Chapter 4 COSTING AND PRICING IN TRANSPORTATION Chapter Objectives: After reading this chapter, you should be able to do the following: 1. Understand the relationship between a rate and a price 2. Be familiar with the various types of market structures found in the transportation industry 3. Gain knowledge of the impact of transportation prices on the relevant market area for a product 4. Be able to explain the differences between cost of service and value of service pricing 5. Understand the different forms of rates used in transportation 6. Appreciate transportation rates have changed under deregulation 7. Determine the strategic role of pricing for transportation firms 8. Calculate the costs of both truckload and less-than-truckload freight moves Chapter Overview Federal regulation of transportation business practices was initiated in the United States in 1887 when Congress passed the Act to Regulate Commerce (later named the Interstate Commerce Act). This legislation established a framework of control over interstate rail transportation, and created the Interstate Commerce Commission (ICC) to administer it. Between 1906 and 1940, oil pipelines, motor carriers, and domestic water carriers were also subjected to ICC control. Air transportation came under federal economic regulation in 1938, with the passage of the Civil Aeronautics Act. Reduction of federal economic regulation of the modes began with partial curtailment of rail regulation in 1976 (Railroad Revitalization and Regulatory Reform Act), air cargo in 1977, and air passenger transportation (Airline Deregulation Act) in 1978. Two years later, interstate motor carriage was almost completely deregulated (Motor Carrier Act of 1980), and extensive additional reductions in railroad regulation were enacted (Staggers Rail Act of 1980). A federal political climate favorable to deregulation continued in the 1990s. Passage of the Trucking Industry Regulatory Reform Act of 1992 removed the power of the states to regulate intrastate motor freight transportation. Three years later, passage of the ICC Termination Act of 1995 (ICCTA) eliminated almost all remaining elements of motor carrier regulation, further reduced rail regulation, and replaced the 108-year old ICC with the Surface Transportation Board (STB). The STB holds responsibility for administering the remnants of economic rail regulation that remains law within the ICCTA. Market-driven pricing of transportation services free from regulatory intervention was a prime objective of deregulation. Thus, motor carriers are free to charge whatever rates they can to generate revenue. Deregulation also freed motor carriers to operate wherever they choose, geographically. Rail carriers are also free to charge rates based exclusively on market conditions, except in situations where the STB might find a rail firm’s market power strong enough to subject rail customers to economic abuse or injury. Before deregulation, all interstate rail freight traffic and much motor freight traffic was moved on published (tariff) rates. Both motor and rail carriers still offer tariff rates. However, under freedom from economic regulation, the use of rates set in confidential contracts between carriers and shippers has become prominent, particularly for traffic tendered by large-volume shippers. Individuals studying transportation should understand the theoretical underpinnings of the rates and prices of transportation agencies. A key point to master at the outset is the idea that a difference exists between the terms rate and price. In the past when transportation regulation was at its peak, it was more appropriate to use the term rate than price. A rate is an amount that can be found in a rate tariff book, as payment to a carrier for performing a given transportation service. This rate is the lawful charge that a carrier can impose on a given commodity movement; therefore, a rate has the full force of the law behind it for its timely payment. A rate is determined primarily by considering a carrier’s costs only and not by assessing the overall market situation at that moment in time and how these market forces influence supply and demand. A price, however, is a much clearer notion of how post-deregulation transportation firms determine and impose charges for their services. A price implies a value or level that is determined based on prevailing market forces. Clearly, the notion of price implies a dynamic economic environment, one that is receptive to changes in customer demand and carrier supply. Although the transportation industry is not completely unique compared to other industries, there are enough differences to justify a thorough discussion of transportation pricing. The first part of this chapter on transportation prices will explore the market structure of the transportation industry. The section on market structure will be followed by an analysis of cost-of-service pricing. This analysis will provide the basis for a discussion on value-of-service pricing. The final part of the chapter will address rate systems and pricing in transportation. MARKET CONSIDERATIONS Before discussing the characteristics of the transportation market, a brief review of basic market structure models is appropriate. Market Structure Models Pure competition is defined as: a large number of sellers, no one firm can influence prices or supply, the product or service is homogeneous, and there is unrestricted entry. The demand curve facing the individual firm is one of perfect elasticity. A monopolistic market has only one seller of a product or service for which there is no close competitor or substitute and that single seller is able to set the price for the service. An oligopoly is defined as competi¬tion between a “few” large sellers of a relatively homogeneous product that has enough cross-elasticity of demand (substitutability) so that each seller must, in pricing decisions, take into account competitors’ reactions. Monopolistic competition has many small sellers, but there is some differentiation of products and no one seller controls a significant portion of the market. Theory of Contestable Markets For deregulation to work for a mode, its market structure must closely resemble pure competition. Even when it appears that a mode is oligopolistic, the theory of contestable markets, which substitutes potential compe-tition for the active participation of many sellers, can be used with some modes such as airlines to allow relaxation of government control. For this theory to work, barriers to entry could not exist, economies of scale could not be present, and consumers had to be willing and able to switch quickly among sellers. Relevant Market Areas A general statement classifying the market structure of the entire transportation industry cannot be made because it is necessary to view structures in particular market areas. In order to determine pricing in transportation, the situation between two points, for one com¬modity, in one shipment size, moving in one direction must be described. The complexity of the situation for each mode, commodity, and market does not eliminate the validity of the economic models described above. It only means that in order to make use of these models we must have knowledge of the situation that exists in the particular market. In setting prices, a carrier must have knowl¬edge of the relevant market and they can possibly use one of the economic models described. Although there will be instances when carriers might find it expedient to generalize in adjusting prices, a much narrower focus is customary in the day-to-day negotiation and analysis of these prices. The deregulation that has occurred in transportation between 1978 and 1996 has made these conclusions even more appropriate. The new competitive environment has made carriers and shippers more sensitive and more prices are being negotiated by shippers and carriers. COST-OF-SERVICE PRICING There are two separate concepts in cost-of-service pricing: basing prices upon average cost or basing prices upon marginal cost. If the firm desires to maximize its profits, it will produce quantity Qm and charge price Pm. The firm would be making excess profits in the economic sense because the price is above average cost and the firm is not producing at a point for optimal allocation of resources. This is a monopoly situation. If this was subject to regulation, a single price would be set that would cover the firm’s cost of production and at the same time sell all the output, then the price should be Pz and the output Qz. In this instance, we would be basing the price on average cost. It appears that the average-cost approach is more socially desirable than the unreg¬ulated, profit-maximizing approach. One of the arguments frequently raised against a strict marginal-cost approach to pricing is that, under decreasing cost conditions, if the firm equates marginal cost with demand, then it will necessitate the firm’s operating at a loss. There is one obvious solution and that is to allow the government to make up the deficit through a subsidy. The assumption that only one group of customers is served exclusively is not a typical situation, except in very special cases among transportation companies. Likewise, costs are not usually separable according to the classes of customers, but rather, common costs are quite typical, particularly with respect to railroads. The presence of common costs raises some problems for cost-of-service pricing, particularly the average-cost approach. Average cost pricing with fixed or common costs, or both, makes these costs price-determining when they should be price-determined. To some extent then, cost is a function of the prices; the prices are not a function of the cost. The presence of common costs does not raise the same theoretical problem for marginal-cost pricing because no arbitrary allocation of these costs is technically necessary. There are some additional problems of a more practical nature, however, with respect to strict marginal-cost pricing. For example, in transportation, marginal costs could fluctu¬ate widely, depending on the volume of traffic offered. An obvious question is whether cost-of-service pricing has any relevance for establishing prices. Prices charged by transportation companies are actually one of the criteria that guide intelligent shippers in selecting the mode of transportation or carrier that is most appropriate for their shipment. For the transportation decision to be properly made, the price charged should reflect the cost of providing the service to ensure carrier and economic system effi-ciency. Cost-oriented prices should be related to what we have defined as marginal cost or variable cost. Such costs, measured as precisely as possible, should serve as the con¬ceptual floor for individual prices. Differential pricing seems to make sense in most instances, but our rationale needs further explanation. In the presentation of cost-of-service pricing, mention was made of decreasing cost industries and some transportation firms fall into this category. If prices are based on strict marginal cost, the firm experiences a loss but the firm has to recover its fixed costs. It can be accomplished by using marginal cost as a floor for prices and using the value of service, or demand, to establish how far above this minimum the rate or price should be set. Value-of-service pricing can assume two meanings. First, prices are set so that on each unit the maximum revenue is obtained regardless of the particular costs involved. The second meaning is that no service should be charged a price that it will not bear when, at a lower price, the service could be purchased. The differences in the elasticities of demand for the different services will deter¬mine the actual level of the prices. The presence of indivisibilities in the cost struc¬ture necessitates the dissimilar pricing. Dissimilar pricing allows common and fixed costs to be spread out over large vol¬umes of traffic. In other words, dissimilar pricing might render economical benefits because prices might be lower than they otherwise would be. The variable, or marginal, cost of providing the service should serve as the floor for carriers when setting prices. This is going to rely entirely on how marginal, or variable, cost is defined and assumes that (1) the carrier knows its costs and (2) it is able to charge a price that will result in a profit. It can be said that dissimilar pricing is the logical approach for pricing in regulated industries. Cost indivisibilities necessitate the practice of discriminatory pricing, but this was approached within what might be called a cost framework. Marginal cost sets the minimum basis for prices, whereas fixed or common costs are, in effect, allocated on the basis of demand elasticity. VALUE-OF-SERVICE PRICING Value-of-service pricing is a frequently mentioned and often criticized approach to pricing that has generally been associated with the railroad industry. One rather common definition of value-of-service pricing in transportation is pric¬ing according to the value of the product; for example, high-valued products are assessed high prices for their movement, and low-valued commodities are assessed low prices. If a cost-based approach is taken to setting prices, high-valued commodities would usually be charged higher prices because they are typically more expensive to transport. The value of the commodity is a legitimate indicator of elasticity of demand; for example, high-valued commodities can usually bear higher prices because transportation cost is such a small percentage of the final selling price. Where alterna¬tives are present at a lower price, shippers are not willing to pay higher prices based upon the value of the product alone. The value of the commodity gives some indication of demand or the ability to bear a charge, but competition also will affect the demand for the service, that is, the height and slope of the demand curve. Third-degree price discrimination is a situation in which a seller sets two or more different market prices for two or more separate groups of buyers of essentially the same commodity or service. Three necessary conditions must exist to allow this: (1) the seller must be able to separate buyers into groups or submarkets according to their different elasticities of demand; (2) the seller must be able to prevent the transfer of sales between the submarkets; and (3) the seller must possess some degree of monopoly power. Differential pricing can be done based on several methods of segregating the buyers into dis¬tinct groups. It can be done by commodity, by place, or by individual person. It should be noted, however, that discrimination based on an individual person is illegal per se on traffic that remains economically regulated by the STB. Value-of-service or differential pricing makes sense from the perspective of the rail¬roads, considering their high level of fixed costs and need to attract traffic. The key to success lies in being able to determine the appropriate costs and to esti¬mate demand elasticity in the various markets. In value-of-service or differential pricing, each particular commodity is paying more than its variable cost and making a contribution to average cost, which also might be a concept of fully allo¬cated cost. One might argue that the coal shippers are not paying their full share and the computer shippers are paying too much. However, for example, Supersaver fares charged by the airlines and full-fare passengers complain hat they are subsidizing discount-fare passengers. Actually, full fares might be higher if the special fares were not offered. The essential ingredient in the value-of-service analysis is the notion that each com¬modity movement has its own unique demand characteristics. Several points about this example need to be emphasized. The determination of cost is a difficult task. Second, most railroads and many other carriers would be considering more than three commodities between two points. Third, the example applies to the railroad because it is more attractive in situations with high fixed costs, yet other carriers, even motor carriers, might find differential pricing attractive. Fourth, some difference would exist in rates among commodities because of cost differences. Finally, the elasticity of demand for a particular commodity might change with competition, or because of some other factors. Conceptually, if cost-of-service pricing serves as the floor for carrier pricing, then value-of-service pricing can serve as the ceiling. However, if we accept the notion that value-of-service pricing is pricing based on “what the traffic will bear,” then an argument can be made that value-of-service pricing is also the floor for carrier prices, rather than the marginal cost of providing the service. For example, a truckload carrier moves a shipment from point A to point B with a variable cost of $90, an average cost of $100, and a price of $110. This is called the carrier’s headhaul because it is this move that initiated the original movement of the carrier’s equipment and the shipper’s goods. As such, the carrier might be able to use value-of-service pricing, charging $110 With the carrier’s equip¬ment at point B, it is necessary to bring the equipment and driver back to point A. This is called a backhaul because it is the result of the original move (headhaul). The carrier now faces a totally different market in this backhaul lane. Assume that marginal cost in this backhaul lane is defined as the variable cost of fuel and driver wages, or $90. If the carrier decides to price based on its marginal cost of $90 (cost-of-service pricing), it is very possible that the market from point B to point A will not “bear” this price and the carrier will be forced to return empty. This will result in a loss to the carrier of $90. Now suppose that the carrier prices this backhaul in accordance with market demands at a level of $80. Although this results in a price below marginal cost, the carrier has minimized its losses by losing only $10 on the move instead of $90. Pricing in this manner can be called loss minimization. So it can be argued that value-of-service pricing can be used as the price ceiling (profit maximization) and as the price floor (loss minimization). If the marginal cost in this backhaul lane is defined as those costs that would be avoided if the carrier, in fact, returned empty; that is, because the vehicle and driver are going to return anyway, the $90 for fuel and wages now becomes the fixed cost, which will now be included in the average cost figure. Marginal cost now becomes the added cost of loading the shipment and the reduced fuel efficiency, which will be assumed to be $20. On the headhaul, the price of $110 covers both the average cost of $100 and the marginal cost of $90. On the backhaul, the $90 is allocated as a fixed cost over the units of output to result in an average cost of $50. Now the $80 price charged covers both the average cost and marginal cost and results in a profit, just as the price produced a profit in the headhaul example. In this example, value of service provided the price ceiling and cost of service provided the price. RATEMAKING IN PRACTICE A complete understanding of carrier cost economics and behavior is a neces¬sary prerequisite to effective management of carrier pricing. The overall carrier pricing function revolves around costing, rates, and tariffs. The work of the carrier’s cost analysts should serve as a pricing input to rate personnel who are responsible for establishing specific rates and general rate levels for the carrier. A carrier may publish their own rates or they may use a rate bureau that is common to many carriers to establish and publish rates. General Rates These are the class, exception, and commodity rate structures in the United States. The class rate system provides a rate for any commodity between any two points. It is con¬structed from uniform distance and product systems. Exception rates are designed so that carriers in particular regions can depart from the product scale system for any one of many possible reasons, which will be discussed later. Commodity rates, on the other hand, are employed for specific origin–destination shipping patterns of specific commodities. Each one of these three systems has a particular purpose. There are thousands of important shipping and receiving points in the United States which gives some insight into the enormous magnitude of the transportation pricing problem. In order to have a rate between any combination, there would be trillions of trillions of possible rates. In addition, it is necessary to consider the thousands and thousands of different commodities and products that might be shipped over any of these routes. CLASS RATES The thousands of shipping points are simplified by dividing the nation into geographic squares. And the most important shipping point for all other shipping points (based on tonnage) in each square serves as the rate base point for all other shipping points in the square. This reduces the potential number of distance variations for rate-making purposes. The distance from each base point to each other base point was deter¬mined by the railroads and is published in the National Rate Basis Tariff. The distance between any two base points is referred to as the rate basis number. The second step deals with the thousands and thousands of different items that might be shipped between any two base points. The railroads and the motor carriers have established a national scale of rate in dollars per hundredweight for each rate basis number. The third step simply groups together products with similar transportation char¬acteristics so that one rating can be applied to the whole group. This number is called a class rating and it is the group into which the commodity is placed for rate-making pur¬poses. CLASSIFICATION FACTORS The factors that are used to determine the rating of a specific commodity are the product characteristics that impact the carrier’s costs. There are four factors are to be considered: product density, storability, handling, and liability. An individual carrier can establish a commodity classification that differs from the national classification. Product density directly impacts the use of the carrier’s vehicle and the cost per hundredweight. The higher the product density, the greater the amount of weight that can be loaded within the vehicle and the lower the cost per hundredweight. Stowability and handling reflect the costs the carrier will incur in securing and handling the product in the vehicle. Such product characteristics as excessive weight, length, and height result in higher stowage costs for the carrier and a cor¬responding higher classification rating. Likewise, products that require manual handling or special handling equipment increase the carrier’s costs and are given a higher rating. Liability considers the value of the product and because higher-valued products pose a greater liability risk (potential cost). Higher-valued products are classified higher than lower-valued products. DETERMINING A CLASS RATE The procedure for determining a class rate for moving a specific commodity between two points is as follows. The first step is to determine the rate base points for the specific origin and destination from the groupings tariff. Next, from the rate basis number tariff, determine the rate basis number for the relevant rate basis points. The class rating for the particular commodity being shipped is found in the classification. Finally, the rate is found in the class rate tariff for the appropriate rate basis number and class rating. The shipping charge for moving a product between a specific origin and destination is determined by multiplying the class rate, which is in cents per hundredweight, by the total shipment weight in hundredweight. EXCEPTION RATES An exception rate is a modification (change in rating, minimum weight, density groups, etc.) to the national classification instituted by an individual carrier. Exception ratings are published when the transportation characteristics of an item in a particular area differ from those of the same article in other areas COMMODITY RATES A commodity rate generally is a specific rate published on a specific commodity or group of related commodi¬ties between specific points and generally via specific routes in specific directions. When the commodity rate is published, it takes precedence over the class rate or exception rate on the same article between the specific points Rate Systems Under Deregulation The diminished role of the rate bureau in carrier rate making has resulted in plethora of individual carrier tariffs. In addition, the greater reliance upon the marketplace to control carrier rates has enabled shippers to greatly increase negotiations, resulting in rate reductions, discounts and contract rates. The product classification will probably continue for some time and the class rate structure will survive for some time to come. The class rate structure is a benchmark from which, in many cases, negotiated rates are based. Another pricing system is based on mileage. The rate is based on the total miles the shipment travels and weight might not even be a factor in the charges. In some cases, the rate is based on actual miles traveled while in other cases the rate is based on the shortest practical distance between the origin and destination. SPECIAL RATES LTL rates reflect the fact the LTL shipments require several handlings while in transit. Each one of these handlings requires dock personnel, material handling equipment, terminal investment and additional management effort. Truckload rates reflects the fact that there is little or no handling by the carrier. TL shipments have lower rates than LTL shipments. Multiple car rates are one method by which a railroad can offer discounts from the single car rate. The cost of moving several cars in a single shipment is proportionally less than the cost of moving each car individually. Incentive rate is a term applied to a rate which is designed to induce the shipper to load existing movements and equipment more fully. By inducing the shipper to load each vehicle more fully, fewer vehicles are needed and there are fewer moves over time, reducing the carrier’s cost. Unit-train rates are another type of incentive rate where the railroad transports an entire trainload of one commodity such as coal or grain. In some cases, the shipper might even provide the railcars, further reducing the carrier’s cost. Per-car or per-truckload rates reflect the use by the shipper of the entire vehicle and generally apply from the origin to the destination without regard to commodity or weight. Any-quantity rates do not provide a discount for larger shipments. These rates are normally used with light weight and bulky commodities. Density rates are based on the weight per cubic foot of the shipment and are used for light and bulky products that use space disproportionally to the weight. This is done to avoid loss of income to the carrier when a light or bulky commodity does not generate sufficient revenue based on weight to offset the carrier’s cost. AREA, LOCATION, OR ROUTE RATES Local rates apply between two points served by the same carrier. Joint rates apply to a shipment which requires two or more carriers to serve both the origin and the destination. Proportional rates are a method by which a carrier with an indirect route can compete for business against a carrier with a more direct route. These rates normally only apply to points beyond the carrier’s own line Differential rates normally apply to a carrier’s route that faces a disadvantage because of longer transit time. These were primarily used by railroads which did not have the shortest route or by water carriers in an effort to offset the slower transit time with lower cost. Per mile rates are based on the actual miles traveled or, in some cases, the practical mileage between the origin and destination. Terminal to terminal rates normally do not include pick up at the shipper and delivery to the consignee. These rates are most often found in connection with air freight. They may also be used in intermodal shipments where the shipper and consignee have their own tractors and can pick and deliver the trailers themselves. Blanket or group rates apply to a range of points or a geographic region. This allows producers in that area to be on an equal competitive footing as it relates to freight rates. TIME/SERVICE RATE STRUCTURES These rate structures are generally dependent on the transit time performance of the railroad in a particular service. One such contract provides for a standard rate for a transit time service norm. The shipper pays a higher rate for faster service and a lower rate for slower service. Another contract calls for additional shipper payments to the carrier for the fast return of empty backhaul shipper-leased cars. Contract rates have become the most widespread type of rates being used, particularly after the 1980 partial deregulation of motor and rail carriers. Rates governed by contracts are not affected by the carrier’s tariffs unless the contract so indicates. Contracts might require that an agreed volume must be shipped during the life of the contract in order to qualify for the lower rates. Contract Rates Contract services are commonplace in motor carriage and rail moves, as well as in water and some air moves. These services are governed by contracts negotiated between the shipper and carrier, not by generally published tariffs. Some specific contract service features that are typically found are described here. One basic contract service feature calls for a reduced rate in exchange for a guar¬antee of a certain minimum tonnage to be shipped over a specified period. Another contract service feature calls for a reduced rate in exchange for the shipper tender¬ing a certain percentage of all tonnage over to the contracting carrier. Another type of rail contract service feature calls for the rate to be higher or lower depending on the specific type of car supplied for loading and shipment, called a car-supply charge. A few contract service features require the shipper to pay a monthly charge to the railroad that supplies certain special equipment for the shipper’s exclusive use. This charge tends to increase the shipper’s use of the cars. Many different rate and service configurations are found in motor carriage and can call for such services as scheduled service, special equipment move¬ments, storage service in addition to movement, services beyond the small package pickup and movement, bulk commodity movement, or hauling a shipper-owned trailer. Carriers and shippers are relatively free to specifically tailor contract services to particular movements, equipment, and time-related services. The key in any con¬tract service is to identify the service and cost factors important to each party and to construct inducements and penalties for each. Deferred Delivery The deferred delivery rate is common in air transportation. In general, the carrier charges a lower rate in return for the privilege of deferring the arrival time of the shipment. For example, air express companies offer a discount of 25 percent or more for second- or third-day delivery, as opposed to the standard next-day deliv¬ery. The deferred delivery rate gives the carrier operating flexibility to achieve greater vehicle utilization and lower costs. OTHER RATE STRUCTURES Several other rate forms serve particular cost or service purposes. Corporate volume rates may contain a discount or other incentive which is based on all the business done by the corporation and is subsidiaries with a given carrier. This recognizes the fact that many large corporations conduct business through a variety of firms but control rests with the parent firm. Many carriers provide shippers with discounts which are deducted from the transportation charges or from the rate itself. These discounts are normally reflected as a percent to be deducted from the base rate and might be subject certain restrictions. Loading and unloading allowances are granted to shippers by LTL carriers when these companies perform the work which would normally be done by the carrier’s personnel. Aggregate tender rates are given as an incentive for the shipper to tender two or more shipments to the same carrier at the same time. The reduction in the rate offered by the carrier reflects the reduced cost the carrier enjoys when picking-up multiple shipments at the same location. Freight All Kinds (FAK) rates are also called all commodity rates. The rate applies to all commodities that the customer ships and is very useful for firms that ship a wide variety of goods. Released-value rates reflect the fact the shipper has agreed to accept a lower than actual value for their product in the event of loss or damage. Since the carrier is not liable for the full value of the products they can offer a lower rate to the shipper, reducing the shipper’s cost. Empty-haul rates are usually for transporting the shipper’s empty equipment to the point of next loading. Two-way or Three-way rates are those rates which apply for either round trip or a triangular move where the carrier is assured of few if any empty miles between loaded moves. Spot-market rates are something new since deregulation. Carriers are now permitted to make “on the spot” rates to adjust for excess capacity or fill idle equipment. Since service cannot be “stored”, it is in the carrier’s best interest to sell the unused capacity at a discount. Menu pricing also reflects the changes under deregulation. Carriers have “unbundled” their pricing and this allows customers to pick and choose which services they wish. PRICING IN TRANSPORTATION MANAGEMENT Under traditional economic regulation, little incentive was present for carriers to differentiate themselves through either service enhancements or pricing strategies. Today, however, both of these differentiating tactics are critical to carri¬ers in all modes, regardless of market structure. Factors Affecting Pricing Decisions Many carrier pricing decisions are based on some reaction to a stimulus from the busi¬ness environment, which can include customers (market), government, other channel members, and competition. The carrier’s price will be set at the level that maximizes its return. The concept of price elasticity also plays an important role in the market’s impact on carrier prices and users have a formidable impact on carrier prices. Other channel members can include other carriers in the same mode and in different modes. For example, interline movements between dif¬ferent carriers that involve revenue splits will certainly impact how each carrier prices its services. If one carrier decides to raise its price, the other carrier either has to reduce its price or risk losing business if that the market has high price elasticity. Competitors will impact carrier pricing strategies. Price leaders that offer discounts to customers will find that competitors will match those discounts, even at the risk of reducing industry profits. Carriers then must respond to changes and directions from their operating envi¬ronment such as when government regulations force carriers to make a change that reduces efficiency. Major Pricing Decisions Pricing decisions can be grouped into three categories. First, a car¬rier faces a decision when setting prices on a new service. Second, a carrier must make decisions to modify prices over time. Market changes, operating changes, and service changes will require prices to be changed. Finally, carriers will make decisions initiating and responding to price changes. In transportation, where many of the markets are oligopolistic, price changes down¬ward can be dangerous because of their potential to decrease industry revenues. Establishing the Pricing Objective Carrier pricing objectives reflect overall company objectives and reflect how the carrier will compete in its markets. Pricing objec¬tives might also change for a particular service offering as it progresses through its product life cycle or to establish various pric¬ing objectives for these markets. Survival pricing tries to take advantage of the marginal cost concept. Closely related is a unit volume pricing objective. This attempts to utilize a carrier’s existing capacity to the fullest, so the price is set to encourage the market to fill that capacity. Another price objective is called profit maximization, which can occur in the short run or in the long run. Carriers using this type of pricing usually are concerned with measures such as return on investment. A skimming price is a high price intended to attract a market that is more concerned with quality, uniqueness, or status and is insensitive to price. Many times a skimming price strategy is followed by a penetration price strategy. This can be an effective strategy because (1) a high price can be charged until competition starts to enter; (2) a higher price can help offset initial outlays for advertising and development; (3) a high price portrays a high-quality service; (4) if price changes need to be made, it is more favorable to reduce a price than to raise it; and (5) after market saturation is achieved, a lower price can appeal to a mass market with the objective of increasing sales. A market share pricing objective can be used in an industry whose revenues are stagnant or declining. This strategy might assume that competitors’ offerings are substitutes and that competitors are not in a position to match the lower prices; if the services were not substitutes, a lower price would not provide a competitive advantage. Finally, a social responsibility pricing objective forgoes sales and profits and puts the welfare of society and customers first. This is often seen where carriers will transport relief supplies at no cost. Estimating Demand Probably one of the most difficult tasks associated with pricing is estimating demand as transportation carriers do not function in per¬fectly competitive markets. Demand estimation can become very tedious and diffi¬cult. Certain concepts and procedures, such as price elasticity (which refers to the change in demand because of a change in price), can be used in this process. In an established market for a carrier, this relationship should be well developed to the point where demand implications from a price change should be easy to estimate. A market test is a possible way to determine potential demand when mar¬ket testing is feasible. Although not a science, demand estimation is a critical part of pricing strategy as it results in potential revenue estimation. With revenue estimated, costs should next be established. Estimating Costs A decision must be made as to which costs should be included in the total cost analysis. Another cost relationship that must be examined is how costs behave at different levels of output or capacity. The existence or nonexistence of scale economies in transportation, for example, will affect how costs behave at different capacity levels. Price Levels and Price Adjustments With demand and cost estimates generated, it is possible to set the actual price. Many methods for doing this exist, including demand-based methods, cost-based methods, profit-based methods, and competition-based methods. Discounts are a reduction from a published price that rewards a buyer for doing something that is beneficial for the supplier. LTL versus TL prices reflect carrier savings from larger shipments, a portion of which is passed on to the customer in the form of a lower price. This could be called a quantity dis-count. Geographic adjustments are common in the transportation industry. Although not directly used by carriers, geographic adjustments are used by shippers and receivers to compensate for transportation costs in the final price to the customer. When using discounts and allowances in the transportation industry, an important rule to remember is that a discount or allowance passed on to a customer must be the result of a reduction in carrier costs so as to avoid conflict with the STB (rebates) and the Justice Department (antitrust and rebates). Most Common Mistakes in Pricing Carriers have not had many years of experience in setting and managing prices on a strategic level. The first common mistake is to make pricing too reliant on costs. Competitive factors, customer preferences and values, and government regula¬tions will affect the level at which the price will be most beneficial to the carrier. The second common mistake is that prices are not revised frequently enough to capitalize on market changes. Setting the price independently of the marketing mix is a third common mistake. The marketing mix, also known as the “4Ps,” consists of product, price, promo¬tion, and place. Managing one of these areas independently of the others will result in a suboptimization of the carrier’s resources and its profits. Finally, price is sometimes not varied enough for different service offerings and mar¬ket segments. Charging one price for all services is not going to maximize the profits for the carrier. Study Questions 1. Compare and contrast pure competition with monopoly from a pricing perspective. If you were a shipper, which would you prefer? Why? Which would a carrier prefer? In pure competition there are a large number of sellers who have no influence over prices or supply, and producers can sell all output at one market price, but nothing above that price. Monopolies can price to their own advantage. A shipper would prefer pure competition which would make carrier and mode decisions easier. Carriers would prefer a monopoly because it would allow them to price to their advantage. 2. Describe an oligopolistic market structure. What alternatives to price competition exist in such markets? Why would these alternatives be important to shippers? Oligopoly is a market structure where a few large sellers of a relatively homogeneous product with enough cross elasticity of demand that each seller must take into account competitors' reactions. In this market, sellers have to consider, in addition to changing prices, competitor's output, promotional activities, and quality of product as competitive alternatives. These alternatives are important because shippers might require different price/service packages. This market is similar to that which exists in the railroad industry but all modes encounter this type of competition on some occasions. 3. What is value-of-service pricing? Is this approach to pricing valid today? Value of service pricing can be conceptualized in a number of ways. One perspective proposes that it is pricing according to the value of the product. Another identifies it as pricing according to what the traffic will bear. One approach sets value of service pricing as third-degree price discrimination, where the seller sets two or more market prices for two or more separate groups of buyers of essentially the same commodity or service. Similar to the third-degree price discrimination approach is differential pricing where the carrier charges different prices to different segments of traffic for essentially the same service and the rate differences cannot be explained by differences in the cost of the service. Value of service pricing is most valid today where the movement of higher value products requires a higher level of transportation service, and the increased presence of competition in the transportation marketplace and differences in elasticities of demand for products creates situations calling for dissimilar pricing. 4. What is cost-of-service pricing? What is the relationship between value-of-service pricing and cost-of-service pricing? Cost of service pricing takes a marginal-cost approach to pricing. Cost of service pricing can also be analyzed as a total cost or fully allocated cost approach to price setting, where the price charged by a carrier for a movement of a commodity represents the recovery of the related costs to make the movement. Here: Price = FC + VC + Profit. Price is determined by the allocation of fixed costs and variable costs to the commodity movement, and adding a margin for profit. Relating pricing to total costs or fully allocated costs does not take into account such considerations as competition and elasticity of demand affecting the price charged. The presence of common costs raises some problems for cost-of-service pricing, particularly the average cost approach. If rates are based upon average of fully allocated costs, it becomes necessary to apportion these costs by some arbitrary means. 5. What is a released value rate and how does it affect a shipper’s transportation costs? Released rates reflect the fact the shipper has agreed to accept a lower than actual value for their products in the event of loss or damage. Since the carrier is not liable for the full value of the products they can offer a lower rate to the shipper, reducing the shipper’s cost. 6. What are the major forces that affect carrier pricing strategies? The major forces affecting carrier pricing are customers (market), government, other channel members, and competition. Value of service pricing focuses on the role of the customer (market) to determine prices. A profit maximizing carrier will not set a price in the long-run that will stop the movement of passengers or freight. This depends upon what the market perceives is a reasonable price and/or what the market is forced to pay. The federal government has economically regulated transportation for more than 100 years. Some of this regulation deals with the prices carriers can charge in terms of how they are constructed and how they are quoted. Channel members include other carriers in the same mode, and other modes. Interline movements can affect how carriers price their services. Competitors also impact pricing strategies. Offering discounts, special fares, and allowances by one carrier can affect the pricing strategies of competing carriers.) 7. How might pricing strategies differ among carriers in perfectly competitive markets, oligopolistic markets, and monopolistic markets? In a perfectly competitive market, carriers cannot influence price. Services are priced at the market level. In oligopolistic markets, the market leader sets the price and competitors respond to that price. In a monopolistic market, there is only one seller, who maximizes profits. 8. What are the various factors used in classifying commodities for tariff purposes? The factors that are used to determine the rating of a specific commodity are the product characteristics that impact the carrier’s costs. In particular, the ICC has ruled and the STB has maintained that four factors are to be considered: product density, stowability, handling, and liability. Although no specific formulas are used to assign a commodity to a particular class, the four factors are considered in conjunction by a carrier classification committee. An individual carrier can establish a commodity classification that differs from the national classification; this individual carrier classification is termed an exception and takes precedence over the national classification. Product density directly impacts the use of the carrier’s vehicle and the cost per hundredweight. The higher the product density, the greater the amount of weight that can be hauled and the lower the cost per hundredweight. Conversely, the lower the product density, the lower the amount of weight that can be hauled and the higher the cost per hundredweight hauled. As shown in Table 4.4, only 6,000 pounds of a product that has a density of 2 pounds per cubic foot can be loaded into the trailer, which means the cost per hundredweight shipped is $6.67. However, 48,000 pounds of a product with a den¬sity of 16 pounds per cubic foot can be hauled at a cost of $0.83 per hundred¬weight. Therefore, the higher the product density, the lower the carrier’s cost per weight unit and the lower the classification rating assigned to the product. Stowability and handling reflect the cost the carrier will incur in securing and handling the product in the vehicle. Such product characteristics as excessive weight, length, and height result in higher stowage costs for the carrier and a cor¬responding higher classification rating. Likewise, products that require manual handling or special handling equipment increase the carrier’s costs and are given a higher rating. The final classification factor, liability, considers the value of the product. When a product is damaged in transit, the common carrier is liable for the value of the product. Because higher-valued products pose a greater liability risk (potential cost), higher-valued products are classified higher than lower-valued products. In addition, products that are more susceptible to damage or are likely to damage other freight increase the potential liability cost and are placed into a higher classi¬fication rating. 9. What are the differences among class, exception, and commodity rates? These are the class, exception, and commodity rate structures in the United States. The class rate system provides a rate for any commodity between any two points. It is con¬structed from uniform distance and product systems. Exception rates are designed so that carriers in particular regions can depart from the product scale system for any one of many possible reasons. Commodity rates, on the other hand, are employed for specific origin–destination shipping patterns of specific commodities. Each one of these three systems has a particular purpose. An exception rate is a modification (change in rating, minimum weight, density groups, etc.) to the national classification instituted by an individual carrier. Exception ratings are published when the transportation characteristics of an item in a particular area differ from those of the same article in other areas. A commodity rate can be constructed on a variety of bases, but the most common is a specific rate published on a specific commodity or group of related commodi¬ties between specific points and generally via specific routes in specific directions. Commodity rates are complete in themselves and are not part of the classification system. If the commodity being shipped is not specifically stated, or if the origin– destination is not specifically spelled out in the commodity rate, then the commod¬ity rate for the particular movement is not applicable. When the commodity rate is published, it takes precedence over the class rate or exception rate on the same article between the specific points. 10. Why were tariffs created? Are they still useful in today’s transportation environment? Tariffs originated under a government regulated pricing system and were enforceable under ICC law. Tariffs are the actual publications in which most rates are printed. Some firms print their own tariffs, which are often referred to as individual tariffs, or they use a rate bureau that is common to many carriers to establish and publish rates. These tariffs are referred to as bureau tariffs. They are still useful as they have the ability to convey pricing and the carrier’s rules and term of sale in a manner which is familiar and understood. Although deregulation has somewhat diminished the use and application of the class, exception, and commodity tariff sys¬tems, various features of these tariff systems are widely used today for the pricing of small LTL freight. Case Questions Case 4.1 – Hardee Transportation (A) 1. What would be the advantages/disadvantages of using cost-of-service versus value-of service pricing for Hardee’s customers? When discussing cost-of-service pricing, what type of cost (average versus marginal) would make more sense for Hardee? The first option would be Activity-based costing (ABC) which identifies costs specifically generated by performing a service or producing a product. ABC does not allocate direct and indirect costs based on volume alone; it determines which activities are responsible for these costs and burdens these activities with their respective portion of overhead costs. Some of the new services which might be requested are somewhat similar in nature to those currently being offered which might provide a basis for developing to cost of the new services. Two types of costs, separable and common costs, must be considered in this determination. Some of the new services will require purchasing additional equipment which must be factored in. Hardee must determine if the new equipment would be exclusively for the new services or if it could be used for other areas of the business and cost appropriately. 2. How would you develop a methodology for Hardee to price its existing services? Its evolving services? Would you use the same or different strategies for each? Hardee will need to carefully review each proposed service to see if these services can be costed on a stand alone basis. In any event, a certain amount of overhead or fixed cost should be added as the underlying business expenses such as utilities, insurance, management and overhead will continue with the expansion and could possibly rise. Hardee must also determine the impact of the loss of the customer requiring the new service and whether a new customer could be located or if the service is so unique that any fixed expense is lost. Hardee’s interest in value of service pricing should work well in this situation as he can factor this in his pricing decisions. He should not lose sight of the fact that such value added services could provide higher customer loyalty making it harder for a customer to switch to a competitor. Case 4.2 -Hardee Transportation (B) The analysis for this case can be structured in the same manner as the truckload costing example given in the Appendix to this chapter. The analysis is as follows. 1. Pickup: 40 miles and 4 hours 2. Sorting: 8 hours (using 2 dock workers) 3. Linehaul: 1249 miles and 43 hours, 48 minutes 4. Delivery: 15 miles and 2 hours, 30 minutes I. Pickup (Remember that revenue miles = loaded miles; in this case this would be 1249 linehaul miles plus 20 miles from the customer back to the dispatch center). 1. What are the pick-up, sort, linehaul, and delivery costs to Hardee for this move? Pick-up = $165.52 Sort = $400.00 Linehaul = $1389.99 Delivery = $26.44 2. What is the total cost of this move? Cost per cwt.? Cost per revenue mile? Total cost = $2140.51 Cost per cwt. = $5.35 Cost per revenue mile = $1.69 3. If Hardee would put two drivers in the tractor for the linehaul move, there would be no rest required for drivers during the linehaul move. What would happen to total costs? In this case, the linehaul portion of the costs need to be recalculated and added to the original pick-up, sort, and delivery costs, remembering to recalculate the administrative/overhead costs on the new total. In the new linehaul calculation the total hours will be reduced from 43.8 hours to 27.8 hours. The new hour total removes 16 rest hours from the total move. The miles remain the same as do all of the item costs. The only total costs that change are the depreciation and interest for the tractor and trailer. The new amounts are: Adding these to the fuel, labor, maintenance, and insurance costs results in a new total linehaul cost of $1311.11. Revenue Needs 1. Cost per cwt. ($2055.32/400) = $5.14 2. Cost per revenue mile ($2055.32/1269) = $1.62 Obviously, adding a second driver reduces total transit time, thus reducing total operating costs. 4. Assume that Hardee has no loaded backhaul to return the vehicle and driver to Pittsburgh. How would you account for the empty backhaul costs associated with this move? Would you include those in the headhaul move? How would this impact your pricing strategy? There is no one answer to this question. Assuming a value-of-service pricing strategy, Hardee would need to consider market conditions and the importance of the headhaul customer. Hardee might not want to add the empty backhaul costs to the headhaul customer’s price for competitive reasons. Assuming a cost-of-service pricing strategy, Hardee would need to recover, at a minimum, the marginal (variable) costs of returning empty. Using the original costing answer to the first question and assuming a single driver, the variable costs of returning empty would be fuel and labor. As such, the empty backhaul would incur another $399.68 in fuel costs and another $524.58 expense for driver wages. Adding this to the original total truckload cost of $2140.51 would result in a round trip cost of $3064.77. The resulting new cost per cwt. would be $7.66 and the new cost per revenue mile would be $2.42. This would obviously increase the price to the headhaul customer. However, as mentioned at the beginning of this answer, Hardee needs to make the decision on which cost to use based on the market conditions and the importance of the headhaul customer. Suggested Internet Project 1. Have the student log into the National Motor Freight Traffic Association website (www.nmfta.org). click on CCSB, and go to Recent Classification Actions. Have them pick a recent decision and discuss the implications this decision would have on a carriers pricing strategies. The student could also try to recreate the decision using the same four criteria (product density, stowability, handling, and liability) used by the NMFC. 2. Have the student log into the Surface Transportation Board website (www.stb.dot.gov/). Go to the E-Library and find recent decisions regarding railroad pricing initiatives. Have the student discuss the rationale for the decision and the resulting impact on the railroad. Instructor Manual for Transportation: A Supply Chain Perspective John J. Coyle, Robert A. Novak, Brian Gibson, Edward J. Bardi 9780324789195
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