from the results expected when a buyer Is purchasing In a competitive market.
The graphic represen
tation in Figure 7 is typical of the graphic representation of a "monopsonistic" buyer.
Figure 7 depicts the typical
relationship between marginal costs and average expenditure of a monopsonistic buyer .4 Graphic representation of MUC and M U R .
In Table VI
the marginal unit revenue and marginal unit costs were com puted.
The results are shown In Figure 8 and Indicate that
the MUG curve will cross the TUC curve at its lowest point* Similarly, the MUC curve will cross the VUC curve at its lowest point.
The most profitable point of operation of the
firm is a production of ninety-five units, determined by the
A
Bowman and Bach, o p . cit., p. 174.
TABLE V DATA FOR COMPUTATION,,OF MARGINAL COST AND AVERAGE EXPENDITURE, TOTAL COST INCLUDING VARIABLE INDIRECT COSTS
(1) Input
(S) Total Cost
(5) Marginal Cost
(4) Average Expenditure #34.40
20
$118.80*
30
154.40
$35.60
34.80
40
186.40
32.00
34.10
50
226.00
39.60
35.20
60
265.60
37.60
35.60
70
502.00
38.40
36.00
80
542.00
40.00
36.50
90
585.90
41.90
37.10
100
450.00
46.10
38.00
* Source: Table III
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169 data was compiled in accordance with the pricing formula; P = 3C + M.- The average price for sale of the product b e lieved to exist by the firm was indicated in column 3, Table XIII, and was taken from the prices shown in Figure 12 for the various outputs.
From the data, the marginal unit
revenue was computed as previously discussed. Price analysis.
In Figure 13, the results were plotted.
The TUC, VTJC and MUC curves were taken from the data in Table XII.
The MUR curve was taken from the data arrayed in
Table XIII.
It was observed that the MUC curve crossed the
MUR curve at about sixty units of output.
This was also the
point at which there was the sharp break in the demand curve, Figure 12, and would result in a very rapid falling off of the firm’s revenue if production was increased beyond this point and price lowered accordingly. In referring to Table XIII, it was observed that at an output of sixty units, there was a slight profit of $1.20. On the other hand, the total cost computed included the “re quired profit.”
This apparent paradox is easily explained.
At an output of sixty units, the theoretical selling price should have been $9.98; this is computed by dividing the total cost at this point by the output at the same point ($598.80
t
60 = $9.98).
However, the estimated sales price
TABLE XIII
COMPUTATION OP MARGINAL UNIT REVENUE OP A HYPOTHETICAL FIRM CONFRONTED WITH AN INELASTIC DEMAND SCHEDULE
(1) Units of Input
(2) Units of Output
(3) Average Price
(4) Total Cost
(5) Total Revenue
(6) Profit
(7) Marginal Revenue
(8) Marginal Unit Revenue
20
20
$10.80
$292.40
$216.00
$-76.40
$106.00
30
30
10.60
367.20
318.00
-49.20
102.00
$10.20
40
40
10.40
431.20
416.00
-15.20
98.00
9.80
50
50
10.20
518.00
510.00
- 8.00
94.00
9.40
60
60
10.00
598.80
600.00
1.20
90.00
9.00
70
70
9.00
682.00
630.00
-52.00
30.00
3.00
80
80
8.00
770.00
640.00
-130.00
10.00
1.00
90
90
7.00
863.70
630.00
-263.70
-10.00
-1.00
100
100
6.00
970.00
600.00
-370.00
-30.00
-3.00
H -a
o
00
00
QQ.
QQ.
- *rli- [ in:
o.o
MUC 00 30
.‘f.O ■ 50 , 60:'
SO ' 90' 100
u U jBtitottt .l'Ui.fe-Jfeg adypcsi.;5iWLSS; XII .eina TCXXI
G R A K H Q F TUC,. VUC
UC, -.AND'
CURVES
OLIGOPOLY AND.MONOPOLISTIC COMPETITION
172 at this point was $10.00 per unit. 12.
This is shown in Figure
The difference of 2 cents per unit will result in a
profit of $1.20 at this volume.
(2 cents per unit multi
plied by sixty units sold.) It was noted that on either side of an output of sixty units, the loss was marked, as computed from the average price.
The loss would be even theoretically larger when it
is remembered that the f irmfs acceptable market price should have been, for example, at an output of twenty units, equal to $14.62 per unit. at that level:
(Total cost divided by the units sold
$292.40
Summary.
t
20 = $14.62.)
Monopolistic competitive and oligopoly
market situations are characteristically subject to an inelas tic demand schedule.
Firms confronted with this type of mar
ket will take into consideration the possible action of rivals should the firm desire to tamper with the existing price structure. In Figure 12, an inelastic demand schedule was depicted, and using data previously assembled in accordance with a pricing formula, a MUR curve predicated upon this demand schedule was constructed.
The results were arrayed in Table
XIII. In Figure 13, the data from Table XIII was plotted graphically. analyzed.
The resulting price and output of the firm was
1
A P P E N D I X
E.
SUMMARY OP APPENDIX In Appendix B the assumed data mentioned in Appendix A was reduced to concrete cost figures; these figures were then applied to the formula and the price resulting analyzed in the case of a pure competitive^ market.
The anomaly of
applying a formula method of pricing to a purely competitive market is not as startling as it would appear because of two reasons.
The first is that orthodox economic approach makes
use to a pure competitive market in order to establish the basic framework for the analysis of more complex market situations.
Secondly, a careful definition of the term
"total cost11 and the concept of an acceptable market price to a large measure removed the apparent contradiction.
This
study assumed that the price computed by the formula repre sented the firm's total cost and that the total cost computed Included a profit requirement necessary for the firm to con tinue to supply the market.
It Is clear that the firm will
examine the prevailing market price in relation to the "total cost" calculated by the formula. Prom the data presented, a MUC and the related MUR curves were ascertained; these results were plotted graphically. Obvious relationships involving marginal concepts were indi cated.
174 Some comment was directed towards the effect of vari able indirect cost arising within the firm and the similarity between the graphic portrayal of this and the textbook graph of a monopsonistic buyer, selling competitively. In Appendix C, the same basic approach was employed as in the case of pure competitive market.
That is to say,
this aspect of the analysis was introduced by defining the market situation of a simple monopolist.
It was made pur
posely broad so that generalizations might be ventured.
It
is apparent that in considering the market situation of mon opoly, oligopoly, and monopolistic competition the function of formula methods of pricing should be significant. The methodology was the same as previously employed. The cost data was reassembled and a price computed by use of the formula, introducing certain modifications.
The MUC and
the associated TOR curves were computed, using an estimated market demand schedule.
The results, graphically plotted,
were analyzed as to price structure by means of marginal analysis.
The obvious relationships were indicated.
The manifold ramifications of monopolistic competition and oligopoly, it was pointed out in Appendix D, were beyond the scope of this investigation.
From the point of view of
formula methods of pricing, the demand schedule Is of major importance.
Typically, in monopolistic competition and
175 oligopoly, the demand schedule is inelastic; the tendency for the development of price stability is well known. By assuming an artifical demand schedule illustrated in Figure 12, a series of assumed prices was developed.
Such
a price schedule was the estimated demand confronting the firm.
Using the same cost figures that produced a total cost
in accordance with the formula of pricing employed in the investigation of simple monopoly, the MUC curve was graphi cally depicted in Figure 13.
The related MUR curve was
calculated and imposed on the same graph. ture was interpreted by means of the graph.
Gf southern California
The price struc