QUESTIONS FOR CLASSROOM DISCUSSION ON COST ANALYSIS

This time, our reading not only gives us a real-world example of cost-analysis, but also yields an excellent transition for our next discussion on the determination of price. As a result, consider the following:

• The article states, “Bottle price is directly linked to cost of producing.” What is the economic reasoning behind this statement?
• If we hold all things related to wine production constant, except for land, why might a winemaker pay more for a vineyard in Napa Valley (per acre) than for land in any other wine region?

Our classroom discussion will take place after spring break!  

Posted by Prof. C-S

Cost Analysis

Discussion on “The Price You Pay: Why Some Wines Cost More Than Others” (The Wall Street Journal, Sept. 12-13, 2009)

 Summary

The article, “The Price You Pay: Why Some Wines Cost More than Others,” explores the range of price differences in wine, which delves into the upcoming unit of Cost Analysis.  Brand name wines may not be the most delicious wines, according to the article, as much more than the name of the wine goes into the pricing of a bottle.  The difference between the inexpensive $5.00 bottles and the bottles that cost upward of $100 depend on costs like land and bottling systems.  Vineyards located in regions like Napa Valley have high real estate costs, with land priced at almost $300,000 per acre, along with five to ten thousand dollars per acre in upkeep a year.  Wines that are grown in regions that are less popular and recognized tend to have lower real estate costs, dropping the price of their bottles.  Also, grapes like Petite Sirah tend to be used for less expensive wines in comparison to Cabernet grapes.  Variable costs like corks and labels are relatively expensive, and the fixed costs associated with wine, like the French barrels and wine presses can cost over $20,000 in total.  Consumers are willing to pay top dollar for the prestigious image that some wines offer, yet there are still many more moderately priced alternatives that are still delicious. 

Commentary

Cost analysis helps to determine the cost of production, including implicit and explicit costs, that vary with output.  In class, we also touched upon returns to scale.  The wine bottles that cost $5-10 probably have increasing returns to scale.  They use less expensive inputs, such as the cheaper land and grapes, and over time, will be able to produce more wine for less.  These companies are able to invest in the same technologies that the expensive wine manufacturers are using, such as the bottling system, but they have cheaper variable costs due to the inexpensive land and grape breeds.  As a company produces more wine, the less it becomes to manufacture the bottles.  The lower priced bottles of wine will typically sell more as the quantity demanded rises, allowing these companies to cover their costs of production.

 Real World Application

McDonald’s is one of the world’s largest fast food restaurants and its success can largely be attributed to its ability to control costs.  The restaurant is able to deliver food in a very short amount of time and for a comparatively low price—two aspects of the business that have made it so successful to date.

Much of McDonald’s success can be attributed to its economies of scale. The company’s competitive advantage with respect to sit-down restaurants is obviously its price point. The firm is so large in size, has such easy access to capital markets, and great bargaining power with suppliers that it is able to purchase production inputs at a drastically lower price than family owned restaurants.  This in turn affords McDonalds the ability to charge low prices and attract a large consumer base—something that has been imperative in its growth. 

Another manner in which McDonalds controls costs and thus has been able to stand out in the fast food space, is through low labor costs.  Because McDonalds has done such a wonderful job in streamlining the making of its various products, McDonalds does not need the skilled chefs that other restaurants would require to remain in business.  Through years of experimentation, McDonalds has the process down so well that nearly anyone can learn how to make a hamburger in a short amount of time (similar to Toyota’s lean manufacturing idea).  Restaurants in South Bend, such as the Mark in Eddy Street, require highly skilled chefs to produce the food that is on their menu.  More highly skilled chefs obviously have to be compensated accordingly and thus the Mark may have a more difficult time controlling labor inputs than McDonalds. 

Overall, McDonalds has been a highly successful franchise for over 50 years and it is imperative to recognize their cost control ability as a key driver in this success.  Their economies have scale have allowed them to purchase inputs at a much lower price than family owned restaurants and their ability to streamline the production process has allowed them to pay their workers comparatively less than other stand-alone restaurants.  

Posted by Lexi, Hannah and Ryan (Section 3)

Cost Analysis Real World Application Blog Post

Discussion on “The Price You Pay: Why Some Wines Cost More Than Others” (The Wall Street Journal, Sept. 12-13, 2009)

 Summary

The Price You Pay: Why Some Wines Cost More Than Others explores both the supply and demand side determinants of wine pricing.  Anyone who has ever purchased wine has most likely been faced with confusion over the vast discrepancies between cheap “two buck chuck” wines and wines that are priced into the hundreds.  According to the article, the expensive wines aren’t simply taking in massive profit margins based on brand name.  In reality, the land that the brand name grapes are grown on can cost $300,000 per acre with $5-10000 per acre per year in upkeep.  Moreover, a barrel can cost $1000 and a tank $10000.  Many other fixed costs such as bottling systems and variable costs such as corks and labels also contribute to the price of wine.  On the other hand, some regions which lack the brand name command cheaper real estate prices.   The article notes, however, that there are plenty of cheaper wines that taste good and more expensive wines that aren’t much better than the cheap stuff.  This all relates directly to classroom production theory, consumer theory, and supply demand equilibrium- wealthy wine consumers are willing to pay top dollar for the prestige and brand image of some grapes and that drives these grape’s prices sky high.  On the other hand, people just looking for a cheap bottle of wine are willing to settle for whatever is reasonable – keeping that vineyard land low priced.

 Commentary

The article notes the extremely high fixed costs of producing wine.  As mentioned earlier, barrels and tanks as well as bottling systems cost tens of thousands of dollars.  How, then, are some brands of wine so cheap?  The answer is that these wines are from lesser known regions where land is cheaper.  In addition, these suppliers take advantage of economies of scale in order to pay less cost per bottle of wine.  The article doesn’t mention this but they are also most likely aged less since aging has a high accounting and opportunity costs by holding them in barrels for so long.

 Another Application

In this article, Eric Bleeker discusses the cost of the iPad 3 and argues that it will remain at the same entry-level price as the iPad 2.  Even though the iPad 3 will consist of more advanced technology, Bleeker suggests that Apple will keep the entry-level cost the same because there is too much risk to raising the price.  There are many arguments as to why Apple must raise the price of the iPad 3.  For example, the iPad 2’s display was 39% of total material costs.  It is almost basically confirmed that the iPad 3 will have a retina display, which includes two to three times the pixels per inch which would obviously drive the costs up.  Bleeker points out that Apple could make the price more expensive than the iPad 2 because they have used a very aggressive pricing strategy since its introduction.  He also notes that the iPad has commanded a comfy profit margin, but it was priced at a level that sacrificed margins for rolling up market share.  However, companies do not always make more profit by placing a higher price on their products.  There is risk to that strategy.  If Apple did end up pricing the iPad 3 higher, it would only widen the gap between the iPad and lower-priced tablets such as the Kindle or Nook.  Further, Apple has not yet completed their full transition into the tablet market as they believe to still be in the very early stages of a shift.  That being said, Apple’s long terms goals would best be suited towards concentrating on that shift using strategically competitive pricing.

Posted by James and Jordan (Section 4)

Resources:

“The Top 3 iPad 3 Storylines: First, How Much Will It Cost?” – Eric Bleeker, The Motley Fool, financedaily.com

Cost Analysis

Discussion on “The Price You Pay: Why Some Wines Cost More Than Others” (The Wall Street Journal, Sept. 12-13, 2009)

 Summary

The article found in the Wall Street Journal discuses wine and why there is a large variation in the price of various bottles. The author states that economies of scale are the main factors for the price variation found in the wine industry. The price of wine is based on more than the flavor. The value of wine is a result of the costs of production as well. The article describes various costs including fixed costs, such as land. Land is one of the higher expenses that wine makers must incur. The cost of land varies depending on the location of vineyards. Lower priced wine typically comes from regions that are not famous for growing grapes.

There are other variable costs incurred such as the amount and type of grapes used in the production of wine. The price of grapes is very volatile and the swings in price affect the price of wine.  In order to make wine, winemakers need more than grapes and a lot of various costs arise from the need of equipment. Barrels, bottles, corks, labels, bottling fees, and maintenance are some of the other variable costs in the production of wine.

Economies of scale allow some wines to be cheaper than others. Economies of scale increases the efficiency of production allowing companies to lower their cost per unit by increasing production and distributing costs amongst a higher number of goods. The average price of wine decreases as the production increases. Thus internal economies of scale exist in the wine industry because the larger the individual firm is the lower their costs per unit are.

Commentary

The first question posed within this article asks why some wines cost $100 and other wines cost $10, with some wines even being as cheap s $5 a bottle. This may initially seem confusing, especially because of all the components that go into the production of a bottle of wine, such as agriculture, barrels, corks, bottles, labels, bottling fees, tanks, and other various costs that go into the production of one bottle of wine. With all of these costs, it makes sense that various bottles of wine are fairly expensive. In the Napa region, for example, land in which grapes are grown can go for as much as $300,000 per acre, with maintenance costs ranging from $5,000 to $10,000 per year. Barrels can also cost as much as $1,000, and stainless steel tanks can cost between $10,000 and $20,000 as well, with bottling lines possibly costing up to half a million dollars. With all of these costs, it seems near impossible for bottles of wine to be cheap.

However, the main reasons bottles of wine can cost only $5 comes in the nature of economies of scale. As the article states, if a company has a large amount of capital already invested into the production of wines, they have the capability to, over time, decrease their average costs through the mass production of wines. If a winery can produce a lot more than another winery, it can lower its prices in order to sell more wine and eventually cover all of its costs, which is contingent on the increased sales. Another reason that some wines can be as cheap as $5 a bottle is because different wines use different grapes, and some wineries are in less popular areas than others. Certain grapes such as Chenin Blanc and Petite Sirah cost less than other grapes such as Chardonnay and Cabernet. Also, because certain grapes are grown in vineyards in different regions, the cost of acquiring/maintaining these lands are a lot cheaper. Vineyards that are not located within that Napa region, for example, will be a lot cheaper to acquire than lands within the Napa region. The wineries that have these locations also have the advantage of having lower fixed costs, which further creates an advantage with economies of scale—since the costs are lower, they can lower the prices of the bottles without losing nearly as much profit.

Description of a real world application

IKEA is renowned for being a leader in the home furnishing sphere. This is because of their ability to sell decent furniture at a much lower price as compared to traditional furniture stores. Two main factors can be contributed for this success.

Firstly, IKEA has been able to reduce a bulk of its cost through economies of scale. IKEA utilizes its massive economies of scale to secure long term contracts with manufacturers. They also reduce cost of raw materials through bulk buying. The massive size of the company means that they can demand lower prices for material which suppliers can and are willing to give as it guarantees them steady income.

Secondly, all the furniture sold in IKEA is designed to be self assembled. This also helps to reduce cost and the use of packaging. For example, the volume of a bookcase case is significantly less when it is not assembled as compared to when it is assembled, as the volume dictates the price in shipping. Also IKEA only rely on the cheaper cargo container for transportation, totally avoiding the more expensive air shipping. Selling unassembled pieces of furniture definitely help to reduce shipping cost for IKEA. Furthermore, this idea works with the consumers. This is because, the steps to assemble to furniture is easily understood and also most of the consumers, especially in Europe, rely on public transportation which means that the flat pack methods allow for easier transportation.

IKEA has always been a forerunner in cost analysis. This is because through cost analysis and the subsequent cost cutting, they are able to sell their product at a advantageous cost and as such attract more customers. All in all, this results in the increase of the productivity of IKEA.  

Posted by Brian, Eddie, Jazmin and Dorothy (Section 2)

Cost Analysis

Discussion on “The Price You Pay: Why Some Wines Cost More Than Others” (The Wall Street Journal, Sept. 12-13, 2009)

 Summary

The article “The Price You Pay: Why Some Wines Cost More than Others” discusses why there are such variances in the cost of a bottle of wine. The price of a bottle of wine is not merely based off what it tastes like; there are many other factors to consider. The grapes used to make the wine have a large impact on the final price. The value of grapes depends on the location and the value of the land which they are grown on. If the grapes are from a vineyard in Napa Valley, they are more likely to have a higher value, thus raising the price of a bottle. In this sense, location of the vineyard is similar to real estate, for perception is related to value. Different varieties of grapes also impact the final price. Popular and well enjoyed grapes will often have a higher price. There are also many other costs of productions that affect the cost of a bottle of wine. Producers must consider the cost of labels, corks, bottles, barrels, tanks, and other inputs as they price the bottle. Economies of scale also play a large factor in bottle price. As more bottles of wine are produced, the unit cost of producing a bottle decreases, making it possible to still have reasonably priced bottles of wine. These factors influence wine bottles’ large range of prices. The article advises that consumers with a more modest budget look for alternative and wine regions and grapes. This article is relevant to classroom theory because it is about the cost of production. There are many costs to consider when producing and pricing a bottle of wine. This article also deals with implicit costs, which are the next best alternative that the resources used in production could have produced instead. An example of an implicit cost in the article would be foregoing one type of grape in favor of another type.

 Commentary

There are several factors that influence the price of a bottle of wine. One determinant is the types of barrels you use in the aging process. A typical French barrel, which holds up to 23 cases of wine, costs you $1,000, while a stainless steel tank can range from $10,000 to $20,000. And a new state of the art bottling line can put you back up to $500,000. In addition, high quality labels and corks can cost from $0.50 to $1.00 each. This large disparity in fixed costs play a huge factor in the price you charge to consumers. Even with the high fixed costs of starting your own vineyard, economies of scale (in the long run) allow for reasonable prices.

 Real World Application

One of the concepts mentioned in this article mentioned how the particular inputs of the product impacted the overall cost of production. Pointing to the idea that wine which is priced ten times higher than another wine may not necessarily taste ten times better; rather it is the consumer perception of the inputs placed into the production process. Real estate is an example that is both mentioned in this article, and is a great example of what we are seeing with the varying wine prices. Two different apartments–both built with very similar size, layouts/floor plans, quality, and features, have an extreme variance in listing price. The variance may be almost exclusively due to their relative locations. Apartment one may be located in a highly valued area in New York City, Chicago, etc. Whereas the other apartment unit may be located in the outskirts of those cities or even in the downtown area of a much smaller city. The difference in listing prices in this case is mostly dependent on the consumer perception of what may be more valuable or preferred.

Posted by Nick, Coley and Jenna (Section 1)