Chapter-4

Basics of Project Costs

 Contents
In this chapter we will see:

Classifications of project costs

Life cycle cost
Investment costs
Production costs
Budgeting
 Take five minutes to write your expectations
 Introduction
There are three basic questions to be answered in project
analysis activities. These are:
1. Can we produce the goods or services?
2. Can we sell the goods or services?
3. Can we earn a satisfactory return on the investment made in the
project?
 To answer these questions we have to do
Technical analysis
Market and demand analysis
Financial analysis
Socio-economic analysis
Institutional analysis
Financial Analysis

Cost of the project

Production cost

Means of finance

Profitability projection
 Financial analysis seeks to ascertain whether the proposed
project will be financially viable in the sense of being able
to meet
the burden of servicing debt
the return expectations
 Classification of project cost
Based on Project Life Cycle
Based on purpose
Investment cost
Production cost
 Life cycle costing (LCC)
Life cycle costing is the total cost of ownership of a product,
structure, or system over its useful life.
For products purchased off the shelf, the major factors are the
cost of acquisition, operation, service, and disposal
For a system or product it is necessary to include the costs
associated with conceptual analysis, feasibility studies,
development design, logistics support analysis, manufacturing,
and testing.
 LCCContd
The five life cycle phases of a system or product
Conceptual design phase
Advanced development and detail design phase
Production phase
Project termination and system operation and maintenance phase
System disinvestment
The main components of project costs:
I. Pre- investment costs: costs incurred in developing the project
concept and preliminary project design.
II. Bidding and procurement-related costs: design and analysis work to
prepare bids .
III.Project development costs: further development and refinement of
the project scheme during the bid and post concession.
IV.Construction cost: Includes the construction of the entire facility,
including the purchase and installation of equipment.
V. Termination cost
VI.Operating costs
 LCCContd
The need for life cycle costing arises because decisions
made during the early stages of a project inevitably have an
impact on future outlay.
The trade off between current objectives and long term
consequences of each decision is therefore a strategic
aspect of a project management that should be integrated
in to the project management system
Project life cycle and its cost
LCCContd
 Investment cost
However investment cost identification is the most difficult
and at the same time the most important function of a
project analysis
Like any forecast, cost estimation includes some
uncertainty
There is uncertainty regarding usage and price
Different investment cost estimation mechanisms are used
in a different ways
 Investment cost items
Land and site preparation
Technology (lump sum and initial payments)
Equipment
Production
Auxiliary
Costs for environmental protection technology,
waste disposal, internal infrastructural services
Spare parts, wear-and tear-parts, tools

17
 Investment cost itemsContd
Civil works
Site preparation and development
Buildings
Outdoor works
Engineering and design costs (unless included in equipment).
Incorporated fixed assets (intangibles)
Project design costs (engineering etc.) (unless included in the
above groups).
Transport, handling costs and charges
Insurance
Duties, taxes
 Pre-production expenditures
Cost of previous studies
Preliminary and capital issue
Project and site management
Pre-production marketing costs
Pre-production implementation costs
Personnel recruitment, training, administration and
overheads.
Trial runs, start-up and commissioning
Interests on loan accrued during construction
Investment Cost Estimation

Calling tenders (specifications, BOQs)

Prices from similar projects to calculate costs (based on
specs, BOQs)
Unit cost parameters
e.g. - cost/m2 of built-up area,
- cost/m3 of enclosed space
Lump sum totals of functional project parts of an
existing project.
Investment cost estimates based on cost parameters and on lump
sums should be adjusted taking into account the following factors:
Investment Cost Estimation (Contd)

Scope of project - ancillaries

Annual inflation rates
Changes in FOREX rates
Location factor
Accessibility to construction site
Local conditions e.g. Climate (heating, air conditioning etc.)
Laws and regulations e.g. on safety, labour
Level of infrastructural and HR development
E.g developed countries 1x
developing countries 1.5 x
Remote site under developed 2.5 x
%age of local inputs for project
Errors in data, physical contingencies
 Problems
Even with careful planning, estimates are wrong
Escalation
Waste
Bad Luck
Most firms add 5-10 percent for contingencies
 Making Better Estimates
Projects are known for being over budget
It is unlikely that this is due to deliberate underestimating
There are two types of errors
Random
Systematic
There is nothing we can do about random errors
Want to eliminate systematic errors
 Example
Towards an entrepreneur university
 Summary of Resources Requirements

Summary Year 1 Year 2 Year 3 Year 4 Year 5

Operational cost 32,100 52,960 64,360 67,360 69,360

Development cost 27,150 16,850 5,300

Set up cost 23,100 0 0

Total 82,350 69,810 69,660 67,360 69,360

$358,540
Overall Total
 Operational cost includes
Employees fee and
Material cost
Development cost includes
International Knowledge transfer or consultant cost
Feasibility study of business incubation
Feasibility study of Science Park
Setup cost includes
Fixed asset requirements for
Enterprise office
Student hatchery
 Cost estimation of Tekeze hydropower
project
Lot Title Component Cost Component

Birr in million Local Foreign

Consultancy service 63.345 0% 100%

Lot 1/2/3 Main civil works 1903.941 30% 70%

Lot 4 Mechanical equipment 182.824 5% 95%
Lot 5 Electrical equipment 285.823 5% 95%
Lot 6 Substation 33.475 5% 95%
Lot 7 High voltage transmission 105.572 15% 85%
Grand Total 2574.98
 Discussion Topics
Consider your own project and try to identify the projects
life cycle cost
Explain how the design of a car affects its life cycle cost.
Discuss a project in which the first phase of the life cycle
accounts for more than 50 % of the life cycle.
Discuss a project in which the detailed design phases
accounts for more than 50% of the life cycle cost.
Propose your own cost estimation mechanisms
Develop the cost breakdown for the project you are
undertaking as a term paper.
 Production Cost
Beyond investment cost, production cost is vital
Example
Hydropower projects
Textile and garment industry
Tanning and leather footwear industry
Competitiveness is in one way or the other depends on the price of
the output.
In this global economy there is no unique project that lasts for long
 Elements and Classification of Costs in
Manufacturing
Various elements of costs are considered separately for
analytic purposes.
They may be broadly classified into two categories,
direct and
indirect costs.
 Direct Costs

Direct costs consist of two elements,

Direct material: The quantity (usage) and the price.
Direct labor: Time (usage or efficiency) and the rates
( price or wage)
 Overhead Costs

Many costs are of indirect nature and are not easily

associated with the output of a particular unit of product
or service.
One should note that indirect costs are costs which are not
easily related to the cost of a particular product.
But it does not mean it is unproductive, useless, or
unbeneficial.
Indirect costs consist of three elements:
 Overhead CostsContd
Factory Expenses: These costs include salaries of foremen and
factory office workers; expenses of maintenance staff;
depreciation of factory equipment and buildings; and payment for
power, water, telephone, telex, etc.

Administrative Expenses: These expenses include salaries of

administrative personnel; expenses for office supplies, telephone,
telex and postage; depreciation of office equipment and buildings;
and insurance fee, etc.

Selling Expenses: They include salaries and commissions of

salesmen; and advertising and traveling expenses for sales
promotion.
 Typical Factory overhead and Corporate
Overhead Expenses
Factory Overhead Expenses Corporate Overhead
Expenses
Plant supervision Corporate executives
Line foreman Sales personnel
Maintenance crew Accounting department
Security personnel Finance department
Tool crib attendant Legal service
Material handling crew Research and development
Shipping and receiving Design and engineering

Applicable taxes Other support personnel

Insurance Applicable taxes
Heat Costs of office space
Light Security personnel
Power for machines Heat
Factory cost Light
Equipment cost Air conditioning
Fringe benefits Insurance
Fringe benefits
 Total Cost

The total cost of a product may be calculated in at least

two different ways, by breaking it into its basic cost
components.

1. Total cost is the sum of manufacturing cost and selling

expenses.
2. The total cost can also be calculated as the sum of fixed cost and
variable costs
Total Cost = Manufacturing Cost + Selling Expenses(SE)

Manufacturing Cost = Factory Cost + Administrative Expenses

MC FC AE
Factory Cost = Prime Cost + Factory Expenses

FC PC FE
Prime Cost = Direct Labor + Direct Material Costs

PC DL DM
Finally total cost is the sum of direct labor, direct material, factory expense,
administrative expense and selling expenses.

TC DL DM FE AE SE
 Fixed costs and variable costs

The total cost can also be calculated as the sum of fixed cost and
variable costs

Total Cost = Fixed Cost + Variable cost

TC FC VC FE AE SE DM DL
 Fixed costs: are expenses which are independent of the
volume of output (i.e. constant for any level of production
output).
Examples of the fixed costs include cost of factory building,
insurance, lighting expenses, the cost of production
equipment, property taxes, salaries of administrative staff,
etc.

All of these fixed costs can be expressed as annual costs.

 Variable costs: expenses which vary or change
proportionally with the level of output (i.e. increases as the
level of production increases).
Direct labor costs (plus fringe benefits), expenses of raw
material, electrical power to operate the production machines,
packing material, chemical input, etc., are some of the variable
expenses.
The ideal concept of variable cost is that it is directly
proportional to output level.
When fixed and variable costs are combined, we get the
total cost of manufacturing as a function of output.
Total cost versus monthly output
 Break - Even Analysis
Business enterprises face problems of selection in which
profit maximization is assumed to be the governing factor.
The businessman is concerned only with revenues, costs and
the consequent profits or losses associated with the
possible alternatives.
Income depends on both price and quantity of sales.
 Break - Even AnalysisContd
The point in the operation of an enterprise of
which revenue (sales) and total cost are exactly
equal is called the break-even point.

At this point of operation an enterprise will,

neither realize an operating income, nor incur an
operating loss.
Break-even chart
The break-even point can be determined from a graphical presentation or can
be computed using a mathematical formula.
Total Cost = Fixed Cost + Variable Cost

Income Price Quantity

At break-even sales,
Total Cost = Income
Price Quantity = Fixed Cost + Variable Cost
Let P = Price
Q = break-even quantity
F = fixed costs, and
V= variable costs/unit
PQ = F + VQ
PQ - VQ = F
Q(P -V) = F

F
Q =
P -V
 Unit Cost of Production

The unit cost of a certain operation is the total cost of

production divided by the number of units produced.
The total cost of production includes both fixed and
variable costs.
Accordingly, because of the fixed proportion of the cost of
production, the unit cost will vary as a function of annual
output Q. As the annual output increases, the unit cost
decreases.
Sometimes unit costs are used as a measure of
performance for a production system.

These unit costs are calculated under assumed

conditions of annual cost and production rate.

The actual cost per unit of production is strongly

dependent on the level of annual output.
Fig. Unit cost as a function of Annual output for two
production methods
 Price Analysis
Some form of price analysis is required for every purchase.
The method and scope of analysis required are dictated by
the dollar amount and circumstances attending each specific
purchase.
Price analysis is defined as the examination of a sellers
price proposal (bid) by comparison with reasonable price
benchmarks, without examination and evaluation of the
separate elements of the cost and profit making up the price.
 Most Prices are Subject to Adjustment: It is because most
firms are free, within broad limits, to adjust their prices at
will that competent buyers can obtain better prices in direct
proportion to their ability to analyze costs, markets, and
pricing methodologies.
Prices can be negotiated very little with firms in the markets of
pure competition or monopoly.
They can be negotiated a great deal with firms operating in the
markets of imperfect competition.
The question then is: what proportion of the nations total market
falls within the area of imperfect competition? What percentages
of a buyers total purchases are subject to price flexibility?
 Variable-Margin Pricing: Most industrial firms sell a line of
products rather than just a single product.
Very few firms attempt to earn the same profit margin on each
product in the line. Most firms price their products to generate a
satisfactory return on their whole line, not on each product in the
line.
Such a variable-margin pricing policy permits maximum
competition on individual products.
The profits from the most efficiently produced and successfully
priced items are used to offset the losses or the lower profit
margins of the inefficiently produced items.
Differences Between Products: There are many
basic differences between the kinds of products
marketed in the various segments of the economy.
Some products in the competitive segment are
undifferentiated products (not distinguished by
specific differences) and others are differentiated.
In some cases, the products are intrinsically different
(differentiated) in others, manufacturers are successful in making
their similar products appear different from their own products
or their competitors.
Even in those cases where a product cannot be made different in
substance, producers can still get premium prices if they can
persuade buyers to believe that their products are superior.
Some producers spend huge sums of money on sales personnel and
advertising to accomplish such a purpose.
 Varying Profit Margins: A seller must recover all costs from
his or her total sales to make a profit.
However, each product in the line does not have to make a profit,
and all accounts do not have to yield the same profit margin.
Sound pricing policy dictates that sellers, in accordance with their
interpretation of the prevailing competitive forces, quote prices
that are high enough to include all variable costs and make the
maximum possible contribution toward fixed costs and profit.
A buyer has four tools which can be used to conduct a
price analysis:
i. Analysis of competitive price proposals;
ii. Comparison with regulated, catalog, or market prices;
iii. Comparison with historical prices; and
iv. Use of independent cost estimates.
 i. Competitive Price Proposals
When this approach is employed, and the following additional
conditions are satisfied, then the resulting low bid normally
provides a fair and reasonable price:
At least two qualified sources have responded to the offer.
The proposals are responsive to the buying firms requirements.
The supplier competed independently for the award.
The supplier submitting the lowest offer does not have an unfair
advantage over its competitors.
The lowest evaluated price is reasonable.
 ii. Regulated, Catalog, and Market Prices
Prices Set by Law or Regulation: When the price is set by
law or regulation, the supplier must identify the regulating
authority and specify what the regulated prices are.
With regulated prices, some governmental body (federal, state, or
local) has determined that prices of certain goods and services
should be controlled directly.
Normally, approval of price changes requires formal review,
hearings, and an affirmative vote of the regulatory authority.
 Catalog Price: An established catalog price is a price that is
included in a catalog, a price list, or some other form that is
regularly maintained by the supplier.
The price sources must be dated and readily available for inspection
by potential customers.
The buyer should request a recent sales summary demonstrating
that significant quantities are sold to a significant number of
customers at the indicated price before accepting a catalog price.
 Market Price: A market price results from the interaction
of many buyers and sellers who are willing to trade at a
given (market) price.
The forces of supply and demand establish the price.
A market price is generally for an item or a service that is
generic in nature and not particularly unique to the seller.
Normally the daily market price is published in local newspapers
or trade publications which are independent of the supplier.
 iii. Historical Prices
Price analysis may be performed by comparing a proposed
price with historical quotes or prices for the same or similar
item.
It is essential to determine that the base prices are fair and
reasonable (as determined through price analysis) and is still a valid
standard against which to measure the offered price.
The fact that a historical price exists does not automatically make
it a valid basis for comparison.
Several issues must be considered:
How have conditions changed?
Were there one-time engineering, setup, or tooling charges?
What should be the effect of inflation or deflation on the price?
 iv. Independent Cost Estimates
When other techniques of price analysis cannot be utilized,
the buyer may use an independent cost estimate as the basis
for comparison.
The buyer must determine that the estimate is fair and
reasonable.
If price analysis is impractical or if it does not allow the buyer to
reach a conclusion that the price is fair and reasonable, then cost
analysis, should be employed.

Price Cost Profit

 Discounts
Discounts frequently are considered to be a routine,
ordinary part of pricing.
Perceptive buyers, however, recognize that this is not always the
case.
Discounts can sometimes succeed as a technique for reducing
prices after all other techniques have failed.
The four most commonly used kinds of discounts are trade
discounts, quantity discounts, seasonal discounts, and cash
discounts.
 Trade Discounts: These discounts are reductions from list
price allowed for various classes of buyers and distributors
to compensate them for performing certain marketing
functions for the original seller (the manufacture) of the
product.
Quantity Discounts: These price reductions are given to a
buyer for purchasing increasingly larger quantities of
materials.
They normally are offered under one of three purchasing
arrangements:
For purchasing a specific quantity of items at one time
For purchasing a specified dollar total or any number of
different items at one time
For purchasing a specified dollar total of any number of items
over an agreed-upon time period
 Seasonal Discounts: Based on the seasonal nature of some
products (primarily consumer products) their producers
commonly offer discounts for purchases made in the off-
season.
Cash Discounts: In many industries, sellers traditionally
offer price reductions for the prompt payment of bills.
When such discounts are given, they are offered as a
percentage of the net invoice price.
 Profit
There are no precise formulas which can be used to help form
a positive judgment concerning the right price, of which
profit is one component.
One objective of sound purchasing is to achieve good supplier
relations.
This objective implies that the price must be high enough to keep
the supplier in business.
The price must also include a profit sufficiently high to encourage
the supplier to accept the business in the first place, and secondly,
to motivate the firm to deliver the materials or service on time.
What profit does it take to get these two desired results? On
what basis should it be calculated?
 Considerations other than production efficiency can also
rightly influence the relative size of a firms profit.
Profit is the basic reward for risk taking as well as the
reward for efficiency; therefore, higher profits justifiably
accompany extraordinary risks, whatever form they take.
A higher dollar profit per unit of product purchased on
small special orders is generally justified over that allowed
on larger orders.
The justification stems from the fact that the producer
incurs a fixed amount of setup and administrative expense,
regardless of the size of the order.
 On occasion, because of various temporary unfavorable supply-
demand factors (e.g., excessive inventories, a shortage of
capital, a cancellation of large orders), a firm may be forced to
sell its products at a loss in order to recover a portion of its
invested capital quickly or to keep its production facilities in
operation.
A firm that manufactures a product according to the design
and specifications of another firm is not entitled to the same
percentage of profit as a firm that incurs the risk of
manufacturing to its own design.
 Price and Pricing Policy
In the long-term (and often in the short-term, too) the
revenue of a business must exceed the total of its various
costs if it is to survive.
The prices at which a business's products are sold obviously
have vital bearing on its potential and actual profitability.
That being the case, one would expect that there would be a
definite set of rules laid down by a business for the fixing of
the prices at which its products will be sold; and that the
same or similar rules would be applied to price setting by all
businesses. However, that is very definitely not the case.
 There are many factors which may affect the prices of
consumer goods, apart from the obvious need for
manufacturers and distributors to obtain reasonable
returns on their capital expenditure and enterprise.
Even that basic requirement is subject to the various
circumstances and market conditions prevailing, and prices
may be raised or reduced in different areas for a variety
of reasons.
For instance, a branch of a supermarket in one town may
sell a product at a loss, whilst another branch of the same
supermarket chain in a nearby town may sell the same size
and the same brand of product above the normal selling
price.
 Some of the factors which may determine the selling price
of an article or a service at any particular time are:
The costs involved in its manufacture, and in its distribution to
consumers.
The nature of the product and the demand for it.
The cost of storing or safeguarding the product.
The prices charged by competitors selling similar products.
The need for immediate profit or for profit in the future.
Government intervention in price restrictions.
The psychological attitude of buyers.
 Discussion Topics
Discuss the current price fluctuation under the
light of project analysis or preparation
 Project Budget
The budget of any specific project is tied to the
organizational budget.
A well designed budget is an efficient
communication channel for management
A successful project manger is one who can achieve
the budget goals with the resources allocated to
his or her project.
 BudgetingContd
A plan for allocating scarce resources to the
various endeavors of an organization
A budget implies constraints
Thus, it implies that managers will not get
everything they want or need
 BudgetingContd
The budget for an activity also implies management support
for that activity
The higher the budget, relative to cost, the higher the
managerial support
The budget is also a control mechanism
Many organizations have controls in place that prohibit
exceeding the budget
Comparisons are against the budget
 Budgeting Methods
1. Top-down
2. Bottom-up
3. Negotiated
 Top-Down Budgeting
Top managers estimate/decide on the overall budget for
the project
These trickle down through the organization where the
estimates are broken down into greater detail at each
lower level
The process continues to the bottom level
 Advantages
Overall project budgets can be set/controlled very
accurately
Management has more control over budgets
Do not need to do as much up-front planning
 Disadvantages
More difficult to get buy in
Leads to low level competition for larger shares of
budget
 Bottom-Up Budgeting
Project is broken down into work packages
Low level managers price out each work package
Overhead and profits are added to develop the
budget
 Advantages
Greater buy in by low level managers
More likely to catch unusual expenses
 Disadvantages
People tend to overstate their budget requirement.
Management tends to cut the budget
 Discussion Topics

Develop a budgeting procedure for an organization.

 Research areas
How to increase competitiveness of an organization
in the preliminary project phases.
 Take few minutes and write your reflections?
Weshall now deal with all the above factors in turn:
Manufacturers' costs: These costs are made up of:
Planning the making of the product, including the cost of research,
design, machinery, etc.
The cost of raw materials.
The cost of direct labor to convert the raw materials into the
finished article.
What are called 'overhead expenses', such as depreciation, power,
rent, heating, lighting, office costs, etc.
Administration expenses such as interest on capital, legal fees, fees
of accountants, executives and directors.
Marketing expenses - advertising and sales publicity of all kinds,
research, selling expenses, salesmens' remuneration, etc.
Service expenses - delivery of goods to the customer, after-sales
service and repairs during a guarantee period, etc.
 The product and the demand for it: The nature of the
product and whether it is considered a necessity or a
luxury to different classes of buyers has an important
bearing.
In a poor district a product may be considered a luxury,
whereas in a wealthy market the same product could be
regarded as a necessity.
In the poor district only products considered to be
necessities will maintain high prices, and demand for luxury
goods could be low even if they were offered for sale at
low prices.
On the other hand, luxury goods in a wealthy market could
maintain high prices and demand, and if they were offered
at low prices, consumers might suspect their quality to be
inferior and refuse to buy them.
 Cost of storing and safeguarding products and cash:
Storage costs have a definite bearing on selling costs.
The expense of building or renting suitable storage
premises can be high, and the cost of equipping and
maintaining such buildings can also be great.
A manufacturer needs a large warehouse to store his stock
of finished products awaiting sale and dispatch.
His customers may be wholesalers who will also need
storage facilities - possibly large warehouses or go downs -
and when they re-sell to their retailers, they too must have
adequate stock rooms or suitable containers in which to
store the products which they buy.
 Prices of competitors' products. Manufacturers seldom
market only one product.
They usually produce a range of products of various
qualities and sell them at various prices according to size or
quality.
As there may be many manufacturers producing similar
products, there could be a large number of sizes, qualities,
and prices for consumers to choose from.
Advertising and publicity material would extol the merits
and benefits of each, and appeal in various ways to the
consumers' motives for buying.
 Prices can be affected by the availability of
substitutes.
Food products are subject to sudden fluctuations in price;
for example, if a housewife who intended to buy beef found
that the price had doubled due to a temporary shortage of
supply, but that other meat product were cheaper, she
could buy a substitute and choose veal or chicken.
If the shortage of beef continued, it could cause the
prices of veal and chicken to rise as demand increases.
 The need for immediate or long-term profit: It is true
to say that as standards of living rise, people become
accustomed to looking for improved products and
technological advances that not only look good but will
provide greater utility of use.
For example, the invention of the 'micro chip' has enabled
the modern washing machine to be programmed to perform
a whole series of operations, resulting in clothes being
washed, rinsed and dried without the housewife having to
be in attendance.
In spite of that, owners of those and other modern
sophisticated appliances could be looking at even better
products within five years, with a view to replacing their
existing machines with appliances having the latest
refinements and providing even greater utility.
 In earlier days, a manufacturer of, say a cooker, would
expect his product to go on selling for up to fifteen years.
The costs incurred in designing, tooling up, manufacturing
and promoting sales of his product would have been
recovered from sales over a period of up to five years.
From thereon a steady volume of sales would have been
anticipated to provide sufficient profits, to satisfy
shareholders of the company, and to enable a development
fund to be built up over the years to finance the designing
and production of another, new model.
When that became necessary, some years in the future,
with that policy the price of the product could remain
fairly constant over a long period of time, and at a lower
level than it would have been if immediate profit, rather
than long-term gain, had been the objective.
 With modern versions of similar products, manufacturers
are faced with the prospects of continuous research to
keep abreast of developments in every sphere and aspect
of their products, and of financing the production of a new
model every five or six years.
That affects sales forecasting and determines sales
objectives that will enable a level of profits which will not
only give shareholders of a company a reasonable return on
their investment, but also provide sufficient money to be
retained in the company's development fund to finance the
next new project, a few years hence.
 Government intervention: The government of a country
may wish to control the amount of hire purchase available
at any one time, since credit may increase demand and
contribute to inflation.
In order to do that it may increase the minimum amount of
deposit which has to be paid, increase the interest rate, or
shorten the period of repayment.
Any, or all, of those measures should discourage consumers
from entering into hire purchase agreements, thus reducing
demand and controlling output on the home market, for
example.
Increases in taxation or in customs duties or the tightening
of import controls can also raise prices, and curtail sales.
 The foregoing factors are some of the unforeseen hazards
which can upset the forecasts of management and
necessitatemodifications to their aims or plans.
 The pshyeological attitude of buyers. When customers fear
that there will be shortage of an article in the future, and no
substitute product is available, they may be inclined to buy more
than they actually need and to pay more because of its scarcity
value.
It often happens that certain products, such as clothes,
footwear, fancy goods, etc., are sold at high prices, and at prices
which yield high profit margins, because consumers believe that
the quality of the products supplied equate to their cost.
If such products were offered at lower prices they might be
sold in a less affluent market, but could lose the more lucrative
wealthy market of fashion-conscious consumers.
If the buying motives of consumers are ignored, sales will fall. If
buyers expect to pay a certain price for a product,
manufacturers should try to comply, and if they are able to
supply a large market and make large profits by so doing, then
that is good business.
 High profits can cushion the effects of inflation. As
manufacturing costs increase, prices may be held down for
a time, and then be increased only gradually as consumers
become accustomed to the general rise in incomes and the
costs of necessities - which tend to increase immediately
raw materials and expenses become dearer. Consumers will
raise many objections to paying a little more for basic
items of foodstuffs.
The same customers, however, when going out to dine, may
buy a high-priced meal in a restaurant, pay a 10% service
charge, tip the waiter, and return home well satisfied with
a pleasant night out.
 Similar satisfaction may be obtained by customers buying
consumer good from a certain prestigious store, or buying
certain expensive brands of goods. The store has a certain
'image'; it has created an impression in the minds of the
public and it has implanted appreciation for the products
and services supplied.
Certain brands of goods command loyalty from buyers for
various reasons. The 'brand image' may be created by any
one or more of many reasons, and may appeal due to a
combination of reasons and buying motives. Ultimately a
reasonable standard of quality (a price that sufficient
buyers can afford to pay) and good regular advertising may
establish a good reputation and a brand image that will
reflect reliability and give confidence to buyers.