Pat Ryan's Price Elasticity of Demand Mileage-Based Pricing Method

Pat Ryan’s Mileage-Based Tariff Concept

The price per-mile used as a base for an LTL tariff (or any ground-based transportation) can be determined by using a cost formula that is based on an optimal mark-up on cost. This method not only considers all relevant costs, but also takes into consideration the effect of price sensitivity of demand for a company’s service. Additionally, this price-per-mile will not be constant, but should vary depending upon the length of haul. Longer distances than the average have a lower average cost per mile, as the pick-up and delivery costs are averaged over more miles.

Cost:
The operating cost, per-hundred-pounds, per-mile is the relevant cost to be used to compute the price charged for a carrier’s service (MC). The relevant costs to be included in the calculation of this figure are the differential costs. Differential costs include all variable costs (but not all fixed costs). All fixed costs do not need to be included when not operating at full capacity. In the long-run, all costs must be included in the equation, as increasing capacity requires increasing fixed costs. All costs are differential in the long-run.
Using activity-based costing to analyze the breakdown of an organization’s costs, a company can break down the operating cost-per-mile into its component costs. The component costs (drivers) of the operating cost-per-mile can be identified and measured as a percent of total sales, in order to determine the percentage change in each cost category from year to year. In this way, a company can see which costs are increasing the fastest, whether year-to-year cost increases are due to fixed or variable costs, and whether the costs are within their control. Here is an example of the operating costs that should be included in the analysis:
1. Driver/owner operator, P&D costs
2. Insurance cost
3. Fuel cost (Including price increase cost and fuel efficiency deterioration cost)
4. Fleet maintenance cost
5. Equipment capital cost
6. General operating cost

Some cost increases are addressed through surcharges and accessorial fees by most carriers and so do not need to be included in the calculation of class rates. For instance, one cost that is outside of a company’s control, fuel price fluctuations, has been addressed through fuel surcharges. However, other costs beyond a company’s control, such as the recent fuel efficiency deterioration (caused by new environmental emissions regulations) are costs that cannot be addressed by surcharges or accessorial fees and so must be included in the MC figure used in the optimal mark-up on cost formula. Other costs are at least partially under a company’s control, such as driver costs, insurance, fleet maintenance and equipment capital cost. However, these costs still tend to increase every year (especially labor costs) and so should also be included in the MC figure. Knowing what current costs to include in the MC figure (and the projected cost increases) is essential to creating a profitable tariff when using the optimal mark-up on cost tariff. What costs to include in the MC figure must be left up to each carrier to decide.

The Competitive Factor:
Price elasticity of demand (εp) measures the responsiveness of quantity demanded to a change in price. Own price elasticity of demand measures how much business will be lost to another company within the same mode, with a given price increase. Quantitatively, an estimated price elasticity measures the percentage change in quantity demanded (or supplied) resulting from a 1 percent change in the price, other factors constant. Within each mode, each company will have its “own” price elasticity of demand. “Own Price Elasticities of Demand” average (-.5) for North American Trucking.
The equation below will yield the average price per-hundred-pounds, per-mile that optimizes profit, given the company’s costs and price sensitivity of demand. We can use this average price per-pound, per-mile for the price of the average shipment (average length of haul, freight class and weight), extrapolating from this average optimal price to all other pricing. We will use the NMFC classification system’s relative values to extrapolate from the average price to all weights and freight classes, while using the equation below to supply the average base price per mile used as input for the price per mile of the average shipment.
The equation for computing the profit-maximizing price based upon cost and the firm’s own price-elasticity of demand is:
1
P= MC (1 + 1/єp)

For the purposes of this illustration, we’ll estimate the operating cost, per-hundred-pounds, per-mile to use in the equation below (although this figure is usually known) in order to compute the optimal price that should be charged per hundred pounds, per mile for our average shipment (at average class and average level of discount). I estimate that the operating cost per hundred pounds, per mile is close to 1 cent. However, this figure would not be an estimate if I had the shipment information that already exists in most company’s records. I also estimate the price elasticity of demand for an imaginary company to be -.7 for the purposes of this illustration. The reason for this higher price elasticity of demand might be due to the fact that the carrier has a limited coverage area and/or an extra call has to be made in order for the shipper to use the carrier’s services.
The calculation below is based upon two estimates. Usually, the price elasticity of demand is the only figure that is estimated.
___1___
P= .01 (1 + 1/-.7) = .023 cents, per-hundred-pounds, per mile.
This converts to .23 cents, per mile. So, the average (1,000 pound-class 70?) shipment, moving 750 miles=$172.50. The average shipment handled by any company is easy to determine, using historical records. This price is probably low when compared with a competitor’s rates for the same shipment. The same shipment moving 2,000 miles= $460.00. The rate for the 2,000 mile shipment is probably high when compared to a competitor’s rates.
The reason for this is that a static price-per-mile cannot produce consistently competitive rates over different lengths of haul. Longer distances than the average have lower average cost per mile, as the pick-up and delivery costs on each end are averaged over more miles. Similarly, shorter hauls than the average have higher average cost per mile. Adjustments can be made to reflect this reality, while making sure that the average rate per mile equals the optimum. In this way, you can both retain your profitability on the short-haul freight and price competitiveness on the long-haul shipments. If we gradually adjust the base rate per mile downward by some percentage from the optimal price as mileage increases from the average length of haul and upward as mileage decreases from the average length of haul, we will produce a tariff that works.