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Fonterra - Case Study

Abstract

There are several tools available for the managers to take decisions. In a production environment, the sole notion of the manager is to strike a balance between the production of the employees and the demands of the consumers. Hence, revenue profits and utility are two factors of concern. When the marginal cost and marginal revenue are equal, it is possible for a firm to achieve a better degree of profit. In this paper, Fonterra's ideal equilibrium quantity, price and elasticity of demand are all evaluated along with the causes of uncertainty to aid the manager in taking production decisions.

Introduction

The paper discusses about a New Zealand based firm named Fonterra that produces milk and allied products. The reason for the evaluation of production is due to the heavy losses faced by the firm in 2018 which forced an analysis of production and revisit of execution strategy for the current year 2019. The idea of this paper is to see how a change of milk price can impact the demand and also result in output variations from economic perspective.

With the help of financial calculations and uncertainty theories, the paper deals with the needs of the firm, Fonterra. Further, the concept of indifference curve is applied in this paper to evaluate the income elasticity of demand. Results from this paper are useful for the managers of Fonterra to plan the strategies when there is either resource scarcity or market uncertainty. All of the answers are based on the utility maximization theory.

1 - Theories of the firm
The most important operations theory that is applicable for Fonterra's case is profit maximization. The theory states that the profit reaches its maximum when the marginal cost incurred is equal to the marginal revenue gained. This has an impact in the production price that will fetch the end product for use. As milk production is the primary business of Fonterra, profit has to be maximized keeping in mind the equilibrium between marginal revenue and cost.

While we analyze profit maximization, we need to focus on internal operations and maximize the sales in such a way that the pricing changes do not affect the output and margins. At the same time, the major factor that impacts any business is competition. When we look at the business returns on a long run, it is important for a firm to eliminate any short run profits and focus on long run profits. Despite the complexities imposed by the market and the changing expectations of the consumers, it is essential to maximize profit as well as sales.

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2 - Consumer behavior
Fonterra deals with consumers who require products on a daily basis. However, there are a couple of constraints faced by them such as utility and budget. When the utility is maximized, the budget constraint automatically eliminates. The best operation curve to understand the impact of reduced price of milk on the consumer choice is indifference curve (Thaler and Mullainathan, 2008). When the price falls, the demand increases. Subsequently, the budget line of the consumer rotates and production capacity increases. With a rise in volumes, there is also an increase in the marginal revenues.

A management theory appropriate to the case of Fonterra to understand the consumer behavior is Maslow's hierarchy of needs. As already mentioned, consumers choose a product only when there is a psychological connection. This psychological need will have to be evaluated and safety and security needs of the consumers should be achieved so that it is possible to enable consumers to actualize/realize the need for products of Fonterra.

3 - Production and scarcity
For any firm to sustain in the market, it is important to ensure a balance between the production/supply and demand.
An important problem faced by an organization is migration.
What happens when organization shifts to a new place?
What happens when customers shift to another brand or place?

These 2 questions need to be answered by the managers.
When organization migrates, the human resources also migrate and this migration is influenced by the change resistance of the individuals. The overhead during migration is the additional investment to be made by the firm to maximize the satisfaction of the employees.

In a place like New Zealand, people always have the tendencies to switch to products of better prices or places with affordable products and amenities (Madhani, 2013). These tendencies can greatly impact the demands and affect the marginal revenues of Fonterra. At this stage, it is mandatory to balance the price of milk products in New Zealand to retain the consumers.

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4 - Income elasticity of demand
The best way to understand income elasticity of demand of milk products by Fonterra is to compare with the case of a smartphone.
Let us say that the elasticity of demand for a smartphone is 2.
When the income of consumers reduces by 5%, there is a directly proportional relationship on the smartphone sales as the sales get reduced by 10%.

In the case of milk, income elasticity of demand is 0.8.
When the income of consumers reduces by 5%, the demand gets reduced by 4%.
When both the percentages are compared, it is evident that smartphone has a higher income elasticity over milk. This also informs the demand for both the products as milk is considered to be a necessity for inhabitants of New Zealand while smartphone is considered to be a luxury product.

5 - Cost
Since the entire business revolves around cost, we need to use certain variables and understand the relationships between them.
Average variable cost is the changes in cost per unit while average fixed cost is the unchangeable cost divided by the output per unit. The average fixed cost increases when the output decreases and this is not a healthy relationship.
Average total cost is supposed to be the sum of both the costs mentioned above.
When the output increases, the gap between two variables - average total and variable costs reduces.

6 - Decision making under uncertainty
Every manager has to think of uncertainties when taking a decision. The reason is that the uncertainty can affect demand as well as production capacity of the firm.
The first type of uncertainty that can affect Fonterra is pattern variation. Demand is not fixed and the variation of demand can affect the supply (Wielan and Wallenburg, 2011). Similarly, the future of the product is unpredictable due to changing consumer patterns.
The second type of uncertainty is interest bias. One's interest cannot be used in taking decisions. For instance, the manager might be interested in skimmed milk over raw milk but this opinion can vary among consumers. When the manager tries to impose self interest bias on the consumer's decisions, the uncertainty increases to such an extent that the future of the business becomes a question mark.
These two uncertainties make it clear that forecasts should never be done based on one's own experience and feelings.

Expected value
Yet another variable that the manager has to take into consideration is expected value.
Sum of all the assigned probabilities that can impact the event results in expected value
When the risk is high, the probability is also high and the expected value demands the need for managers to take wiser investment decisions (Cecere et al, 2005). In several cases, the manager takes the responsibility to judge the potential of an event through the expected value. It is also a reminder for the manager to stay aware of all the risks and uncertainties associated with an event and then finalize the course of action based on the potential and value of event.

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7 - Pricing under perfect competition

a. The first variable is equilibrium (Cecere et al, 2005). This is a condition where the market demand and supply are equal. Q is the equilibrium quantity to be evaluated.
Demand is 1000-2Q and supply is 100+Q.
1000-2Q=100+Q
900=3Q
This implies that Q=300
The equilibrium price for 300 units of milk is
P=100+Q=100+300=$400

b. The second variable is profit maximizing condition. This is the case where the marginal revenue and marginal cost are equal. Equilibrium price is the marginal revenue in this case.
2q+1=400
2q=399
q=199.5 units
For the profits to maximize, the production has to achieve at least 199.5 units.
Total revenue TR = price P * quantity Q = 400*199.5
The total revenue here is $79800.
Total cost = 100+q*q+q=100+199.5*199.5+199.5=$40099.75
Total profit = total revenue-total cost=79800-40099.75=$39700.25

c. In this case, the total profit is exceeding zero and this is an indicator that the profit is in short run and will not be suitable for the market.
For Fonterra to enter and sustain in the competitive market on a longer run, the profit has to be equal to zero. In this production industry, there is a variable called supernormal profit which is an indicator for new firms to attract and invest (Bernheim and Rangel, 2008). When firm numbers increase, the price automatically decreases due to the competitive nature. This can further decrease the profit level and the firms will eventually enter into zero economic profit condition.

d. For a company to enter into long run equilibrium the condition is marginal cost and average total cost should be equal.
2q+1=(100+q*q+q)/q
2q2+q=100+q2+q
q=10 units
Now, the marginal cost value is
2q+1=20+1=$21
Total revenue = marginal cost * q=21*10=$210
Total cost = 100+100+10=$210
Now both the values are equal and we have achieved the equilibrium state.
e. For the quantity to be supplied on a long run, the ideal number is.
P=1000-2Q
21=1000-2Q
As a result, Q=489.5 units

Conclusion
From this paper and the derivations in the previous sections, it is clear that the pricing is entirely based on profit maximization. This is indirectly proportional to the competition, price and equilibrium quantity. When the competition is high, the prices need to be competitive and this can affect the production margin. Yet, the firm has to now make a proper decision carefully evaluating the uncertainties and the consumer expectation. The equilibrium quantity and indifference curve concepts mentioned here are appropriate for the manager to go ahead with suitable decisions.

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