Short-Run Price Decision of Price Setting Firm

Companies can encounter situations where they have temporary un-utilized capacity and are faced with the opportunity of bidding for a one-time special order in competition with other suppliers. In this situation only the incremental costs of undertaking the order should be taken into account. It is likely that most of the resources required to fill the order will have already been acquired and the cost of these resources will be incurred whether or not the bid is accepted by the customer Typically, the incremental costs are likely to consist of

  • Extra materials that are required to fulfil the order
  • Any extra part-time labor, overtime or other labor costs
  • The extra energy and maintenance costs for the machinery and equipment required to complete the order

The incremental costs of one-off special orders in service companies are likely to be minimal. For example, the incremental cost of accepting one-off special business for a hotel may consist of only the cost of additional meals, laundering and bathroom facilities. Bids should be made at prices that exceed incremental costs. Any excess of revenues over incremental costs will provide a contribution to committed fixed costs that would not otherwise have been obtained. Given the short-term nature of the decision long-term considerations are likely to be non-existent and, apart from the consideration of bids by competitors, cost data are likely to be the dominant factor in determining the bid price.

Any bid for one-time special orders that is based on covering only short-term incremental costs must meet all of the following conditions:

  • Sufficient capacity is available for all resources that are required to fulfil the order. if some resources are fully utilized, opportunity costs of the scarce resources must be covered by the bid price.
  • The bid price will not affect the future selling prices and the customer will not expect repeat business to be priced to cover short-term incremental costs.
  • The order will utilize unused capacity for only a short period and capacity will be released for use on more profitable opportunities. If more profitable opportunities do not exist and a short-term focus is always adopted to utilize unused capacity then the effect of pricing a series of special orders over several periods to cover
    incremental costs constitutes a long term decision. Thus, the situation arises whereby the decision to reduce capacity is continually deferred and short-term incremental costs are used for long-term decisions.

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