Lamm, R. Mcfall, Jr.

English

Research Papers in Economics

SOUTHERN  JOURNAL  OF AGRICULTURAL  ECONOMICS  JULY,  1976
ESTIMATING  MARKETING MARGIN COST
COMPONENTS:  AN APPLICATION  OF
SIMULATION TO PRODUCTS OF THE
VEGETABLE  OIL INDUSTRY*
R. McFall Lamm, Jr.
While  many  methods  have  been  proposed  for  the final section.
evaluating  agricultural  processing  market  efficiency,
estimation  of product marketing margins has received
the  most attention  and direct research effort. Despite  PROBLEMS  WITH COST
this  fact,  there  are  many  technical  and  statistical  COMPONENT STUDIES
problems  associated  with  both  the  performance  of  Most  statistical  and  accounting  cost  component
marketing  analyses  and  utilization  of margin  reports  studies  performed  in  the  past  have  concentrated  on
[2, 7, 9,  12].  Most  early  marketing  margin  studies  products  whose  production  processes  are  relatively
either  ignored  or  circumvented  these  problems,  con-  simple.  Three  constraining  factors  have  been  pri-
centrating  on  estimating  absolute  magnitudes  of  marily  responsible  for  this.  First,  the  number  of
marketing  margins over  time  [1, 3, 5,  10].  Marketing  calculations  required  by  a  cost components  study  is
margin  studies  performed  in  the  last  few years  have  an  increasing  function  of  the  complexity  of  the
continued,  in  varying  degrees,  to  ignore  these  and  process.  The  more  complex  the  process,  the  greater
other  problems implicit in the  analysis. Relative levels  the  burden  of  numerical  manipulation.  Second,  the
of  marketing  margins  over  time  may  provide  some  difficulty  of repeating analyses at later time  periods is
insight  into marketing efficiency,  but those of various  complicated  by  maintaining  consistency  in  variable
cost  components  of  the  marketing  margin  over  time  definitions,  since  some  products  change  form  over
appear  to  give  even  more  suitable  indications  of  time.  Errors  in  defining  variables  for  subsequent
changing market performance.  repetitions  can  lead  to considerable  misstatement  of
The  object of this study was to develop a method  production  costs.  Third, obtaining  necessary  data for
for  estimating  cost  components  of  the  marketing  cost  component  analyses  of  products  with  complex
margin  when  no  firm  accounting  data  were available.  production  processes  is  difficult.  This  is  because
It  is  demonstrated  that  utilization  of  a  simulation  products  with  complex  production  processes  are
model  allows  for  an  explicit  determination  of  cost  more  likely  to  be  traded  in markets  where  there  are
components.  Advantages  and  disadvantages  of  this  few  producing  firms  and  the  availability  of market
approach  are  discussed  briefly  in  the  first section  of  information is limited [11].
this  paper.  The  formulation  of the simulation  model  Restraints  on  the  performance  of  cost  compo-
is  described  in  the  second  section.  In  the  third  nent  studies  for products with more complex produc-
section,  selected  results  of  estimating  (marketing)  tion  processes  can  be  overcome,  to  a  considerable
cost components  of the marketing  margin  for marga-  extent,  by  developing  and  using an  event simulation
rine  and  cooking  oil  are  presented  and  evaluated  in  model  of  the  production  process  being  considered.
light  of the  existing state of cost component method-  This  approach  requires  direct  measurement  of  pro-
ology.  Implications  of  the  results  are  considered  in  duction  parameters  for  typical  producing  plants  in
R.  McFall Lamm, Jr. is Research  Associate at Virginia Polytechnic  Institute and State  University,  Blacksburg,  Virginia.
*This paper  is based  on research performed  under  contract for the Economic  Research Service, USDA.  The views presented
here  do  not necessarily  reflect  those  of the Economic  Research  Service.  The author is  indebted  to William T. Boehm, J. Paxton
Marshall,  and  two anonymous  referees  who made  useful comments  on drafts of this paper.
109the  industry,  along  with construction  of a representa-  exhibiting  essential  characteristics  of the  group  were
tive  plant  model  based  on  these  measurements.  If  then  incorporated  in  the  model plant. Since included
measured  production  and  cost  functions  of  the  stage  technologies  are  representative  of  the  sample,
constructed  plant model are  truly  representative  of a  then,  by  implication,  a  model  composed  of  these
typical  plant  in  the  industry,  then  reported  cost  representative  stage  technologies is also representative
components  for the  model  plant  should approximate  if all interrelationships  are  correctly included.
the  true  cost  components  for  the  industry.  This  A  typical  plant  in  the  vegetable  oil  industry
approach  is  essentially  an  extension  of  the  jointly produces refined vegetable  oil (cottonseed and
Marshallian concept  of the representative  firm.  soybean),  margarine  and  cooking  oil  at  a  single
Several  problems  are  associated  with the applica-  production  facility.  Thirteen autonomous production
tion  of  this  procedure  to  the  measurement  of  cost  stages  are  included  in  this process.  It is not  required
components.  First,  data  requirements  are substantial,  that  each  product  pass  through  all  thirteen  produc-
both  in  quality  and  quantity.  Data  required  to  tion  stages,  although  there  are  constraints  on  the
construct  a  production  simulation  model  are  usually  order  through  which  the  stages  must be  passed.  The
not  available  from  secondary  sources  and  must  be  production  process  begins  with  arrival  of  crude
collected  from  primary  sources. Second, the research-  vegetable  oil  at  the  plant and  ends  at the thirteenth
er must have a comprehensive  technical  knowledge  of  production  stage,  when margarine  and cooking oil are
the  industry.  Finally,  the  model  must  be  updated  released  from  storage  for  transportation  to distribu-
regularly,  to  reflect  technology  changes  in  the  in-  tion  centers.  All  these  features  are  incorporated
dustry.  The  sum  value of these disadvantages must be  directly  into  the  model  by  specifying  technical
considered in light of available alternatives  [11].  coefficients  to represent  the  actual  production  pro-
The  only  obvious  alternative  available  for  esti-  cess as accurately  as possible.2
mating  industry  cost  components  is  the  use of firm  Technical  coefficients  of  the  model  were  deter-
accounting  data. However,  such use to determine  cost  mined using  one  of two alternative approaches.  First,
components  in  the  case  of  products  with  complex  if the  technical  coefficients were  measurable  directly
production  processes  involves  a  substantial  project.  at  the  plant,  then  a  measure  of each  was  obtained
Not  only  must  costs  from  different  accounting  from  all  plants  processing  the  representative  technol-
systems  be  made  comparable,  but  even  if  this  is  ogy.  For example,  the technical  coefficient giving the
achieved,  there  is  no way  of determining whether  the  rate  at  which  cooking  oil  bottles  were  filled  by  a
accounting  costs  are  equivalent  to  actual  economic  filling  machine  was  taken  as  the  mean  of  rates
costs.  For the  vegetable  oil industry,  accounting  data  reported by different plants possessing the representa-
are  not  readily  available.  There  is  no  question  of  tive  type  of filling  machine.  Second,  if the  technical
whether  this  source  should  be used.'  For this reason,  coefficients  were not measurable directly  at the plant,
use  of a production  simulation  model offers the  only  then  a  measure  of  the  required  coefficients  was
viable  method  of  approximating  production  cost  obtained  from  alternative  sources,  usually equipment
components  of the marketing margin for vegetable  oil  manufacturers.  For example,  most companies  had no
products.  information  on  the  energy  requirements  of  their
cooking  oil  filling  machine,  although  they knew their
total plant energy  requirements.  Consequently  it was
~~THE  MODEL ~necessary  to  obtain  pertinent  information  from
The  method  used  here  to  generate  the  produc-  equipment manufacturers.
tion  cost  components  of  the  marketing  margin  for  It  should  be noted that all costs of marketing the
cooking  oil,  and  margarine,  is  basically  an  extension  products  considered  in  this  study  were  not  deter-
of  conventional  economic  engineering  cost  analysis  mined  directly  by  the  simulation  model,  which
[8].  Rather  than  modeling  a  single  representative  estimates production costs only. Specifically,  interest,
plant  in its entirety, the procedure required  modeling  advertising,  and  transportation  expenditures  are  not
representative  production  stages  of  plants  in  the  directly  related to physical production  of the product
industry.  Data  were  compiled  initially  on  fifteen  and  were  calculated  separately,  by  using  aggregate
plants  in  the  industry.  Production  stage  technologies  data available  from  published  sources.  All other costs
The major corporations  in the vegetable  oil industry  generally  permitted  plant visitations  and the collection of production
data for this study. However,  no company  would release  firm cost data, even when anonymity  was assured.
Over  fifteen  hundred  equations  were  included  in  the  specification  of  the  model,  to  allow  for  all feasible  variations  and
substitutions  in factors and products. Nonlinear relationships were approximated using linear segments.
110were  obtained  directly  from  the  simulation  model.  results  are  reproduced  in  Table  1.  Each  component
The  computer  program  representing  the  simulation  cost  is  reported  per  final  product  unit,  four-stick
was  structured  so  that  given  an  initial  price  vector,  pound packages  for margarine  and twenty-four  ounce
necessary  operational  parameters,  and  a  time period  bottles  for  cooking  oil.  The  total of all  components
of  operation,  production  costs  for  manufacturing  represents  the  value  added  by  refining  and  manu-
margarine  and  cooking  oil  were  completely  deter-  facturing  respectively.  Cost  components  for  both
minant.  Within  the  program,  price  vector  could  be  margarine  and  cooking  oil represent  components  for
generated randomly for multiperiod simulation  exper-  name  brand  products  only,  private  label  products
iments,  or  actual  prices  could  be  used  to  represent  being  excluded  from  the  analysis  because  of  their
real-world  situations  for a  one-period  simulation  [4].  relatively  small shares of the  total market. Definitions
To  generate  the  production  cost components  of the  of each  component  are consistent  with specifications
marketing  margin  for  vegetable  oil  products  in  1974,  used  by  the  Economic  Research  Service.  An  excep-
this  latter  procedure  was  used.  Relevant production  tion  is  profit,  which  is  taken  in  this  study  as  the
and  price  data  were  collected,  and  the  simulation  residual  between  calculated  cost  of  production  per
carried  out for  a  single event-a  one year's  operation  unit, and factory price  per unit of product.3
of the model plant.  Examination  of  Table  1  reveals  that  relative
RESULTS  profit on margarine  for both refining and manufactur-
ing  was  13.1  percent  of  value  added  per  unit  of
Eleven  cost  components  for  margarine,  cooking  product  in  1974,  while  the  corresponding  figure  for
oil  and  the  refined  oil  used  in  these  products  were  cooking  oil  totaled  22.5 percent. The estimated  1974
estimated  using  the method outlined above  (based on  level  of profit on margarine  is not out of line with the
1974  industry  prices  and  utilization  ratios).  These  reported  profit  levels  of  food  processors  in  general,
TABLE  1.  ESTIMATED COST COMPONENTS  FOR MARGARINE  AND COOKING OIL,  1974 (IN DOLLARS)
Cost  Margarine  Cooking Oil
Component  Refining  Manufacturing  Refining  Manufacturing
Per pound package  Per 24-ounce  bottle
Labor  .0013  .0110  .0029  .0058
Packaging  .0000  .0333  .0000  .0987
Transportation  .0097  .0186  .0172  .0198
Business taxes  .0160  .0117  .0333  .0771
Depreciation  .0077  .0153  .0136  .0092
Repairs  .0003  .0005  .0005  .0025
Advertising  .0001  .0217  .0001  .0302
Interest  .0008  .0022  .0014  .0030
Energy  .0008  .0003  .0013  .0001
Othera  .0172  .0150  .0202  .0117
Profit  .0147  .0113  .0307  .0710
Total  .0686  .1409  .1214  .3291
aIncludes processing chemicals, unallocated  fixed costs,  food ingredients (except base oil), and materials not elsewhere listed.
3The  factory  prices  of margarine  and cooking  oil for 1974  were  determined by  averaging  published prices  of the principal
producers  weighted  by  market  share.  This information  for branded label products is  not currently  available  from any published
source.
111but  the  estimated  profit  level  for  cooking  oil  is  estimating  cost components  for  products  with  com-
substantially  greater  than the reported  profit levels  of  plex  production  processes.  Principal  constraints
most  food  processing  companies.  This  result  is  not  which  have  hindered  the  performance  of cost  com-
surprising  when  prior  information  on  each  of  these  ponent  analyses  up  to this time  are not those  on the
markets is considered.  The bottled cooking oil market  simulation  approach.  If  the  representative  plant
is  dominated  by  three  firms  which  control  approx-  model  is  specified  accurately,  then  production  and
imately  seventy-six  percent  of  the  total  market.  On  cost functions  of the model  will approximate those  of
the  other  hand, the packaged  margarine  market is less  a  typical  industry  plant,  giving  an  approximation  of
concentrated,  the  leading eight producers  controlling  industry  production  cost  components.  Although  vali-
seventy-one  percent  of  the  market.  For  this reason,  dation  of  the  model  is  difficult, many  problems  are
one  might expect  a greater relative  profit in the more  overcome  by  the approach  outlined here,  particularly
concentrated  cooking  oil  market.  This  expectation  is  the  calculations  problem,  and  that  of  maintaining
supported  by the evidence  presented  here.  consistency  in variable  definitions over time.
There  are  limitations  which  must be  considered  Implications  of  this  study  are  important  for
before  evaluating information  generated  by the simu-  policy  decisions  with  respect  to  the  vegetable  oil
lation  model.  Before  results of any simulation  can  be  industry.  For example,  there has been much debate  in
regarded  as  accurate,  they must be verified empirical-  recent  years  over  the  question  of responsibility  for
ly  [6].  The  only way  which  the  results presented  in  the  increase  in  food  prices.  Although  much  of  the
Table  1  can  be  validated  is  to  obtain  industry  cost  increase  is  directly  attributable  to  governmental
data on  the components.  Not only is this information  inflation  of the money supply, it is quite possible  that
unavailable  from  companies  in  the  industry,  it is not  food  processors  have  been  able  to  increase  their
likely  forthcoming.  For  this  reason,  an  explicit  relative returns  through the exercise  of market power.
validation  of  the  cost  components  presented  in  A  cost  component  analysis  of the marketing  margin
Table  1  has  not  been  made.  On  the  other  hand,  an  allows  for  a  straightforward  evaluation  of this  ques-
approximate  validation  of the  simulation model itself  tion.  This  study  of  the  vegetable  oil  industry  indi-
was  possible  from  census  reports  on input utilization  cated  that  profits  on margarine  were  not  out of line
and  output  in  the  vegetable  oil  industry.  This  partial  with  profit  levels  of  other  food  products.  However,
validation  is  the best  that can  be accomplished,  given  the  profit  level  on  bottled cooking  oil was  found to
constraints  under  which  the  analysis  was  performed.  be  substantially  greater  than relative  profits  on other
food  products.  Whether  this  result  is  a  short  run
phenomena,  evidence  of returns to advertising,  or the
CONCLUSION  identification  of  market  inefficiency,  is  a  question
Cost  component  studies  performed  in  the  past  which  remains  to  be  answered.  The  point  worth
have  used firm  accounting  data as a basis for analysis.  noting  is  that  the  simulation  approach  outlined  here
These  studies  have  been  limited  to  products  with  provides  a  means  for  approximating  processing  cost
relatively  simple  production  processes  because  of  components,  and  identifying  possible  sources  of
complications  in  obtaining  firm  cost  data.  The  market  inefficiencies,  where  no  other  method  is
method  proposed  here  offers  a  viable alternative  for  available.
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113

A Representative and Deterministic Cost Component Model of the United States Vegetable Oil Industry,&quot;

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Behavior of Meat Marketing Margins,&quot;

Discussion: Marketing Costs and Margins,&quot;

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Marketing Costs and Margins: Current Use in Agribusiness Market Structure Analysis,&quot;

Marketing Costs and Margins: New Perspectives in a Changing Economy,&quot;

Simulating Stable Stochastic Systems: III. Regenerative Processes and Discrete-Event Simulations,&quot;

The Behavior of Marketing Margins on Citrus Fruits,&quot;

The Behavior of Marketing Margins on Dairy Products,&quot;

The Relationship of Volume, Prices, and Costs of Marketing Margins for Farm Foods,&quot;

ESTIMATING MARKETING MARGIN COST COMPONENTS: AN APPLICATION OF SIMULATION TO PRODUCTS OF THE VEGETABLE OIL INDUSTRY

ESTIMATING MARKETING MARGIN COST COMPONENTS: AN APPLICATION OF SIMULATION TO PRODUCTS OF THE VEGETABLE OIL INDUSTRY

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