Create and answer a case study similar to Memo 12 from Time Warner (Most Relevant Chapters 1, 8, and 11) that uses a cost-benefit analysis in determining what products or programs to keep. - Salli Horst
Final Wiki Paper Background
Martha Jane is a stay at home mom to a 1 year old daughter. She would like to earn extra money for the family. She has previously made custom dog beds for friends and would like to know if it would be profitable to make the dog beds for extra income. Martha Jane takes old suitcases and repurposes them into one of a kind dog beds. The suitcases come from auctions, yard sales and thrift stores. The remainder of the supplies can easily be purchased. The average cost of a dog bed is $50 for labor and materials. She would sell the dog beds at craft fairs and through the Etsy website. Etsy charges $.20 per item listed and then gets 3.5% of the sale as a fee.
Martha Jane has also been approached by a former employer that would like her to come back and work part-time. She would work 2 days a week for a total of 16 hours. The job pays $10 an hour. If Martha Jane would take the part time job she would have to put her daughter in daycare that would cost $30 a day.
Which option would be more profitable for Martha Jane?
Discussion
Per Dog Bed
Sales Price
$100.00
Materials
$50.00
Etsy Charges (.20 + 3.5%)
$3.70
Profit
$46.30
*taxes not taken into consideration
Part Time Job (per week)
Wages ($10hr/16 hrs)
$160.00
Daycare
$60.00
Commuting Expense
$20.00
Balance
$80.00
*taxes not taken into consideration
The US pet industry currently brings in $50.8 billion a year and has increased every year since 2002. A large portion of pet owners consider their pets part of the family and purchase more than just food for their pet. “While humans are not the end user of pet products, they are the ones making the purchase decision, so it makes sense that products are developed with humans in mind as much as animals.” Pet owners are purchasing “lifestyle products” for their pets that reflect the owner’s personality. (Irwin, 2011) A custom dog bed fits perfectly into a “lifestyle product.”
The accounting profit for Martha Jane is listed in the charts above. Accounting profit is the price of the product times the amount sold. Economic profit is the accounting profit minus the opportunity cost. (Baye, 2010) In this case the accounting profit per dog bed is $46.30. If Martha Jane takes into consideration the economic profit she must consider the opportunity cost. Opportunity cost is “the cost of the explicit and implicit resources that are forgone when a decision is made.” (Baye, 2010)
Explicit costs are easier to evaluate than implicit costs. Investopedia (2011) defines accounting costs as “A business expense that is easily identified and accounted for. Explicit costs represent clear, obvious cash outflows from a business that reduce its bottom-line profitability.” And implicit costs as “a __cost__ that is represented by lost opportunity in the use of a company's own resources, excluding cash.” In Martha Jane’s situation the implicit costs of taking the job could include the time away from home, the inability to educate her child while she is in daycare and the mother is at work.
Dr. Porter (2008) who created The Five Forces Framework lists the forces as, Entry, Power of Buyers, Substitutes and Complements, Industry Rivalry and Power of Input Suppliers. He has also updated his framework to include four additional forces – savvy customers, powerful suppliers, aspiring entrants and substitute offerings. (Porter, 2008) For Martha Jane’s case there are no barriers to entry. She can easily set up her small business or close it down. For power of buyers there is a fairly small niche market for the type of dog bed that she would sell. There are substitutes available and there are no customer switching costs. The supplies that would be needed to create the dog bed are all readily available. Only the old suitcases would be an item that had to be located and would be at yard sales and auctions. In these cases the power of the suppliers would be limited. Finally, for industry rivalry this is a small enough segment of the market that the items are fairly differentiated, and which bed is purchased will be determined by the preferences of the buyer.
Dr. Porter (2008) suggests that you “position your company where forces are weakest, exploit changes in the forces, reshape the forces in your favor.” In Martha Jane’s case she would be offering a unique dog bed. There would be substitutes available, but nothing identical to Martha Jane’s creation. Each dog bed would be unique.
Buyer power is “the ability of a buyer to reduce price profitability below a supplier’s normal selling price, or more generally the ability to obtain terms of supply more favorable than a supplier’s normal terms.” (Zhiqi, 2008) Since Martha Jane would also sell her dog beds at craft fairs, buyers would be able to negotiate with Martha Jane on the price of her dog bed. Otherwise, when the dog beds are posted on Etsy the price charged is the price listed, and Martha Jane will not negotiate on the price.
A custom dog bed would be fairly elastic in demand. Baye (2010) defines elasticity as “a measure of the responsiveness of one variable to changes in another variable; the percentage change in one variable that arises due to a given percentage change in another variable,” or in layman’s terms, the change in the number of dog beds that Martha Jane would sell if the price would increase or decrease. A custom dog bed is not a necessity for a pet. It is a luxury item. If the price of the dog bed was too high, customers may choose an alternative type of dog bed for their pet.
Own Price Elasticity Equation
EQx,Px = %êQXd/%êPx
Qxd is the percentage change in the quantity demanded
Px is the percentage change in the price
“Basic economic theory predicts that a consumer’s willingness to pay for a good is affected by the availability of complements and substitutes.” (Rousu, Beach & Corrigan, 2008) The availability of substitutes affects the elasticity of an item. There are many substitutes available for a dog bed. All that is required is an internet search, and the consumer will be provided with a multitude of choices, from inexpensive fiberfill dog beds to very expensive dog beds that resemble custom furniture.
Investopedia (2011) defines a normal good as “the quantity demanded for a particular good or service as a result of change in the given level of income. A normal good is one that experiences an increase in demand as the real income of an individual or economy increases.” A custom dog bed is a normal good. This also means that a decrease in the consumer’s income will lead to a decrease in the sale of custom dog beds.
In order to obtain the supplies needed to make the dog beds, Martha Jane would participate in a spot exchange. This means Martha Jane would have an informal relationship with the seller and would be able to purchase the item and not have to adhere to a contract. (Baye, 2010) With Martha Jane being a small business with a low supply, there is no reason for her to have a contract for any of her inputs.
Once Martha Jane has started her business, she will have to determine how much to charge for her custom dog beds. There is a formula to determine the markup to maximize profit, but the segment of the market that Martha Jane would cater to is too specific to determine the own-price elasticity. Baye (2010) indicates that most home producers who sell their items at crafts fairs typically charge between 1.5 and 5 times their marginal cost. Martha Jane has researched similar type dog beds and had determined to charge 2 times her marginal cost.
Markup Equation for Monopolistic Competition
P = [Ef/ (1+Ef)] MC
Ef is the own-price elasticity of demand for the firm’s product
MC is the firm’s marginal cost
Martha Jane’s dog bed business meets the requirement for monopolistic competition. Monopolistic Competition is defined as “a market in which (1) there are many buyers and sellers; (2) each firm produces a differentiated product; and (3) there is free entry and exit.” (Baye, 2010) The essential feature of monopolistic competition is product differentiation. (Woo, 2011) Woo (2011) also states that “by advertising (or creating) distinguishing features of products, firms not only generate differentiation in products but also make these products more likely to be used as positional goods.” Essentially, the custom dog bed would be a “status symbol.” Not every dog owner is going to be willing to pay the additional cost a custom dog bed would demand.
Martha Jane will need to differentiate her product from all the other dog beds in the marketplace. The internet is a good tool to market her specific product. Besides offering her dog beds on Etsy, she could create a Facebook page and take custom orders to match the buyer’s décor of their home. The internet allows for a personalized shopping experience that previously was ignored when companies started to focus on mass marketing. (Montgomery, 2001) A business like Martha Jane’s would not have been available to people outside of the craft fairs, as this type of business does not have the budget for a big marketing campaign. By tailoring her product to a specific market segment, Martha Jane will be participating in niche marketing. (Baye, 2010)
With limited credit being available and lower demand for their products, the recent economic crisis hit small businesses hard, more so than large businesses. (Sahin, Kitao, Cororaton & Laiu, 2011) Martha Jane will have to take into consideration how big of a market there is for her custom dog beds. At this time, she does not see that there will be a need for any credit as she only plans to have a few dog beds in inventory at a time.
Recommendations
Martha Jane’s underlying goal is to make some additional money for her family. The part time job would gross $320 a month in accounting profit. The time away from her family is difficult to gauge in a dollar figure to determine economic profit. In order to make the same amount of money each month on the dog bed business, Martha Jane would have to sell 7 dog beds for an accounting profit of $324.10. With the current economic climate she may have difficulty consistently selling this many dog beds each month.
If she looked strictly at accounting profit and the likely number of dog beds sold in a month, the most profitable option would be to take the part-time job. Martha Jane’s main determining factor in making her decision between the two options will be the value she places on spending additional time with her young child as compared to the guarantee of specific income each month.
Multiple Choice Questions
1. Which choice is one of Porter’s Five Forces?
a. Niche marketing
b. Power of Buyers
c. Taxes
d. Research & Development
2. Which is a marketing strategy where goods and services are made specifically to meet the needs of a particular type of consumer? a. Comparative advertising b. Brand equity c. Niche marketing d. Green marketing
3. Which is a market where there are many buyers and sellers, each company sells a product that can be distinguished from products another company sells; and there is free entry and exit to the market.
a. Monopolistic competition
b. Perfect competition
c. Monopoly
d. Oligopoly
4. The change in quantity demanded compared to the change in price.
a. Log-linear demand
b. Cross price elasticity
c. Income elasticity
d. Own price elasticity
5. Which does not take into consideration the opportunity costs.
a. Economic profits
b. Implicit cost
c. Accounting profit
d. Explicit cost
Answers:
1. b – Power of Buyers - Porter's Five Forces includes Entry, Power of Buyers, Substitutes and Complements, Industry Rivalry and Power of Input Suppliers
2. c – Niche marketing - a marketing strategy where goods and services are made specifically to meet the needs of a particular type of consumer
3. a – Monopolistic competition - market where there are many buyers and sellers, each company sells a product that can be distinguished from products another company sells; and there is free entry and exit to the market.
4. d – Own price elasticity - how much the quantity demanded decreases(increases) when the price increases(decreases).
5. c – Accounting profit - the amount taken in from sales - price times quantity sold. Opportunity cost is considered in economic profit.
References
Baye, M. R. (2010). Managerial economics and business strategy (7th ed.). New York: McGraw-Hill/Irwin.
Rousu, M. C., Beach, R. H., & Corrigan, J. R. (2008). The Effects of Selling Complements and Substitutes on Consumer Willingness to Pay: Evidence from a Laboratory Experiment. Canadian Journal Of Agricultural Economics, 56(2), 179-194. doi:10.1111/j.1744-7976.2008.00124.x
Şahin, A., Kitao, S., Cororaton, A., & Laiu, S. (2011). Why Small Businesses Were Hit Harder by the Recent Recession. Current Issues In Economics & Finance, 17(4), 1-7.
Woo, W. (2011). Status and welfare under monopolistic competition. Social Choice & Welfare, 36(2), 227-239. doi:10.1007/s00355-010-0472-7
Zhiqi, C. (2008). Defining buyer power. Antitrust Bulletin, 53(2), 241-249.
Week of November 28, 2011 Blog
In a prior post I discussed the current trade deficit with China and how the cost savings of production in China is slowly eroding and production will move back to the United States.
In a recent Star Tribune article they discussed recent trade agreements that President Obama signed with Panama, Colombia and South Korea. The Star Tribune is located in Minnesota and exports quite a bit to South Korea. They mention that prior to the trade agreements being signed that exports from the European Union had increased 30 percent to South Korea.
Minnesota also exports soybeans to Colombia and had lost more than $60 million between 2008 and 2010 due to trade pacts between Canada and Argentina.
The article goes on to question if these new trade agreements will create more jobs in the US? The article concludes with the statement “the problem with trade is that the losses are often immediate and somewhat easy to tally, while the benefits may be decades in the making.”
Health care reform is a hot button topic and I’m sure will be discussed even more in the upcoming Presidential election.
A study published in the journal Neurology examined the cost vs benefit of disease-modifying drugs (DMD’s) that are used to treat multiple sclerosis.
The study states that these drugs cost around $3,000 a month in the U.S. Per the study a patient would gain an extra two months or less of good heath from using these drugs compared to other treatments that are used to treat symptoms of MS. They study estimates that DMD’s cost around $1 million for each year of “relatively healthy life” for a person with MS after 10 years of use.
The article goes on to further state that a common definition of “cost-effective’ treatment is between $50,000 and $150,000 for each good-quality year of life gained. The lead researcher of the study, Katia Noyes, stated that “this study was not designed to try to deprive people with MS of any therapy. It was not intended to tell doctors what to prescribe or insurance companies what to pay for.”
She does point out that with the current climate of health care reform that we need to look at the value of different therapies and consider their cost-effectiveness for patients.
How many of you recycle at home? At work or school you may see recycling boxes or containers for paper, plastic, cans, etc. Besides being good for the environment it can be cost beneficial.
In my local area, as a cost cutting measure, they scaled back the recycling program stating it was costing the city more money to operate it than they could sell the recycled items. They no longer take glass and closed down the drop off location. You can only do curbside pickup, which is complicated. They only pick up certain items on alternating weeks. Recycling should be easy in order to encourage people to participate.
It has been shown that well run recycling programs cost less then to send trash to a landfill. I’m not sure that the city took this into consideration as the cost to have a bag of trash picked up is passed on to the consumer and recently more than doubled. It has also been shown that economies of scale comes into play with recycling and that as more people that recycle the cheaper it gets.
New York City originally wanted to do away with recycling, stating it cost $40 million a year to operate, has now streamlined their recycling program so that it is efficient and it now saves the city $20 million a year.
The EPA states “A well-run curbside recycling program can cost anywhere from $50 to more than $150 per ton…trash collection and disposal programs, on the other hand, cost anywhere from $70 to more than $200 per ton. This demonstrates that, while there’s still room for improvements, recycling can be cost-effective.”
The University of Oregon did a cost benefit analysis of recycling on campus. They saw their savings grow from $96,132.41 in 1992 to $257,723.60 in 2009.
The local city government should look at ways to make the recycling program more efficient instead of cutting back or doing away with it entirely.
Anyone who flies know that airport security is a hassle. Now there is a proposal to increase the security fee that you pay when you purchase a plane ticket.
The New York Times states that passengers currently pay $2.50 security fee for each segment of a trip, up to a maximum of $10 for a round trip ticket. The increase in fees was included in the deficit reduction plan which would make the fee up to $15 for a round trip ticket.
When Congress created the TSA (Transportation Security Administration) after the September 2001 terrorist attacks the intention was to recover the costs of the TSA through passenger fees and a separate security fee paid by the airlines, but the fees have not increased to cover the security costs and the additional costs have been shifted over to the general tax payer.
Of course there has been some controversy about increasing the fee. No one likes paying more for a plane ticket. Especially with the increases in fuel costs in recent years that has made the cost of flying go up.
Robert Poole, director of transportation policy at the Reason Foundation, has studies how aviation security is financed in other countries and agrees it is fair that users should pay for the security costs, instead of the general taxpayer.
Mr. Pool does think that the TSA does a lot of “wasteful spending.” That if the security fee does increase that passengers are going to be more concerned in how the money is spent.
The Governmental Accountability Office has issued reports showing that the TSA has a tendency to purchase equipment without doing a cost-benefit analysis. For example the “air puffer” machines that were used to detect explosives; they were known to break down frequently. Baggage scanning machines that don’t meet current explosives detection standard and the $750 million spent on behavioral detection officers.
Stephen Lord, director of homeland security issues at the GAO stated “Usually you validate a concept and then you field it, but they deployed the program and then they started validating it, which we have some concerns about.”
There is no question that airport security is important. I know I want to make it to my destination safely, but I also want the money spent wisely that I pay for a security fee.
Hewlett-Packard announced last Thursday that they have decided to keep their personal computer unit after extensive review. Originally they had announced they were going to spin off the personal computer unit.
They announced in August that they were going away from the consumer market and looking at alternatives for its Personal Systems Group.
The CEO said the company was “stronger with the unit” due to their supply chain and procurement.
Obviously HP did a cost-benefit analysis in regards to spinning off the personal computer unit. The second article indicates that spinning off the unit would have cost HP over $1 billion annually.
Robert S Adler, a commissioner for the Consumer Product Safety Commission, wrote an op-ed piece for the New York Times last week about how politicians in Washington feel about cost-benefit analysis.
He states that the House of Representatives has created an independent committee to conduct cost-benefit analysis of regulations proposed by the EPA, even though the EPA already does its own analyses. He points out that all executive agencies under a Presidential directive currently do their own analyses.
At his own agency he says they have been contacted by politicians and business to cut back on their regulations to “jump start” the economy. He says they are told the way to do this is to do an elaborate-cost benefit analysis on everything they do, referring to it as “paralysis by analysis.”
The Consumer Product Safety Commission writes safety rules to eliminate or reduce deaths and injuries by consumers. They estimate that roughly 31,000 people die and 34 million people suffer product-related injuries every year. This translates to costs of approximately $200 billion annually. He also points out that product-related tragedies almost always result in lost economic productivity.
He contends that “anyone who insists that regulations necessarily impose new costs on society shouldn’t be taken seriously. The costs are already there, in the form of deaths and injuries – and are often as much of a drag on our economy as any safety rule. So the real issue is who should bear the costs.”
In conclusion he objects that many of those who want extensive cost-benefit analysis have no concern that the regulation be more focused or rational. They only want to consider the cost to the businesses, not the benefits to the consumers.
Anyone ever checked the tag of the item they are currently using to see where it is made? Most likely it says China. At one time I took a friend’s challenge to see if I could do my Wal-Mart list without buying anything made in China. The result? I couldn’t do it.
The Journal of Commerce recently had an article stating that manufacturing will most likely shift away from China in the next few years and could create up to 3 million jobs in the US.
The cause is that labor costs in China are rapidly rising and the increase in the value of the Chinese currency against the US dollar. This reduces the benefits of having the product manufactured in China.
The article indicates that within the next 5 years that the cost will only be 10 to 15 percent less in China that manufacturing the product in the US, and that is before shipping costs.
The industries most likely to see production coming back to the US include transportation goods, electrical equipment, appliances, furniture, plastics, and rubber products. Boston Consulting Group states that the shift of production back to the US could lower the non-oil trade deficit by 20 to 35 percent and add $100 billion to the US economy.
As we can see the lower costs of shifting production to China are no longer going to provide the benefit that the companies desire in order to maximize profits.
Week of October 10, 2011 – Time Warner Case Study Discussion
Background Memo
Memo 12
To: Pricing Department
From: Regional Manager, Region 3
Re: New Channel Lineup
We are thinking of adding three networks to our basic lineup: Bravo, ESPNews, and MTV2. Each of these networks would charge us programming fees on a per subscriber basis, as follows:
Bravo – 8 cents per subscriber per month
ESPNews – 10 cents per subscriber per month
MTV2 – 7.5 cents per subscriber per month
To offset a portion of these fees, each network would allow us to sell some local advertising time on their networks. Based on current network ratings, our advertising department estimates that the monthly advertising revenues earned would amount to $1,200 on Bravo, $1,500 on ESPNews and $1,200 on MTV2.
Approximately 46 percent of the 110,000 customers in Regional 3 market currently subscribe to our basic services. Anytime the basic channel lineup is adjusted, there is a shift in the number of customers who take the basic cable package. We tend to loose a few channel loyal customers anytime we drop a channel, and likewise, gain a new group when a channel is added. Our marketing department has provided estimates on the number of loyal customers for each channel. This represents an estimate of the number of cable customers we will lose if we drop a particular network. Likewise, it also provides an estimate of the number we can gain by adding a new channel. Currently, we do not have the capacity to add new channels to our basic lineup without dropping existing channels. Our marketing department estimates the following increases in subscribers by adding these new channels: Bravo – 150, ESPNews – 300, and MTV2 – 225. Our current pricing (not including taxes) for the basic package is $34.99 per month. Our programming fees for the basic package total $14.55 per month.
The current basic cable lineup is attached. The list only includes networks that could be feasibly be replaced. It excludes channels that must be retained due to governmental regulation (local access channels, etc) as well as broadcast networks.
Using the information, please make a recommendation for whether we should add any of the proposed networks to our basic package.
Discussion
The solution provided by Dr. Horowitz included some figures that are not listed in the book and apparently are on an Excel spreadsheet that did not come with the book.
With the additional figures it shows that ESPN and TNT have high monthly subscriber costs, but generate fees from advertising and subscriptions that offset the programming fees. It also indicates that Biography and the Game Show Network only add very low profits.
Since they are unable to add any channels without deleting current channels there is an opportunity cost to changing the channel lineup. They can drop the Biography Channel ($2,746) and the Game Show Network ($2,198.40) for a total of $4.944.00. Since MTV2 contributes $9,055.88 to profit it should replace the Game Show Network. ESPNews ($11,967) should replace Biography ($2,746) since it increases profits by $9,221.
The total change in profit by replacing Biography and The Game Show Network with MTV2 and ESPNews would increase profits on the basic cable lineup by $16,078.48.
Revenues from
Total Monthly
Profit
Subscriptions
Program Fee
and Advertising
ESPN
$357,900.00
$6,000.00
$351,900.00
TNT
$84,478.00
$550.00
$83,928.00
Biography
$2,750.00
$3.50
$2,746.00
Game Show Network
$2,200.00
$1.20
$2,198.40
Bravo
$6,449.00
$12.00
$6,436.50
ESPNews
$11,997.00
$30.00
$11,967.00
MTV2
$9,073.00
$16.88
$9,055.88
References
Baye, M. R. (2010). Managerial economics and business strategy (7th ed.). New York: McGraw-Hill/Irwin. Week of October 3, 2011 Blog
In 2007 a study was conducted to see if it would be beneficial for a wind farm to be built at the United States Military Academy at West Point, NY.
In the proposal the site would remain federally owned with a developer owning and operating the wind farm. There would be no “up front” costs to the military. At present all of the installation’s electricity is purchased from the local utility. If the wind farm were to be built it would be able to provide approximately 25% of their electrical needs.
The study indicated that using 2008 figures the annual cost savings would be $1,734,820. They also concluded that as long as the cost to purchase wind power was less than $.15/kWH it was economically feasible.
At the time the article was written in 2010 the authors stated that the project had not progressed from the study stage.
Ever wondered what the most environmentally friendly vehicle was for the cost (cost/benefit analysis)? Business Fleet decided to answer that question by having popular fleet vehicles tested to determine the cost of the vehicles vs. the environmental savings. They tested greenhouse gas emissions and smog emissions against the total lifetime cost of the vehicle. Their results show that the Toyota Prius won “hands down,” even though it has a higher price to purchase. Some companies simply look at the “dollars and cents” of purchasing fleet vehicles. How much for the vehicle, the maintenance, the fuel mileage, etc. Depending on corporate culture they may prefer to buy more environmentally friendly vehicles, even though they have an increased cost. If you would like to see the complete listing of the vehicles tested you can click the link below.
I looked for some additional information to see if I could find firm figures on the true additional cost of a green vehicle to see if it actually saved the company money. I was not able to find any firm figures on what companies with large fleets spend on vehicles and their cost per mile. Greenfleet magazine (link below) had an article on the “Real-World Hybrid Fleet Operating Expenses.” The companies interviewed have had hybrid vehicles in their fleet for multiple years. They are seeing an increase in fuel mileage, which is important due to the large fluctuation in gas prices the last few years. The fleet manager for EMD Millipore says that the cost to purchase is more, but it is offset with the higher fuel mileage.
It appears that a “green” vehicle in the right situation can be a cost savings and not just a public relations device.
- Salli Horst
Final Wiki Paper
Background
Martha Jane is a stay at home mom to a 1 year old daughter. She would like to earn extra money for the family. She has previously made custom dog beds for friends and would like to know if it would be profitable to make the dog beds for extra income. Martha Jane takes old suitcases and repurposes them into one of a kind dog beds. The suitcases come from auctions, yard sales and thrift stores. The remainder of the supplies can easily be purchased. The average cost of a dog bed is $50 for labor and materials. She would sell the dog beds at craft fairs and through the Etsy website. Etsy charges $.20 per item listed and then gets 3.5% of the sale as a fee.
Martha Jane has also been approached by a former employer that would like her to come back and work part-time. She would work 2 days a week for a total of 16 hours. The job pays $10 an hour. If Martha Jane would take the part time job she would have to put her daughter in daycare that would cost $30 a day.
Which option would be more profitable for Martha Jane?
Discussion
The US pet industry currently brings in $50.8 billion a year and has increased every year since 2002. A large portion of pet owners consider their pets part of the family and purchase more than just food for their pet. “While humans are not the end user of pet products, they are the ones making the purchase decision, so it makes sense that products are developed with humans in mind as much as animals.” Pet owners are purchasing “lifestyle products” for their pets that reflect the owner’s personality. (Irwin, 2011) A custom dog bed fits perfectly into a “lifestyle product.”
The accounting profit for Martha Jane is listed in the charts above. Accounting profit is the price of the product times the amount sold. Economic profit is the accounting profit minus the opportunity cost. (Baye, 2010) In this case the accounting profit per dog bed is $46.30. If Martha Jane takes into consideration the economic profit she must consider the opportunity cost. Opportunity cost is “the cost of the explicit and implicit resources that are forgone when a decision is made.” (Baye, 2010)
Explicit costs are easier to evaluate than implicit costs. Investopedia (2011) defines accounting costs as “A business expense that is easily identified and accounted for. Explicit costs represent clear, obvious cash outflows from a business that reduce its bottom-line profitability.” And implicit costs as “a __cost__ that is represented by lost opportunity in the use of a company's own resources, excluding cash.” In Martha Jane’s situation the implicit costs of taking the job could include the time away from home, the inability to educate her child while she is in daycare and the mother is at work.
Dr. Porter (2008) who created The Five Forces Framework lists the forces as, Entry, Power of Buyers, Substitutes and Complements, Industry Rivalry and Power of Input Suppliers. He has also updated his framework to include four additional forces – savvy customers, powerful suppliers, aspiring entrants and substitute offerings. (Porter, 2008) For Martha Jane’s case there are no barriers to entry. She can easily set up her small business or close it down. For power of buyers there is a fairly small niche market for the type of dog bed that she would sell. There are substitutes available and there are no customer switching costs. The supplies that would be needed to create the dog bed are all readily available. Only the old suitcases would be an item that had to be located and would be at yard sales and auctions. In these cases the power of the suppliers would be limited. Finally, for industry rivalry this is a small enough segment of the market that the items are fairly differentiated, and which bed is purchased will be determined by the preferences of the buyer.
Dr. Porter (2008) suggests that you “position your company where forces are weakest, exploit changes in the forces, reshape the forces in your favor.” In Martha Jane’s case she would be offering a unique dog bed. There would be substitutes available, but nothing identical to Martha Jane’s creation. Each dog bed would be unique.
Buyer power is “the ability of a buyer to reduce price profitability below a supplier’s normal selling price, or more generally the ability to obtain terms of supply more favorable than a supplier’s normal terms.” (Zhiqi, 2008) Since Martha Jane would also sell her dog beds at craft fairs, buyers would be able to negotiate with Martha Jane on the price of her dog bed. Otherwise, when the dog beds are posted on Etsy the price charged is the price listed, and Martha Jane will not negotiate on the price.
A custom dog bed would be fairly elastic in demand. Baye (2010) defines elasticity as “a measure of the responsiveness of one variable to changes in another variable; the percentage change in one variable that arises due to a given percentage change in another variable,” or in layman’s terms, the change in the number of dog beds that Martha Jane would sell if the price would increase or decrease. A custom dog bed is not a necessity for a pet. It is a luxury item. If the price of the dog bed was too high, customers may choose an alternative type of dog bed for their pet.
Own Price Elasticity Equation
EQx,Px = %êQXd/%êPx
Qxd is the percentage change in the quantity demanded
Px is the percentage change in the price
“Basic economic theory predicts that a consumer’s willingness to pay for a good is affected by the availability of complements and substitutes.” (Rousu, Beach & Corrigan, 2008) The availability of substitutes affects the elasticity of an item. There are many substitutes available for a dog bed. All that is required is an internet search, and the consumer will be provided with a multitude of choices, from inexpensive fiberfill dog beds to very expensive dog beds that resemble custom furniture.
Investopedia (2011) defines a normal good as “the quantity demanded for a particular good or service as a result of change in the given level of income. A normal good is one that experiences an increase in demand as the real income of an individual or economy increases.” A custom dog bed is a normal good. This also means that a decrease in the consumer’s income will lead to a decrease in the sale of custom dog beds.
In order to obtain the supplies needed to make the dog beds, Martha Jane would participate in a spot exchange. This means Martha Jane would have an informal relationship with the seller and would be able to purchase the item and not have to adhere to a contract. (Baye, 2010) With Martha Jane being a small business with a low supply, there is no reason for her to have a contract for any of her inputs.
Once Martha Jane has started her business, she will have to determine how much to charge for her custom dog beds. There is a formula to determine the markup to maximize profit, but the segment of the market that Martha Jane would cater to is too specific to determine the own-price elasticity. Baye (2010) indicates that most home producers who sell their items at crafts fairs typically charge between 1.5 and 5 times their marginal cost. Martha Jane has researched similar type dog beds and had determined to charge 2 times her marginal cost.
Markup Equation for Monopolistic Competition
P = [Ef/ (1+Ef)] MC
Ef is the own-price elasticity of demand for the firm’s product
MC is the firm’s marginal cost
Martha Jane’s dog bed business meets the requirement for monopolistic competition. Monopolistic Competition is defined as “a market in which (1) there are many buyers and sellers; (2) each firm produces a differentiated product; and (3) there is free entry and exit.” (Baye, 2010) The essential feature of monopolistic competition is product differentiation. (Woo, 2011) Woo (2011) also states that “by advertising (or creating) distinguishing features of products, firms not only generate differentiation in products but also make these products more likely to be used as positional goods.” Essentially, the custom dog bed would be a “status symbol.” Not every dog owner is going to be willing to pay the additional cost a custom dog bed would demand.
Martha Jane will need to differentiate her product from all the other dog beds in the marketplace. The internet is a good tool to market her specific product. Besides offering her dog beds on Etsy, she could create a Facebook page and take custom orders to match the buyer’s décor of their home. The internet allows for a personalized shopping experience that previously was ignored when companies started to focus on mass marketing. (Montgomery, 2001) A business like Martha Jane’s would not have been available to people outside of the craft fairs, as this type of business does not have the budget for a big marketing campaign. By tailoring her product to a specific market segment, Martha Jane will be participating in niche marketing. (Baye, 2010)
With limited credit being available and lower demand for their products, the recent economic crisis hit small businesses hard, more so than large businesses. (Sahin, Kitao, Cororaton & Laiu, 2011) Martha Jane will have to take into consideration how big of a market there is for her custom dog beds. At this time, she does not see that there will be a need for any credit as she only plans to have a few dog beds in inventory at a time.
Recommendations
Martha Jane’s underlying goal is to make some additional money for her family. The part time job would gross $320 a month in accounting profit. The time away from her family is difficult to gauge in a dollar figure to determine economic profit. In order to make the same amount of money each month on the dog bed business, Martha Jane would have to sell 7 dog beds for an accounting profit of $324.10. With the current economic climate she may have difficulty consistently selling this many dog beds each month.
If she looked strictly at accounting profit and the likely number of dog beds sold in a month, the most profitable option would be to take the part-time job. Martha Jane’s main determining factor in making her decision between the two options will be the value she places on spending additional time with her young child as compared to the guarantee of specific income each month.
Multiple Choice Questions
1. Which choice is one of Porter’s Five Forces?
a. Niche marketing
b. Power of Buyers
c. Taxes
d. Research & Development
2. Which is a marketing strategy where goods and services are made specifically to meet the needs of a particular type of consumer?
a. Comparative advertising
b. Brand equity
c. Niche marketing
d. Green marketing
3. Which is a market where there are many buyers and sellers, each company sells a product that can be distinguished from products another company sells; and there is free entry and exit to the market.
a. Monopolistic competition
b. Perfect competition
c. Monopoly
d. Oligopoly
4. The change in quantity demanded compared to the change in price.
a. Log-linear demand
b. Cross price elasticity
c. Income elasticity
d. Own price elasticity
5. Which does not take into consideration the opportunity costs.
a. Economic profits
b. Implicit cost
c. Accounting profit
d. Explicit cost
Answers:
1. b – Power of Buyers - Porter's Five Forces includes Entry, Power of Buyers, Substitutes and Complements, Industry Rivalry and Power of Input Suppliers
2. c – Niche marketing - a marketing strategy where goods and services are made specifically to meet the needs of a particular type of consumer
3. a – Monopolistic competition - market where there are many buyers and sellers, each company sells a product that can be distinguished from products another company sells; and there is free entry and exit to the market.
4. d – Own price elasticity - how much the quantity demanded decreases(increases) when the price increases(decreases).
5. c – Accounting profit - the amount taken in from sales - price times quantity sold. Opportunity cost is considered in economic profit.
References
Baye, M. R. (2010). Managerial economics and business strategy (7th ed.). New York: McGraw-Hill/Irwin.
Explicit cost. (n.d.). In Investopedia. Retrieved on December 2, 2011, from http://www.investopedia.com/terms/e/explicitcost.asp#axzz1fP1mhsZV
Implicit cost. (n.d.). In Investopedia. Retrieved on December 2, 2011, from http://www.investopedia.com/terms/i/implicitcost.asp#axzz1fP1mhsZV
Irwin, T. (2011, October 31). Pet Products Poised For Continued Growth. Retrieved November 26, 2011, from http://www.mediapost.com/publications/article/161433/pet-products-poised-for-continued-growth.html
Montgomery, A.L. (2001). Applying Quantitative Marketing Techniques to the Internet. Interfaces, 21(2), 90-108. Retrieved from URL: http://www.jstor.org/stable/25062671
Normal good. (n.d.). In Investopedia. Retrieved on December 2, 2011, from http://www.investopedia.com/terms/n/normal-good.asp#axzz1fU2Bg7Vx
Porter, M.E. (2008, January). The Five Competitive Forces that Shape Strategy. Harvard Business Review. Retrieved December 2, 2011 from http://hbr.org/2008/01/the-five-competitive-forces-that-shape-strategy/ar/1
Rousu, M. C., Beach, R. H., & Corrigan, J. R. (2008). The Effects of Selling Complements and Substitutes on Consumer Willingness to Pay: Evidence from a Laboratory Experiment. Canadian Journal Of Agricultural Economics, 56(2), 179-194. doi:10.1111/j.1744-7976.2008.00124.x
Şahin, A., Kitao, S., Cororaton, A., & Laiu, S. (2011). Why Small Businesses Were Hit Harder by the Recent Recession. Current Issues In Economics & Finance, 17(4), 1-7.
Woo, W. (2011). Status and welfare under monopolistic competition. Social Choice & Welfare, 36(2), 227-239. doi:10.1007/s00355-010-0472-7
Zhiqi, C. (2008). Defining buyer power. Antitrust Bulletin, 53(2), 241-249.
Week of November 28, 2011 Blog
In a prior post I discussed the current trade deficit with China and how the cost savings of production in China is slowly eroding and production will move back to the United States.
In a recent Star Tribune article they discussed recent trade agreements that President Obama signed with Panama, Colombia and South Korea. The Star Tribune is located in Minnesota and exports quite a bit to South Korea. They mention that prior to the trade agreements being signed that exports from the European Union had increased 30 percent to South Korea.
Minnesota also exports soybeans to Colombia and had lost more than $60 million between 2008 and 2010 due to trade pacts between Canada and Argentina.
The article goes on to question if these new trade agreements will create more jobs in the US? The article concludes with the statement “the problem with trade is that the losses are often immediate and somewhat easy to tally, while the benefits may be decades in the making.”
http://www.startribune.com/business/132340033.html
Week of November 21, 2011 Blog
Health care reform is a hot button topic and I’m sure will be discussed even more in the upcoming Presidential election.
A study published in the journal Neurology examined the cost vs benefit of disease-modifying drugs (DMD’s) that are used to treat multiple sclerosis.
The study states that these drugs cost around $3,000 a month in the U.S. Per the study a patient would gain an extra two months or less of good heath from using these drugs compared to other treatments that are used to treat symptoms of MS. They study estimates that DMD’s cost around $1 million for each year of “relatively healthy life” for a person with MS after 10 years of use.
The article goes on to further state that a common definition of “cost-effective’ treatment is between $50,000 and $150,000 for each good-quality year of life gained. The lead researcher of the study, Katia Noyes, stated that “this study was not designed to try to deprive people with MS of any therapy. It was not intended to tell doctors what to prescribe or insurance companies what to pay for.”
She does point out that with the current climate of health care reform that we need to look at the value of different therapies and consider their cost-effectiveness for patients.
http://www.msnbc.msn.com/id/43844786/ns/health/t/benefit-ms-drugs-comes-steep-price-study/
Week of November 14, 2011 Blog
How many of you recycle at home? At work or school you may see recycling boxes or containers for paper, plastic, cans, etc. Besides being good for the environment it can be cost beneficial.
In my local area, as a cost cutting measure, they scaled back the recycling program stating it was costing the city more money to operate it than they could sell the recycled items. They no longer take glass and closed down the drop off location. You can only do curbside pickup, which is complicated. They only pick up certain items on alternating weeks. Recycling should be easy in order to encourage people to participate.
It has been shown that well run recycling programs cost less then to send trash to a landfill. I’m not sure that the city took this into consideration as the cost to have a bag of trash picked up is passed on to the consumer and recently more than doubled. It has also been shown that economies of scale comes into play with recycling and that as more people that recycle the cheaper it gets.
New York City originally wanted to do away with recycling, stating it cost $40 million a year to operate, has now streamlined their recycling program so that it is efficient and it now saves the city $20 million a year.
The EPA states “A well-run curbside recycling program can cost anywhere from $50 to more than $150 per ton…trash collection and disposal programs, on the other hand, cost anywhere from $70 to more than $200 per ton. This demonstrates that, while there’s still room for improvements, recycling can be cost-effective.”
The University of Oregon did a cost benefit analysis of recycling on campus. They saw their savings grow from $96,132.41 in 1992 to $257,723.60 in 2009.
The local city government should look at ways to make the recycling program more efficient instead of cutting back or doing away with it entirely.
http://www.recycling-revolution.com/recycling-benefits.html
http://environment.about.com/od/recycling/a/benefit_vs_cost.htm
http://pages.uoregon.edu/recycle/PrgmStru_cbanaly_text.htm
Week of November 7, 2011 Blog
Anyone who flies know that airport security is a hassle. Now there is a proposal to increase the security fee that you pay when you purchase a plane ticket.
The New York Times states that passengers currently pay $2.50 security fee for each segment of a trip, up to a maximum of $10 for a round trip ticket. The increase in fees was included in the deficit reduction plan which would make the fee up to $15 for a round trip ticket.
When Congress created the TSA (Transportation Security Administration) after the September 2001 terrorist attacks the intention was to recover the costs of the TSA through passenger fees and a separate security fee paid by the airlines, but the fees have not increased to cover the security costs and the additional costs have been shifted over to the general tax payer.
Of course there has been some controversy about increasing the fee. No one likes paying more for a plane ticket. Especially with the increases in fuel costs in recent years that has made the cost of flying go up.
Robert Poole, director of transportation policy at the Reason Foundation, has studies how aviation security is financed in other countries and agrees it is fair that users should pay for the security costs, instead of the general taxpayer.
Mr. Pool does think that the TSA does a lot of “wasteful spending.” That if the security fee does increase that passengers are going to be more concerned in how the money is spent.
The Governmental Accountability Office has issued reports showing that the TSA has a tendency to purchase equipment without doing a cost-benefit analysis. For example the “air puffer” machines that were used to detect explosives; they were known to break down frequently. Baggage scanning machines that don’t meet current explosives detection standard and the $750 million spent on behavioral detection officers.
Stephen Lord, director of homeland security issues at the GAO stated “Usually you validate a concept and then you field it, but they deployed the program and then they started validating it, which we have some concerns about.”
There is no question that airport security is important. I know I want to make it to my destination safely, but I also want the money spent wisely that I pay for a security fee.
http://www.nytimes.com/2011/09/27/business/plan-to-raise-fees-for-air-travelers-sets-off-debate.html?_r=1&scp=6&sq=cost%20benefit&st=cse
Week of October 31, 2011 Blog
Hewlett-Packard announced last Thursday that they have decided to keep their personal computer unit after extensive review. Originally they had announced they were going to spin off the personal computer unit.
They announced in August that they were going away from the consumer market and looking at alternatives for its Personal Systems Group.
The CEO said the company was “stronger with the unit” due to their supply chain and procurement.
Obviously HP did a cost-benefit analysis in regards to spinning off the personal computer unit. The second article indicates that spinning off the unit would have cost HP over $1 billion annually.
http://www.cnbc.com/id/45066439
http://news.yahoo.com/hp-decides-keep-pc-division-202804686.html
Week of October 24, 2011 Blog
Robert S Adler, a commissioner for the Consumer Product Safety Commission, wrote an op-ed piece for the New York Times last week about how politicians in Washington feel about cost-benefit analysis.
He states that the House of Representatives has created an independent committee to conduct cost-benefit analysis of regulations proposed by the EPA, even though the EPA already does its own analyses. He points out that all executive agencies under a Presidential directive currently do their own analyses.
At his own agency he says they have been contacted by politicians and business to cut back on their regulations to “jump start” the economy. He says they are told the way to do this is to do an elaborate-cost benefit analysis on everything they do, referring to it as “paralysis by analysis.”
The Consumer Product Safety Commission writes safety rules to eliminate or reduce deaths and injuries by consumers. They estimate that roughly 31,000 people die and 34 million people suffer product-related injuries every year. This translates to costs of approximately $200 billion annually. He also points out that product-related tragedies almost always result in lost economic productivity.
He contends that “anyone who insists that regulations necessarily impose new costs on society shouldn’t be taken seriously. The costs are already there, in the form of deaths and injuries – and are often as much of a drag on our economy as any safety rule. So the real issue is who should bear the costs.”
In conclusion he objects that many of those who want extensive cost-benefit analysis have no concern that the regulation be more focused or rational. They only want to consider the cost to the businesses, not the benefits to the consumers.
http://www.nytimes.com/2011/10/17/opinion/safety-regulators-dont-add-costs-they-decide-who-pays-them.html
Week of October 18, 2011 Blog
Anyone ever checked the tag of the item they are currently using to see where it is made? Most likely it says China. At one time I took a friend’s challenge to see if I could do my Wal-Mart list without buying anything made in China. The result? I couldn’t do it.
The Journal of Commerce recently had an article stating that manufacturing will most likely shift away from China in the next few years and could create up to 3 million jobs in the US.
The cause is that labor costs in China are rapidly rising and the increase in the value of the Chinese currency against the US dollar. This reduces the benefits of having the product manufactured in China.
The article indicates that within the next 5 years that the cost will only be 10 to 15 percent less in China that manufacturing the product in the US, and that is before shipping costs.
The industries most likely to see production coming back to the US include transportation goods, electrical equipment, appliances, furniture, plastics, and rubber products. Boston Consulting Group states that the shift of production back to the US could lower the non-oil trade deficit by 20 to 35 percent and add $100 billion to the US economy.
As we can see the lower costs of shifting production to China are no longer going to provide the benefit that the companies desire in order to maximize profits.
http://www.joc.com/global-trade/manufacturing-jobs-shift-china-us-report-says
Week of October 10, 2011 – Time Warner Case Study Discussion
Background Memo
Memo 12
To: Pricing Department
From: Regional Manager, Region 3
Re: New Channel Lineup
We are thinking of adding three networks to our basic lineup: Bravo, ESPNews, and MTV2. Each of these networks would charge us programming fees on a per subscriber basis, as follows:
To offset a portion of these fees, each network would allow us to sell some local advertising time on their networks. Based on current network ratings, our advertising department estimates that the monthly advertising revenues earned would amount to $1,200 on Bravo, $1,500 on ESPNews and $1,200 on MTV2.
Approximately 46 percent of the 110,000 customers in Regional 3 market currently subscribe to our basic services. Anytime the basic channel lineup is adjusted, there is a shift in the number of customers who take the basic cable package. We tend to loose a few channel loyal customers anytime we drop a channel, and likewise, gain a new group when a channel is added. Our marketing department has provided estimates on the number of loyal customers for each channel. This represents an estimate of the number of cable customers we will lose if we drop a particular network. Likewise, it also provides an estimate of the number we can gain by adding a new channel. Currently, we do not have the capacity to add new channels to our basic lineup without dropping existing channels. Our marketing department estimates the following increases in subscribers by adding these new channels: Bravo – 150, ESPNews – 300, and MTV2 – 225. Our current pricing (not including taxes) for the basic package is $34.99 per month. Our programming fees for the basic package total $14.55 per month.
The current basic cable lineup is attached. The list only includes networks that could be feasibly be replaced. It excludes channels that must be retained due to governmental regulation (local access channels, etc) as well as broadcast networks.
Using the information, please make a recommendation for whether we should add any of the proposed networks to our basic package.
Discussion
The solution provided by Dr. Horowitz included some figures that are not listed in the book and apparently are on an Excel spreadsheet that did not come with the book.
With the additional figures it shows that ESPN and TNT have high monthly subscriber costs, but generate fees from advertising and subscriptions that offset the programming fees. It also indicates that Biography and the Game Show Network only add very low profits.
Since they are unable to add any channels without deleting current channels there is an opportunity cost to changing the channel lineup. They can drop the Biography Channel ($2,746) and the Game Show Network ($2,198.40) for a total of $4.944.00. Since MTV2 contributes $9,055.88 to profit it should replace the Game Show Network. ESPNews ($11,967) should replace Biography ($2,746) since it increases profits by $9,221.
The total change in profit by replacing Biography and The Game Show Network with MTV2 and ESPNews would increase profits on the basic cable lineup by $16,078.48.
References
Baye, M. R. (2010). Managerial economics and business strategy (7th ed.). New York: McGraw-Hill/Irwin.
Week of October 3, 2011 Blog
In 2007 a study was conducted to see if it would be beneficial for a wind farm to be built at the United States Military Academy at West Point, NY.
In the proposal the site would remain federally owned with a developer owning and operating the wind farm. There would be no “up front” costs to the military. At present all of the installation’s electricity is purchased from the local utility. If the wind farm were to be built it would be able to provide approximately 25% of their electrical needs.
The study indicated that using 2008 figures the annual cost savings would be $1,734,820. They also concluded that as long as the cost to purchase wind power was less than $.15/kWH it was economically feasible.
At the time the article was written in 2010 the authors stated that the project had not progressed from the study stage.
http://web.ebscohost.com/ehost/pdfviewer/pdfviewer?sid=654d7661-8f7e-40c7-b1a8-fee3a592aca3%40sessionmgr13&vid=3&hid=8
Bastian, N. D., & Trainor, T. E. (2010). Going Green at West Point: Is It Economically Beneficial? A Cost-Benefit Analysis of Installing a Wind Farm at the United States Military Academy. Engineering Management Journal, 22(3), 12-20. Retrieved from EBSCOhost.
Week of September 26, 2011 Blog
Ever wondered what the most environmentally friendly vehicle was for the cost (cost/benefit analysis)? Business Fleet decided to answer that question by having popular fleet vehicles tested to determine the cost of the vehicles vs. the environmental savings. They tested greenhouse gas emissions and smog emissions against the total lifetime cost of the vehicle. Their results show that the Toyota Prius won “hands down,” even though it has a higher price to purchase. Some companies simply look at the “dollars and cents” of purchasing fleet vehicles. How much for the vehicle, the maintenance, the fuel mileage, etc. Depending on corporate culture they may prefer to buy more environmentally friendly vehicles, even though they have an increased cost. If you would like to see the complete listing of the vehicles tested you can click the link below.
I looked for some additional information to see if I could find firm figures on the true additional cost of a green vehicle to see if it actually saved the company money. I was not able to find any firm figures on what companies with large fleets spend on vehicles and their cost per mile. Greenfleet magazine (link below) had an article on the “Real-World Hybrid Fleet Operating Expenses.” The companies interviewed have had hybrid vehicles in their fleet for multiple years. They are seeing an increase in fuel mileage, which is important due to the large fluctuation in gas prices the last few years. The fleet manager for EMD Millipore says that the cost to purchase is more, but it is offset with the higher fuel mileage.
It appears that a “green” vehicle in the right situation can be a cost savings and not just a public relations device.
http://www.businessfleet.com/News/Story/2011/07/Top-Cost-Effective-Green-Fleet-Vehicles.aspx
http://www.greenfleetmagazine.com/article/50453/real-world-hybrid-fleet-operating-expenses