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4: The pros and cons of marginal pricing

20th February 1970
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Page 38, 20th February 1970 — 4: The pros and cons of marginal pricing
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Which of the following most accurately describes the problem?

THE LACK of an effective pricing policy could be the biggest single factor contributing to the present-day state of the freight transport industry.

Pricing always appears to be the answer to the industry's problems. Keep rates low and get the traffic, it is said, charge high rates for a premium service, get anything at all for the back load, low profits and big turnover, the more traffic you (especially railways) carry the cheaper it becomes therefore charge low rates, charge on cost-plus basis, charge market rates. Yet none of these cliche pricing policies seems to provide a solution.

The reason is that pricing is frequently treated in isolation and not as part of the total marketing operation. Price is all too often seen as something set by others and over which an individual company has no control, but in fact it is necessary for each individual company or organization to have a sound pricing policy if it is to recover the costs of the services provided and obtain an adequate profit for itself.

The implications of this last statement are that total revenue shall exceed total cost and therefore it seems logical that prices should take account of costs of operation. But the vexing thing is that in the competitive transport situation the prices you can charge are seldom under your entire control, and while by strong marketing you may be able to manipulate charges over a wide range, the outside limits of that range are generally set by the prices being charged by all the other operators in the same field.

You may opt out of this situation by always quoting on a cost-plus basis (assuming true costs are always known at the precise time!) but by doing so you will not maximize profits. Let me illustrate this with an example.

The cost per ton in this hypothetical situation reduces proportionately as the size of the consignment increases and you charge on a basis of cost plus 20 per cent At 20 tons your costs are 30s. and your rate 36s., but consignors are generally paying the market rate of 38s. If you stick to your cost-plus principle you will be charging 2s a ton less than customers are generally willing to pay. At 15 tons your cost is 35s and therefore your rate 42s, but it so happens that for this weight of consignment consignors are generally paying 40s. Therefore, all things being equal, although 40s would have given you some profit you will not secure the traffic at all at 42s.

So that maintaining a strict cost-plus pricing policy will probably result, at one end of the scale, in profitable traffic not being secured because your prices are too high, and at the other end of the scale traffic being carried at prices lower than they need be.

While, therefore, costs have some relevance to pricing policy your prices are fixed, within a range, by the prices of similar services available to the buyer. The extent to which you are able to charge above the market rate may depend on your marketing policy, e.g. strong selling and advertising, but nevertheless there is a limit to the variations in prices for similar services.

The three market factors that have the most influence on rate levels are (i) the kinds of goods to be carried, (ii) the quantity of goods, and (iii) the kind of service required.

Generally speaking, for large quantities of traffic the price per unit tends to be less than for small quantities and therefore factor (ii) can be regarded, at this stage, as a constant, but factors (i) and (iii) are variants and interrelated in that the price for carrying a certain commodity is affected by the kind of service required and conversely the price for a certain kind of service will depend on the commodity being carried.

To illustrate the point I have shown below an arbitrary set of value indices from 1 to 10 for a set of service requirements:— Regular inter-factory or depot movements Regular traffic with high standard of service but of routine nature Import movements from ports 2 Regular traffic with high standard of service and lots of day-to-day attention required 5 Export traffic to ports 7 Occasional loads requiring an average service 7 Multiple drop and parcels 8 "Personal" service to customers 9 Occasional loads requiring good service 10 What I am saying here is that, all things being equal, customers are generally willing to pay high rates for occasional loads requiring a high standard of service in contrast to very low rates for regular inter-factory or factory-depot movements.

Below is given a similarly arbitrary scale c values for different commodities an traffics:— Extracted raw materials • Low value-per-unit consumer goods, e.g. grocery products Semi-processed materials (low value) Waste products Semi-processed materials (high value) Bulk commodities requiring special vehicles Machinery and high value consumer goods 1 Goods requiring custom built vehicles 1 By applying these (or other) values one ca assess the relationship of market rates ft different traffics and service requirement For example, for regular factory to dep( movement of grocery products one Woul not expect to command a high rate (4/20 yet a high standard of service for spasmod movement of machinery or high-yak durables can command a high rate (20/20 At first glance one could say the walla reflect the costs of providing the type of se vice required and therefore support ti argument that prices should be based strict on cost, but this is not a valid argument. is true that the costs (per unit) of providir a service giving a high standard to occasion loads must be higher than the unit costs regular daily factory-depot movements bo iere is both a separate cost structure and a eparate market for each type of service, and le fact that the price for one type of service my be 10 per cent higher than cost does not lean that the same constant will or need pply to other services. The price for any one ind of service is still affected by what ustomers are paying for a similar kind of rvice, and by the extent you are able to ifferentiate your service.

These tables are in no way a guide to best" traffics as it will be realized that it

eft: Plate glass is a commodity requiring a rstom-built vehicle and this affects transport costs. his is also a commodity which can be classed as an !cash:mai load requiring good service. These two ctors would give the traffic a high cost rating and insequently such traffic, as here, is carried on vn-accouni or Contract A transport.

dow: The BRS contract traffic from General Foods 4, of Banbury, demands a high standard of service rd day-ro-day attention. This pats it in the five-point lue bracket but there is a balancing factor—it does ,t require a special body.

ay be more profitable to carry a large count of low profit-per-unit traffic than to trry occasional loads at high prices, but e shown merely to highlight the interaction commodity, quantity and service on prices.

rites policy In a situation, therefore, where price nges for different services tend to reflect e cost of providing those services but where e actual price obtained is dependent to a -ge extent on what others are charging, at does the freight operator do to ensure secures traffic at rates that give him an equate return?

First, it is necessary for him to separately unify the special kind of service or services is providing and to make himself aware of e prices generally being paid for each of ose kinds of services.

An operator who provides both a customsigned service for the regular traffic of a .ge manufacturer may also provide a gular trun king service between principal ies. It is likely, therefore, that some of the .sts of operation are shared jointly between e two services, at least such costs as anagement, marketing, administration and .ssibly certain labour and vehicle costs, but !. rates charged for each kind of service 3 likely to be quite different.

He must then decide what price-level ficy he is going to pursue. He may decide to arge more than market and back this up th a strong service element, aggressive selling and advertising, ancillary services, etc., so that the service is marketed at a premium, and he established himself as a price leader and becomes traffic selective, or he may go for the opposite end of the price scale and charge low rates and provide a service with a minimum of trimmings. Alternatively. he may accept the market rates on offer and rely for profits entirely by concentrating on cost reduction, .

Having decided what rates to charge for his services or each of his services, he should calculate an optimum (tonnage) throughput of traffic which when multiplied by the rates Will give him not less than the minimum acceptable level of profit. If that optimum level is not reached or maintained then action will have to be taken to redress the situation.

This could take the form of stepping up selling and advertising or reducing overall capacity, i.e. by varying the marketing "mix". The shorter the period over which the

Marginal pricing: 13 lock A represents the weekly tonnage capacity for one vehicle (70 tons). The planned tonnage c at ordinary rates will produce the planned level of profits and therefore the remaining capacity (20 tons) can be sold at lower rates so long as out-of-pocket expenses are covered. But beyond point d an additional vehicle would be required and while capacity is doubled (block B) the planned tonnage at ordinary rates is also doubled, and marginal pricing cannot then be undertaken until 100 tons a week at ordinary rates is being achieved. This is merely to illustrate that whenever additional capacity has to be provided, the level below which marginal pricing should not be used automatically rises.

measurement is taken, the easier it is to take remedial action.

When that optimum level is reached marginal pricing can (in theory) be adopted for any additional traffic that can be carried within the existing capacity.

Marginal pricing The principle of marginal costing and pricing is based on the premise that for any traffic additional to that already being carried the costs incurred are confined to the additional costs resulting from carrying that extra traffic. To put it at its simplest, it is the theory that the cost of putting an extra wagon on the back of a train is negligible.

Marginal costing and pricing has a strong

appeal because of its apparent simplicity and "logicality" ("anything at all is better than running back empty") yet unless it is fully understood and its application rigidly controlled it can have very harmful effects on individual operators and the freight industry as a whole.

Marginal pricing dangers The dangers of uncontrolled marginal pricing are twofold—to the operator himself and to the general level of freight rates.

The danger for the operator lies in the fact he is frequently apparently depending on marginal pricing (which is typified in knockdown rates for back loading) to give him his ordinary profit instead of resorting to marginal pricing to give him super-profits. This is assumed from the low overall profitability of the road haulage industry and the proliferation of back-loading rates available on high-density routes.

It is necessary to define a back load in the marginal price context. If traffic is carried in both directions as a planned and predetermined operation then the lower costs resulting from this balanced working will be taken into account when arriving at the rate to be charged. But if a return load is purely for tuitous, i.e. was not predetermined, this is a back load. If the operator can be reasonably certain of getting unplanned return loads that will not seriously affect his main operations and can forecast his costs and revenues from those back loads this can be taken into account in his total cost/revenue profit plan, but by definition it is unlikely that back load tonnage and revenue can (a) be accurately forecast and (b) be obtained without seriously affecting the maintenance of schedules.

Normal profits can only be achieved if they are planned profits and so cost and revenue flows that will produce those profits must be known and controlled.

Therefore an operator should seek to obtain his normal profits on those services and traffics that are planned and in the absence of a planned return load all costs should be allocated to the one way journey only, and the rates charged on that journey should be sufficient to cover those costs and give a profit. Only at this point does marginal pricing become a sound policy.

To put it in a nutshell—profits, to be achieved, must be planned for and therefore the two profit components, cost and income, must be controlled to the point of an acceptable profit level. When that level is reached additional (super) profits can be obtained by marginal pricing, but only up to the point at which existing capacity is filled.

This is a counsel of perfection and in the cut and thrust world of transport the ideal is seldom attainable, but I have attempted to strip the problem down so that it can be seen for what it is, and tried to destroy a few pricing myths in the process.

Resorting to marginal pricing inevitably has an effect on the total market rates struc ture. Once a customer has tasted a low rate he wants to keep it and what was originally regarded as an exception becomes the rule and therefore if reduced rates are to be charged to fill marginal capacity they should be effectively identified and isolated from regular traffic flows.

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