Question

For Pepsi, a Business Decision with Social Benefit PepsiCo has done a deal with 300 small Mexican farmers close to their two factories to buy corn at a guaranteed price. PepsiCo saves transportation costs and the use of local farms assures it access to the type of corn best suited to its products and processes. "That gives us great leverage because corn prices don't fluctuate so much, but transportation costs do," said Pedro Padierna, president of PepsiCo in Mexico. Source: The New York Times, February 21,2011 a. How do fluctuations in the price of corn and in transportation costs influence Pepsico's shortrun cost curves? b. How does the deal with the farmers to avoid fluctuations in costs benefit PepsiCo?

Short answer

The deal helps PepsiCo avoid costs fluctuation by guaranteeing corn prices and reducing transportation costs, leading to more stable short-run cost curves.

Step-by-step solution

Title - Understand the impact of corn price fluctuations

When the price of corn fluctuates, PepsiCo’s cost of raw materials varies. In the short run, this can cause shifts in PepsiCo’s variable costs, potentially increasing or decreasing according to the market price of corn. Since PepsiCo relies significantly on corn for their products, fluctuations in corn prices directly affect the company's short-term cost structure.

Title - Assess the role of transportation costs

Transportation costs, on the other hand, also impact PepsiCo’s overall costs. These costs can vary due to fuel price changes, logistical inefficiencies, or distance. Variations in transportation costs lead to unpredictable total costs, affecting PepsiCo's short-run average total cost curve.

Title - Connection between corn price fluctuations, transportation costs, and short-run cost curves

Both corn price and transportation cost fluctuations influence the shape of PepsiCo’s short-run cost curves. When corn prices increase, the average variable cost (AVC) and marginal cost (MC) curves shift upwards. Similarly, rising transportation costs mean higher average fixed costs (AFC), shifting the average total cost (ATC) curve upwards.

Title - Evaluate stability from the deal with farmers

The deal with farmers guarantees a steady price for corn, thus avoiding variability in this key input cost. This stability leads to predictable variable costs for PepsiCo, allowing for smoother production planning and cost management in the short run. It eliminates a significant source of volatility in their cost structure.

Title - Assessing additional benefits

Besides cost stability, using local farms reduces transportation needs, thus lowering associated costs and risks. Reduced transportation costs directly impact PepsiCo's average fixed costs and contribute to overall cost savings.

Key concepts

Cost Structure

Cost structure refers to the way a company organizes and categorizes its expenses. For PepsiCo, understanding the cost structure is crucial for managing both fixed and variable costs. By identifying major cost components, such as the price of corn and transportation expenses, PepsiCo can effectively plan its finances. Reduced variability in these costs, thanks to deals with local farmers, allows for a more predictable and controlled cost structure. This predictability benefits not only the company's budgeting but also its pricing strategy and profitability.

Variable Costs

Variable costs are expenses that vary in direct proportion to the volume of goods produced. For PepsiCo, corn prices represent a significant variable cost. When the price of corn fluctuates, it directly affects the company's production costs. The deal with local farmers to buy corn at a guaranteed price stabilizes these variable costs. This means PepsiCo can maintain consistent production costs despite market fluctuations, which helps in pricing products competitively and managing profit margins more effectively.

Fixed Costs

Fixed costs are expenses that do not change with the level of production, such as rent, salaries, and machinery. In the context of PepsiCo, transportation costs can be partially fixed if they involve long-term contracts. However, these costs can also vary due to external factors like fuel price changes. By sourcing corn locally, PepsiCo reduces the variability in transportation costs, turning a portion of these costs from variable to more predictable fixed costs. This helps in stabilizing the overall cost structure.

Short-Run Cost Curves

Short-run cost curves represent the costs a company incurs over a short period, where some inputs are fixed, and others are variable. For PepsiCo, the short-run cost curves are influenced by both corn and transportation costs. When the price of corn or transportation costs increase, the average variable cost (AVC) and marginal cost (MC) curves shift upwards, causing the average total cost (ATC) curve to rise. Conversely, deals that provide price stability help in keeping these curves flatter and more predictable.

Transportation Costs

Transportation costs include all expenses related to moving goods from one location to another. For PepsiCo, these costs can vary due to changes in fuel prices, logistical challenges, or distance. By sourcing corn from local farmers, PepsiCo significantly reduces its transportation costs. This not only lowers overall expenses but also minimizes risks associated with transportation, such as delays and spoilage. Lower transportation costs contribute to a more efficient cost structure and can improve the company's overall profitability.

Price Stability

Price stability refers to the ability to keep prices consistent over time. For a company like PepsiCo, achieving price stability in its inputs, like corn, is crucial for maintaining a stable cost structure. The agreement with local farmers to buy corn at a fixed price ensures that PepsiCo faces fewer price fluctuations. This leads to more predictable costs, allowing for better budgeting and financial planning. Price stability also enables the company to offer more consistent pricing to its customers, enhancing its competitive edge in the market.