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2011 | OriginalPaper | Chapter

3. The Cost Approach to Pricing: Joint Cost Allocations

Author : Dr. Roger L. Conkling

Published in: Energy Pricing

Publisher: Springer Berlin Heidelberg

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Abstract

You are the manager of a large manufacturing plant located on the plains of Kansas, and you have just been informed that your company is being sued for selling one of its several products (product A) below cost in order to meet competition. All products manufactured at the plant use the same structure, the same machinery, and the same labor force. Your lawyer advises that your best defense is to prove that your price for product A meets or exceeds the cost of producing it. In other words, you must compute the cost of product A. What will you do? You might reread Chap.​ 3, leading you to divide total plant costs into those costs directly assignable to product A and those incurred jointly by product A and the other products. You might then functionalize the joint costs, to the greater-than-normal degree utilized by Southern California Edison Company, thus increasing the direct costs assignable to the individual products and decreasing the joint costs to be allocated among them. The remaining joint costs could then be allocated by the relative number of product units involved. Or, if you were an energy utility, you could follow Chap.​ 3 directly.

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previous chapter The Cost Approach to Pricing: The Direction of Cost
next chapter The Cost Approach to Pricing: The Tenneco Pattern
Footnotes
1
We digress at this juncture to point out that automobile manufacturing, like the utilities, is a capital-intensive industry. According to the press reports, in normal operations GM was making a profit on its larger SUV’s and trucks, but taking a loss on its lighter, smaller vehicles. When the market crashed, sales of the larger types plummeted, erasing its profitable sales and creating spare, unused capacity. GM’s plants were expensive to construct and operate. They needed volume production to be economical. When production fell, the cost per vehicle produced kept rising as fewer units were available to absorb fixed costs.
In Chap.​ 2, fixed costs were considered to be paid off in equal installments of the units produced. This was because they were incurred under price regulation, which deplores an excess or a deficit in cost recovery. However, in the absence of price control, the recovery of fixed costs in the price of the product may be construed to be quite different. To the extent that the price permits, the producer may consider that excesses of the price over the actual costs are cumulative, so that at some point in the productive process it can be said that all fixed costs have been recovered by the prices charged, and that all future prices represent gain. Thus, an automobile manufacturer might state that a break-even point would be reached at production of a given number of vehicles with additional vehicles built beyond this number representing profit. This type of thinking is quite common in the oil and natural gas producing industry, the well owners considering that they had to raise a certain number of barrels of oil or cubic feet of natural gas to cover their costs with profits starting only with subsequent production.
 
2
In case of doubt as to the classification of an expense, the decision must hinge on this question—is the equipment installed to serve a specific customer or customer group? If it is clear that except for the need of rendering the particular service to the particular users the equipment would not have been installed, the costs are direct and are solely the responsibility of these customers.
 
3
For an interesting discussion of the definition and nature of joint costs, the reader may wish to refer to the Taussig-Pigou controversy which took place early in the last century. See Taussig, F.W., “Railway Rates and Joint Costs Once more,” Quarterly Journal of Economics, Vol. XXVII, 1913, pp. 378–384; also pp. 536–538 and 692–694; and Pigou, A.C., “Railway Rates and Joint Costs,” pp. 535–536 and 687–692, in the same volume of the Journal. See also, Sickler, B.J., “A theory of Telephone Rates,” Journal of Land and Public Utility Economics, Vol. 4, 1928, pp. 175–188.
 
4
These methods are sometimes looked upon more narrowly as methods of allocating “demand” costs. However, their applicability is less limited if they are considered in relation to the broader category of joint costs.
 
5
Nash, L.R., Public Utility Rate Structures, McGraw Hill Book Cp, Inc., New York, NY, 1933.
 
6
It is a general characteristic of utilities that their product cannot be stored although, of course, water, both as a utility and for hydroelectric generation, and gas, can be stored to a limited degree. For all practical purposes, electricity must be generated simultaneously with customer requirements for it. Sufficient telephone circuits must be available to handle calls when subscribers wish to make them. As many busses must be provided as are needed to carry rush hour traffic. Water or gas mains must be large enough to keep water or gas flowing when required. These are commonly accepted minimum standards of utility service. It is obvious that the peak loads which must be handled determine the number and size of the facilities which the utility must provide.
In a hydro-electric system, water may be stored in storage reservoirs and, to a limited degree, as pondage in run-of-the-river plants. It also may be stored for short periods as part of a pumped-storage project. Natural gas can be stored in depleted oil or gas reservoirs, above ground in tanks as liquefied natural gas (LNG), or as line-pack in mains.
 
7
For a complete discussion, see Nash, L.R., Ibid., Ch. XI, p. 234; Hills, H.W., “Demand Costs and their Allocation,” Electrical World, January 22, 1927, pp. 198, ff; and Nordin, J.A., “Allocating Demand Costs,” The Journal of Land and Public Utility Economics, May, 1946, p. 168.
 
8
Nordin, J. A., Ibid, pp. 163—170.
 
9
Conkling, R.L., “Generation Cost Unbundling: Untangling the Gordian Knot,” The Electricity Journal, March 1997.
 
10
A draft of the above description of the method was provided to the author by Ed Woodruff, Regional Economist, North Pacific Division, Corps of Engineers, Department of the Army. Mr. Woodruff is credited with writing the cost allocation instructions for the payout of the Federal multiple-purpose projects of the Columbia River Power System, which includes numerous dams and power plants on the Columbia River and its tributaries, as well as flood control and irrigation projects.
 
Metadata
Title
The Cost Approach to Pricing: Joint Cost Allocations
Author
Dr. Roger L. Conkling
Copyright Year
2011
Publisher
Springer Berlin Heidelberg
Book
Energy Pricing

Print ISBN: 978-3-642-15490-4

Electronic ISBN: 978-3-642-15491-1

Copyright Year: 2011

DOI
https://doi.org/10.1007/978-3-642-15491-1_3