PRICE LEADERSHIP IN AN OLIGOPOLY*General Motors CorporationIn an article in the NACA Bulle...

PRICE LEADERSHIP IN AN OLIGOPOLY*

General Motors Corporation

In an article in the NACA Bulletin, January 1, 1927, Albert Bradley described the pricing policy of General Motors Corporation. At that time, Mr. Bradley was general assistant treasurer; subsequently, he became vice president, executive vice president, and chairman of the board. There is reason to believe that current policy is substantially the same as that described in the 1927 statement. The following description consists principally of excerpts from Mr. Bradley’s article.

General Policy Return on investment is the basis of the General Motors policy in regard to the pricing of product. The fundamental consideration is the average return over a protracted period of time, not the specific rate of return over any particular year or short period of time. This long-term rate of return on investment represents the official viewpoint as to the highest average rate of return that can be expected consistent with a healthy growth of the business, and may be referred to as the economic return attainable. The adjudged necessary rate of return on capital will vary as between separate lines of industry as a result of differences in their economic situations; and within each industry there will be important differences in return on capital resulting primarily from the relatively greater efficiency of certain producers.

The fundamental policy in regard to pricing product and expansion of the business also necessitates an official viewpoint as to the normal average rate of plant operation. This relationship between assumed normal average rate of operation and practical annual capacity is known as standard volume.

The fundamental price policy is completely expressed in the conception of standard volume and economic return attainable. For example, if it is the accepted policy that standard volume represents 80% of practical annual capacity, and that an average of 20% per annum must be earned on the operating capital, it becomes possible to determine the standard price of a product—that is, that price which with plants operating at 80% of capacity will produce an annual return of 20% on the investment.

Standard Volume Costs of production and distribution per unit of product vary with fluctuation in volume because of the fixed or nonvariable nature of some of the expense items. Productive materials and productive labor may be considered costs which are 100% variable, since within reasonable limits the aggregate varies directly with volume, and the cost per unit of product therefore remains uniform.

Among the items classified as manufacturing expense or burden there exist varying degrees of fluctuation with volume, owing to their greater or lesser degree of variability. Among the absolutely fixed items are such expenses as depreciation and taxes, which may be referred to as 100% fixed, since within the limits of plant capacity the aggregate will not change, but the amount per unit of product will vary in inverse ratio to the output.

Another group of items may be classified as 100% variable, such as inspection and material handling; the amount per unit of product is unaffected by volume. Between the classes of 100% fixed and 100% variable is a large group of expense items that are partially variable, such as light, heat, power, and salaries.

In General Motors Corporation, standard burden rates are developed for each burden center, so that there will be included in costs a reasonable average allowance for manufacturing expense. In order to establish this rate, it is first necessary to obtain an expression of the estimated normal average rate of plant operation.

Rate of plant operation is affected by such factors as general business conditions, extent of seasonal fluctuation in sales likely within years of large volume, policy with respect to seasonal accumulation of finished and/or semifinished product for the purpose of leveling the production curve, necessity or desirability of maintaining excess plant capacity for emergency use, and many others. Each of these factors should be carefully considered by a manufacturer in the determination of size of a new plant to be constructed, and before making additions to existing plants, in order that there may be a logical relationship between assumed normal average rate of plant operation and practical annual capacity. The percentage accepted by General Motors Corporation as its policy in regard to the relationship between assumed normal rate of plant operation and practical annual capacity is referred to as standard volume.

Having determined the degree of variability of manufacturing expense, the established total expense at the standard volume rate of operations can be estimated. A standard burden rate is then developed which represents the proper absorption of burden in costs at standard volume. In periods of low volume, the unabsorbed manufacturing expense is charged directly against profits as unabsorbed burden, while in periods of high volume, the overabsorbed manufacturing expense is credited to profits, as overabsorbed burden.

Return on Investment Factory costs and commercial expenses for the most part represent outlays by the manufacturer during the accounting period. An exception is depreciation of capital assets which have a greater length of life than the accounting period. To allow for this element of cost, there is included an allowance for depreciation in the burden rates used in compiling costs. Before an enterprise can be considered successful and worthy of continuation or expansion, however, still another element of cost must be reckoned with. This is the cost of capital, including an allowance for profit.

Thus, the calculation of standard prices of products necessitates the establishment of standards of capital requirement as well as expense factors, representative of the normal operating condition. The standard for capital employed in fixed assets is expressed as a percentage of factory cost, and the standards for working capital are expressed in part as a percentage of sales, and in part as a percentage of factory cost.

The calculation of the standard allowance for fixed investment is illustrated by the following example.

The amount tied up in working capital items should be directly proportional to the volume of business. For example, raw materials on hand should be in direct proportion to the manufacturing requirements—so many days’ supply of this material, so many days’ supply of that material, and so on—depending on the condition and location of sources of supply, transportation conditions, etc. Work in process should be in direct proportion to the requirements of finished production, since it is dependent on the length of time required for the material to pass from the raw to the finished slate, and the amount of labor and other charges to be absorbed in the process. Finished product should be in direct proportion to sales requirements. Accounts receivable should be in direct proportion to sales, being dependent on terms of payment and efficiency of collections.

The Standard Price These elements are combined to construct the standard price as shown in Table 1. Note that the economic return attainable (20% in the illustration) and the standard volume (80% in the illustration) are long-run figures and are rarely changed;1 the other elements  of  the price are based on current estimates.

Differences among Products Responsibility for investment must be considered in calculating the standard price of each product as well as in calculating the overall price for all products, since products with identical accounting costs may be responsible for investments that vary greatly. In the illustration given below, a uniform standard selling price of $1,250 was determined. Let us now suppose that this organization makes and sells two products, A and B, with equal manufacturing costs of $1,000 per unit and equal working capital requirements, and that 20,000 units of each product are produced. However, an analysis of fixed investment indicates that $10 million is applicable to Product A, while only $5 million of fixed investment is applicable to Product B. Each product must earn 20% on its investment in order to satisfy the standard condition. Table 2 illustrates the determination of the standard price for Product A and Product B.

1A Brookings Institution Survey reported that the principal pricing goal of General Motors Corporation in the 1950s was 20% on investment after taxes.

TABLE 1 Illustration of Method of Determination of Standard Price

From this analysis of investment, it becomes apparent that Product A, which has the heavier fixed investment, should sell for $1,278, while Product B should sell for only $1,222, in order to produce a return of 20% on the investment. Were both products sold for the composite average standard price of $1,250, then Product A would not be bearing its share of the investment burden, while Product B would be correspondingly overpriced.

Differences in working capital requirements as between different products may also be important due to differences in manufacturing methods, sales terms, merchandising policies, etc. The inventory turnover rate of one line of products sold by a division of General Motors Corporation may be six times a year, while inventory applicable to another line of products is turned over 30 times a year. In the second case, the inventory investment required per dollar cost of sales is only one-fifth of that required in the case of the product with the slower turnover. Just as there are differences in capital requirements as between different classes of product, so may the standard requirements for the same class of product require modification from time to time due to permanent changes in manufacturing processes, in location of sources of supply, more efficient scheduling and handling of materials, etc.

The importance of this improvement to the buyer of General Motors products may be appreciated from the following example. The total inventory investment for the 12 months ended September 30, 1926, would have averaged $182,490,000 if the turnover rate of 1923 (the best performance prior to 1925) had not been bettered, or an excess of $74,367,000 over the actual average investment. In other words, General Motors would have been compelled to charge $14,873,000 more for its products during this 12-month period than was actually charged if prices had been established to yield, say, 20% on the operating capital required.

TABLE 2 Variances in Standard Price Due to Variances in Rate of Capital Turnover

Conclusion The analysis as to the degree of variability of manufacturing and commercial expenses with increases or decreases in volume of output, and the establishment of “standards” for the various investment items, makes it possible not only to develop “Standard Prices,” but also to forecast, with much greater accuracy than otherwise would be possible, the capital requirements, profits, and return on capital at the different rates of operation, which may result from seasonal conditions or from changes in the general business situation. Moreover, whenever it is necessary to calculate in advance the final effect on net profits of proposed increases or decreases in price, with their resulting changes in volume of output, consideration of the real economics of the situation is facilitated by the availability of reliable basic data, it should be emphasized that the basic pricing policy stated in terms of the economic return attainable is a policy, and it does not absolutely dictate the specific price. At times, the actual price may be above, and at other times below, the standard price. The standard price calculation affords a means not only of interpreting actual or proposed prices in relation to the established policy, but at the same time affords a practical demonstration as to whether the policy itself is sound. If the prevailing price of product is found to be at variance with the standard price other than to the extent due to temporary causes, it follows that prices should be adjusted; or else, in the event of conditions being such that prices cannot be brought into line with the standard price, the conclusion is necessarily drawn that the terms of the expressed policy must be modified.2

2This paragraph is taken from an article by Donaldson Brown, then vice president, finance, General Motors Corporation, in Management and Administration, March 1924.

*Each of these items includes $50 of labor costs.

In the 1975 model year, General Motors gave cash rebates of as high as $300 per car off the list price. In 1972 and 1973, prices had been restricted by price control legislation, which required that selling prices could be increased only if costs had increased. Selling prices thereafter were not controlled, although there was always the possibility that price controls could be reimposed. In 1975, demand for automobiles was sharply lower than in 1974, partly because of a general recession and partly because of concerns about high gasoline prices. Does the cash rebate indicate that General Ivitors adopted a new pricing policy in 1975, or is consistent with the policy describedin thecase?