Agenda
• Price discrimination
• Cost-plus contracts
Price Discrimination
Antitrust: Consisting of laws to
protect trade and commerce from
unlawful restraints and monopolies
or unfair business practices.
Sited from Merriam-Webster
Price Discrimination
• Sherman Act of 1890
– Illegal to monopolize trade
– Illegal to conspire in restraint of trade
– Prohibits predatory pricing
• Clayton Act of 1914
– Elaborated on the Sherman Act
– Forbids price discrimination in favor of big
buyers
– Forbids purchasing stock in a competitor
Price Discrimination
• Robinson-Patman Act of 1936
–Amended the Clayton Act
–Administered by the U.S. Federal Trade
Commission
–Fundamental principal of the act:
•“To assure, to the extent reasonably
practicable, that businessmen at the same
functional level would stand on equal
competitive footing so far as price is
concerned.”
Price Discrimination
• Robinson-Patman Act of 1936
– Identified three possible defenses against
charges of price discrimination:
• Differences in prices arising from differences in
manufacturing costs
• Quantity purchases from customers
• The need to meet competitors’ prices
– As originally drafted, the Act applied to
“commodities,” and this still appears to be
the case. In other words, goods, not
services.
Price Discrimination
• Hanson Paint and Glass Co. vs. Pittsburg Plate
Glass Industries, 1973
• William Inglis and Sons Baking Co. vs. ITT
Continental Baking Company Inc., 1981
• Brooke Group Ltd. vs. Brown & Williamson
Tobacco Corp., 1993
Price Discrimination
Hanson Paint and Glass Co.
vs.
Pittsburg Plate Glass Industries, 1973
Hanson, an old employee of Pittsburgh glass
company, opened his own store.
He bought supplies from Pittsburgh and other
companies at low prices, but continued to
operate at a loss.
Pittsburgh sold to Hanson’s competitor at a
lower price.
Hanson accused PPG of violating the RobinsonPatman Act.
Price Discrimination
Hanson Paint and Glass Co.
vs.
Pittsburg Plate Glass Industries, 1973
Recall the three possible defenses:
• Differences in prices arising from
differences in manufacturing costs
• Quantity purchases from customers
• The need to meet competitors’ prices
Price Discrimination
Hanson Paint and Glass Co.
vs.
Pittsburg Plate Glass Industries, 1973
1) Price differences as a result of different
manufacturing techniques.
PPG proved that Hanson bought a
different cut of glass than his
competitor, Martex.
Price Discrimination
Hanson Paint and Glass Co.
vs.
Pittsburg Plate Glass Industries, 1973
2) Different prices due to different quantities
purchased.
PPG showed that Hanson bought 41 sq. ft.
compared to Magnolia, another competitor,
buying 429 sq. ft.
Price Discrimination
Hanson Paint and Glass Co.
vs.
Pittsburg Plate Glass Industries, 1973
3) Attempt to Meet Competition
PPG offered Martex a higher discount
because PPG had been turned down once
before due to Martex finding a better price
at Safelite.
Hence: PPG won this case by using all three
defenses identified in the Robinson-Patman
Act
Price Discrimination
William Inglis and Sons Baking Co.
vs.
ITT Continental Baking Company Inc., 1981
Both companies sold bread under a brand
name label and a generic label.
Name Label: Available nationally at all stores:
Inglis - Sunbeam
Continental - Wonder Bread
Generic label sold at a price below the
advertised name label.
Price Discrimination
William Inglis and Sons Baking Co.
vs.
ITT Continental Baking Company Inc., 1981
Continental’s selling price went from 19 to 18
cents; two years later went to 17.2 cents.
Inglis charged that, “The low prices on private
label bread were subsidized by prices on
brand name bread.”
Price Discrimination
William Inglis and Sons Baking Co.
vs.
ITT Continental Baking Company Inc., 1981
• Inglis claimed that Continental:
– Sold bread below cost (average variable
cost) during the 1970s
– Forced Inglis out of business because of a
“monopoly”
– Charged different prices in Nevada than in
California
– Violated the Robinson-Patman Act
• The jury granted Inglis $5 million
Price Discrimination
William Inglis and Sons Baking Co.
vs.
ITT Continental Baking Company Inc., 1981
• The judge threw out the verdict.
• Inglis appealed the ruling.
• The judge and the Appeals Court
– Defined “attempt to monopolize”
– Determined when prices are predatory
– Determined when companies can reduce
prices to meet competition
Price Discrimination
William Inglis and Sons Baking Co.
vs.
ITT Continental Baking Company Inc., 1981
• Inglis used variable costing to prove
Continental set prices lower than cost
– Included all costs as variable except plant
depreciation, taxes, and business license
fees
– Determined cost and selling price as:
•Cost:
$0.206
•Selling Price:
$0.172
Price Discrimination
William Inglis and Sons Baking Co.
vs.
ITT Continental Baking Company Inc., 1981
• Judge Williams and the Appeals Court
determined that
– marginal costing should be used: Look at
the change in sales price relative to the
change in variable costs
– many costs claimed by Inglis to be
variable were really short-run fixed costs.
• Inglis was forced to drop the case
Predatory Pricing
Brooke Group Ltd.
vs.
Brown & Williamson Tobacco Corp., 1993
• The U.S. Supreme Court defined
predatory pricing as
– A situation in which a company has set prices
below average variable cost and planned to
raise prices later to recover the losses from
lower prices.
• Relevant for both short-term and longterm pricing decisions.
Predatory Pricing
Brooke Group Ltd.
vs.
Brown & Williamson Tobacco Corp., 1993
• The U.S. Supreme Court used economic theory
to conclude that predatory pricing does not
work, and ruled in favor of B&W.
• The Court determined that “Congress did not
intend to outlaw price differences that result
from or further the forces of competition.”
Predatory Pricing
Brooke Group Ltd.
vs.
Brown & Williamson Tobacco Corp., 1993
• In the subsequent 37 predatory pricing
cases after this case, the defendants
prevailed.
• In 2001, a Federal judge threw out a
lawsuit against American Airlines alleging
predatory pricing in the Dallas-Fort
Worth market.
Predatory Pricing
• Predatory pricing also applies to antidumping laws in international trade.
• U.S. anti-dumping laws stipulate that the
import price cannot be lower than the
cost of production.
• The World Trade Organization found that
the number of cases brought under antidumping laws increased 35% from 1995
to 2000.
Agenda
• Price discrimination
• Cost-plus contracts
Cost-Plus Contracts
• Where are these contracts found:
–Defense contractors
–University research
–The entertainment industry
• Why are these contracts used:
–To share risk more efficiently
Cost-Plus Contracts
• Where are these contracts found:
–Defense contractors
–University research
–The entertainment industry
• Why are these contracts used:
–To share risk more efficiently
Defense Contractors
• In the first presidential debate, John
McCain called for eliminating costplus contracts in the defense
industry. He urged for all contracts
to be written as fixed cost contracts.
Defense Contractors
• Common Types of Fraud in Defense
Contracts
– Cross-Charging
– Improper Cost Allocation
– Inflating Costs
Cross Charging
• One of the most common types of
defense contractor fraud
• May occur when a company has a “fixed
price contract” and a “cost-plus contract”
– Fixed Price Contract: The company receives a
fixed price for a certain number of goods
regardless of the cost of production.
– Cost-Plus Contract: The company is
reimbursed for the cost of production, plus a
percentage of its costs as a profit.
Cross Charging
• The company has an incentive to charge
time that it spends working on the fixedprice contract to the cost-plus contract.
Cross Charging
The United States vs. Jana, Inc.
• Jana, Inc. was a defense contractor for
the United States government.
– Jana had several different contracts with the
United States.
– One of the contracts was a fixed-price
contract with the U.S. Army
– Another contract was a cost-reimbursement
time and materials contract with the U.S.
Navy.
Cross Charging
The United States vs. Jana, Inc.
• Jana assigned similar charge codes to the two
contracts.
• While work was being done, employees
accurately identified time spent on each project
on their time cards.
• Jana would later go back and change one
number in the charge code so that work being
done on the fixed-price contract would be billed
to the cost-plus contract with the Navy.
Cross Charging
The United States vs. Jana, Inc.
• An employee of Jana obtained an altered time
card and notified the Department of Justice.
• The Department of Justice randomly sampled
time cards related to the two contracts and
found numerous alterations
Improper Cost Allocation
• Improper cost allocation is similar to
cross-charging.
• In this case the contractor normally has
both commercial business contracts and
defense contracts.
• The contractor is supposed to allocate
overhead costs among the various
contracts based on actual costs incurred.
Improper Cost Allocation
• Overhead costs should be allocated on
the basis of square footage, direct labor
charges, or other meaningful cost drivers.
• The contractor has an incentive to
improperly shift overhead from the
commercial contracts to the government
contracts.
Inflating Costs
• Inflating costs during negotiations with
the government to get a higher price for
a sole-source contract violates the law.
• The government requires that all
contractors reveal all relevant information
about costs to the government in solesource contracts.
Inflating Costs
• Some companies inflate their cost
estimates by including “pads.”
• The inflated costs are sometimes referred
to as management reserves or
negotiation losses.
• These costs could be legitimate cost
items but they must be fully disclosed
and cannot be buried in other cost
estimates.
Inflating Costs
The United States vs. FMC Corp.
• FMC was a diversified manufacturing
company that made the Bradley
Fighting Vehicle from 1991 to 1994.
• The government paid FMC $1.1
billion.
Inflating Costs
The United States vs. FMC Corp.
• In 1995 a mid-level manager from FMC filed a
lawsuit against FMC for defrauding the
government.
• FMC had budgeted far less for research and
development than what they had quoted.
• When the employee informed senior company
officials, they refused to allow the employee to
disclose the company’s internal budget.
Inflating Costs
The United States vs. FMC Corp.
• As a result of the lawsuit, FMC had to pay
the government $13 million to settle the
case.
• The employee received $2.86 million for
reporting the fraud.
Cost-Plus Contracts
• Where are these contracts found:
–Defense contractors
–University research
–The entertainment industry
• Why are these contracts used:
–To share risk more efficiently
University Research
Scandal in the Laboratories
• How does the government determine cost
reimbursement rates for Federallysponsored research?
• The Facilities & Administrative Cost Rate:
– Federal agency negotiators and university
administrators agree on an overall
percentage
– Based on documented historical costs and
cost analysis studies
– Negotiated every three years
University Research
Scandal in the Laboratories
• The reimbursement rates vary from
institution to institution.
– Construction, maintenance, utilities and
administrative costs vary by institution and
region
University Research
Scandal in the Laboratories
• In 1990, Paul Biddle filed a lawsuit
against Stanford University
• Claimed Stanford was overcharging
taxpayers for research related expenses
– Creative bookkeeping practices used to
charge the government for:
• Depreciation on a 72 ft. yacht
• Faculty discounts on tickets to athletic events
• A percentage of the cost of flowers, bedsheets,
tablecloths and antiques for the president’s house
University Research
Scandal in the Laboratories
• Stanford’s Overhead rate
– 74%, among highest in the country
– In part because Stanford was very
aggressive about recovering every nickel
– University President Donald Kennedy said “I
expect our controllers to do their best on
behalf of the university.”
– Some argue that the school was overly
zealous in its quest for money.
University Research
Scandal in the Laboratories
• Schools differ in the items they include in
overhead:
– Columbia, Harvard, M.I.T. and Cornell argue
that the president’s residence is a part of
“general administration”
• They charge the government anywhere from 14%
to 68% of the maintenance costs
• Yale and John Hopkins consider the amount
involved too small to bother inclusion
• These charges are legal, unlike those for
Stanford’s yacht, but difficult to defend
University Research
Scandal in the Laboratories
• Federal Audit Process
– The government is supposed to audit the
institution every two to three years
• In Stanford’s case, claims and receipts were not
checked from 1983 through 1988
• Government Budget Cuts
– Less willing to help universities expand or
update their scientific infrastructure
University Research
Scandal in the Laboratories
• March, 1991
– Congress held hearings on Stanford.
• July, 1991
– President Donald Kennedy resigned
• August, 1992
– The General Accounting Office issued a study
of Stanford and three other universities
• Found over-billing of a total of $29 Million by all
four universities, far less than claimed by Biddle
University Research
Scandal in the Laboratories
• 1993
– The Justice Department announced that it would not
intervene as a plaintiff in the Biddle case
• 1994
– The Office of Naval Research announced that it
would drop all charges of wrongdoing against
Stanford
• Stanford repaid the government $2.2 million for
all unresolved claims from 1981 through 1992,
and received $700 million during that same
time period.
Cost-Plus Contracts
• Where are these contracts found:
–Defense contractors
–University research
–The entertainment industry
• Why are these contracts used:
–To share risk more efficiently
The Entertainment Industry
The Problem
• Creators, actors and actresses sign
contracts that provide them a
percentage of the profits that are
generated from their films and television
shows.
• Production studios are creating their own
definition of net profits that guarantees
that profit participants rarely receive their
cut.
The Entertainment Industry
• The 1989 movie Coming to America
grossed $240 million, of which Paramount
received $122 million.
• The net profit participants were told the
film had a net loss of nearly $16 million.
• Questionable accounting practices by the
production studios:
– Double charging
– Cost shifting
– Questionable allocation methods for general
overhead
The Entertainment Industry
Coming to America
•
•
•
•
•
Gross income
Distribution Fee
Distribution Expenses
Production Costs
Interest Expense
• Net Profit (Loss)
$122 million
$ 40 million
$ 34 million
$ 58 million
$ 6 million
--------------($ 16 million)
---------------
The Entertainment Industry
• Other individuals from the entertainment
industry who have been “burned.”
–James Garner
•The Rockford Files
–Stan Lee (creator of Spider-man)
•Contracted with Marvel for 10% of the
profits.
•The film grossed more than $400 million.
•Stan Lee “never saw a penny.”
•The studio reported millions of dollars in
“earnings,” but no “profits” as defined by
their contract with Lee.