Pat Ryan’s “Optimal Mark-up on Cost Tariff” Synopsis

The price per mile to use as a base for a transportation tariff can be determined using an optimal mark-up on cost formula. This method not only considers all relevant costs, but takes into consideration the effect of price sensitivity of demand for a company’s services (the competitive factor). The resulting price per mile is not static, but is adjusted to be competitive, while seeking to achieve the average (mean) optimal mark-up on cost.

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)

The relevant costs to be included in the calculation of this Marginal Cost figure (MC) are the differential costs per mile. These costs include all variable costs (but not all fixed costs) when a trucking company is not operating at full capacity. However, if a company is expanding beyond its capacity, all costs must eventually be included in the equation, as increasing capacity requires increasing fixed costs. All costs are differential in the long run.

When using the optimal mark-up on cost formula, knowledge of the own price elasticity of demand (єp) is the only estimate made in this formula. This estimate is needed for a firm to maximize profits. Own price elasticity of demand indicates what effect pricing changes will have on the firm’s revenues, based upon the amount of business that may be lost to competitors due to a price increase.

A shortcoming of some mileage-based tariffs is that the per-mile price produced by the formula is static and causes long-haul destinations to be uncompetitively priced (high) and short-haul lanes to be priced too cheaply. However, if the base rate per pound/miles is adjusted downward by some percentage from the optimal price as mileage increases from the average length of haul and upward by some percentage as mileage decreases from the average length of haul, a profitable tariff that is also competitive in the marketplace can be produced. Other adjustments should be made for metropolitan areas versus rural areas. In any case, the average rate per mile that customers pay must equal the optimum mark-up on cost rate.

From the optimal price per mile determined by the formula (applied to the average shipment weight and freight class), one would then extrapolate to all other possible weights and freight classes, by modifying the optimal price per mile, based (in part) upon the distance the shipment must travel. In order to extrapolate completely, to the other freight classes and weights, one would also need access to the National Motor Freight Classification Committee's relative freight class values.

This model for a tariff will retain both profitability and price competitiveness to all points, if it is created carefully. The resulting pricing structure will represent an LTL trucking company's own, unique class pricing system (based on their own costs & relative competitiveness), with rates that both provide enough revenue and are competitive in the marketplace.