Assignment - Write a Paper on Decision Making Analysis. The assignment is about the case study of the company named Fonterra based in New Zealand. The company deals with the production of milk and related products.
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Answer - Decision Making Analysis
Abstract
Every manager in an organization takes the responsibility to discharge right decisions that will benefit customers as well as employees. While the focus of organization is to maximize profits, it is essential to understand the utility percentage of a product or service. In general, profit is high when marginal cost and revenue are the same or when the latter is higher than the original cost. Based on this notion, the decision is taken and production is altered. When the manager wants to understand the price changes and maximize demand, it is a good idea to study demand elasticity consistently and this factor can impact income and the actual production cost for a given product.
Introduction
Fonterra is the organization chosen for this assignment and the firm deals with milk production and other value added products. According to the given case, the production of milk led to huge losses the previous year and there is a need to revise the production strategy for this year owing to the market variation in milk prices and the expectations of the customers. Further, it is the right time to evaluate the demand and develop a production cycle.
The purpose of this assignment is to answer to the queries of manager about demand and supply equilibrium. It begins with theories associated with the firm an analysis of consumer behavior. Further, the production possibilities are detailed with calculations relating to costs, income elasticity of demand an equilibrium price. Indifference curves are also drafted in this paper following the calculations to support suggestions with evidences.
Question 1: Theories of the firm
For the given case of Fonterra, it is essential to apply a finance theory.
a. Profit maximization
As the idea is to suggest an ideal strategy for the manager, profit maximization is appropriate as it focuses on profit and suggests the suitable production level and product pricing. It is always ensured that the demand is high for the given product and the output is planned accordingly. As already mentioned, this theory ensures that the values of marginal costs and revenues are equal.
b. Conditions when the model will not hold
The reality is firms need to focus on related objectives like sales maximization in addition to profit maximization and this is the best way to fulfill the desires (Thaler and Mullainathan, 2008). It is inappropriate to regard marginalization as the primary factor to fix the price and production output. It is never possible to determine profits in advance as it is supposed to be a residual element and there are several market forces influencing the outcomes.
For example, a sudden increase in competition can result in drop of the numbers. At this stage, companies like Fonterra will have to be careful in reducing the short run profits and focus on huge profits that can allow the company to sustain and widen its vision. This is perhaps the principle of a profitable trade too. There are a number of complexities that organizations face lately due to changing customer requirements and increasing competition that tend to impact prices and demand-supply equilibrium.
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Question 2: Consumer behaviour
When we study the case of Fonterra from consumer's perspective, it is evident that every consumer faces constraints in terms of budget and application. These factors can affect their choices and the demand for the product (Bernheim and Rangel, 2008). The best way to maximize utility/application and enhance the affordability is to make use of indifference curve.
The purpose of the curve is to evaluate the impact of price fall on the choices of consumers. Similarly, the impact of price fall on the production cost of the milk products by Fonterra can be evaluated. While this curve is one way to study the production curve of Fonterra, Maslow's hierarchy of needs is another theory that helps to connect with the behavior of consumers by applying the variables.
Milk is a basic necessity of every consumer and hence, there is a psychological connection. This perhaps confirms the scope for milk and milk associated products produced by Fonterra.
Question 3: Production and scarcity
Often, organizations fail to understand the impact of migration on the financial performance. Whenever there is a migration, the organization is forced to invest more on human resources to retain the same production level. If this level is not attained, the products can become scarce and will have immediate replacements from other brands functioning in the same region. As New Zealand is popular for milk production, Fonterra has to pay attention to migration.
The other bottomline is the migration of consumers to other place due to high price of products or scarcity of basic amenities. This migration can once again affect the production levels and profit rates of Fonterra.
Question 4: Income elasticity of demand
An important factor to evaluate in this case is income elasticity of demand. Let's take the case of a smartphone.
In general, the income elasticity is 2. This implies that a 5% reduction in the income can result in 10% reduction in demand for the product - smartphones. It is given that income elasticity for milk product is 0.8. This implies that a reduction in consumer income by 5% can result in reduction in demand for the product by 4%.
The comparative numbers state that income elasticity is lesser for milk and hence, milk is supposed to be a necessity for people in New Zealand whereas smartphone is considered to be a luxury.
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Question 5: Cost
The next factor that impacts the business is the cost per unit.
Average total cost = total cost incurred per product
Average variable cost = variable cost incurred per product
Total cost = fixed cost + variable cost
Average fixed cost = fixed cost incurred per product/output
The final formula denotes that an increase in output can result in fall of the average fixed cost.
This also implies that all the variables are interrelated.
The gap exhibited between 2 key variables - average total and variable costs can be directly conveyed with the variable - average fixed cost.
Question 6: Decision making under uncertainty
Since Fonterra is in the production business, uncertainty is at a high level (Cunningham, 2002).
There are two sources that can result in uncertainty. These are mentioned below.
- Pattern uncertainty
For instance, it is easy to predict that a specific place is said to enjoy rainfall for the day but the pattern/distribution of rainfall in every region in the said location is unknown. The same applies to the milk business. It is totally uncertain if the present consumption pattern will exist the same way in the near future.
- Self-interest uncertainty
One's experience and personal judgment can never be taken as the final decision. In most of the cases, self-interest bias results in flop. In general, personal feeling is always different and it can favor a specific person or a situation and not produce accurate forecast.
The best way to evaluate uncertainty at a given point is to identify the expected value.
Expected value = Sum of assigned probabilities during a particular event
The values of risk and uncertainty can vary based on the occurrence. When the risk of an uncertainty is high, the probability is also set to a high value.
This uncertainty is important for the managers to evaluate before taking investment decisions (Madhani, 2013). Further, it is possible for understanding the event value through the calculation of expected value. The manager can later decide on the suitable course of action.
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Question 7: Pricing under perfect competition
a. The purpose of this paper is to find out the point when Fonterra achieves equilibrium. This point is way too important to strike a balance between production level and demand from the customer's end (Kirkpatrick and Dahlquist, 2007).
Here is the formula to calculate the equilibrium quantity, Q.
Market demand = Market supply
1000-2Q = 100+Q
900=3Q
Q=300
This Q value implies that 300 units of milk is the perfect quantity for supply and there is a demand for the same already.
So, the equilibrium price, P for this equilibrium quantity is,
P = 300+100 = $400
All it takes is $400 to achieve the equilibrium quantity.
b. The next value to evaluate for the managers of Fonterra to take a decision is profit maximizing condition.
Marginal cost = Marginal revenue
In the previous section, marginal revenue is already identified as $400.
2q+1=400
q=399/2=199.5 units
The net revenue needs to be calculated further.
Total (Net) revenue = Price x Quantity
TR=PxQ=400x199.5=$79800
Having found out the total revenue, the next step is to calculate the total cost.
Total cost (TC) = 100+q2+q = 100+199.52+199.5
= 100+39800.25+199.5=$40099.75
Net or total profit = total revenue - total cost = 79800-40099.75 = $39700.25
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c. As the total profit is above zero, it is understandable that the identified value of equilibrium is short run and in cases of stiff competition in the market, the profit might achieve a zero value. When we talk about profits to be planned by Fonterra, it is to be noted that this industry has supernormal profits as well and these profits tend to invite new entrants to the industry (Thaler and Mullainathan, 2008). Eventually, the stiff competition can force a decrease in the price which will eventually have an impact on the profit level and pressure faced by the firm.
At the end of this profit cycle, the firm reaches zero economic profit.
d. So, what has to be done for profit on a long run? We need to use the condition -
Marginal cost = average total cost
2q+1=(100+q2+q)/q
Cross multiplying,
2q2+q=100+q2+q
q2=100
q=10 units
Marginal cost is
2q+1=2x10+1=$21
Net revenue, TR = 21x10=$210
Net cost, TC=100+q2+q=100+100+10=$210
As TR=TC, this is the best equilibrium quantity and price that Fonterra can achieve.
e. The ideal quantity for long term production is -
P=1000-2Q
21=1000-2Q
Q=489.5 units
This is the quantity to be produced by Fonterra.
Conclusion
As already said in the previous sections, Fonterra has to focus on equilibrium price and quantity that will lead to zero profits on a longer run. Since profit maximization is the vision here, pricing decisions are accordingly altered. The main responsibility of the manager at this stage is to plan uncertainties and not use personal interest for pricing bias. The reason is that the expected value has an influence on the risk possibilities. So far, the consumer behavior theories have made it clear for the managers of Fonterra to understand what the consumers prefer.
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