How to track costs and calculate price?

Question

I run a large Massively Multiplayer Online (MMO) gaming community and one of the services we’ve try to provide to our members is crafting. One of the challenges of this has been determining the price of crafted items when we sell to our membership.

While a lot of the time the materials that we use to craft items is donated to us; there a plenty of occasions were we run short or need rare materials that make up a bulk of the cost of an item. When this happens, we have to buy them from other players at the market rate in-game.

In a lot of MMOs, the price of the crafting materials can be higher than the crafted item on the market. This happens for several different reasons. Crafting material is necessary to “level” a character’s crafting ability meaning the materials are more valuable than the end result. Crafting is chance based and some outcomes are less desirable so the non-desirable results are sold to recoup as much cost as possible to fund another chance.

On top of all this, we want to offer our crafted items at a discounted rate than what our membership can get on the open market. Determining a price that keeps our profit margins at least breaking even with our losses have been difficult. In the past, we’ve tried basing the price on the material price with a base discount, but a lot of times this doesn’t adequately cover our costs or beat the prices on the market.

How can we determine a price for an item that takes into account our supply of donated materials and materials we have to purchase? Is there a standard method of tracking costs in this situation?

I'm a gamer and a web developer, not a economist so some help here would be appreciated. Thanks!

Answer 1

Part of your question is to find the threshold price of a crafted item that covers exactly its cost of production, especially when production is random. Once you know this threshold, the price you will ask to a buyer has to be greater than this threshold. Otherwise, you make losses.

Consider the craft of a precise item. First, you need to determine a value for each item that enters as inputs. The sum will be denoted $V_I$. If you do not have any idea about the values, you can set them as average market prices, so that $V_I$ is the average market price for all the inputs. In other words, $V_I$ is what it costs you to produce the item if you have to buy the inputs on the market.

If there were no randomness in production, you would ask at least a price $p\geq V_I$ to any buyer who does not provide you with any input. Conversely, if the buyer comes with all the inputs, you have zero cost and your constraint is simply $p\geq 0$. If the buyer comes with some inputs, the price should be higher than the value of the remaining inputs.

It becomes more difficult with randomness in production. You need to determine two elements: i) the probability $q$ to fail in producing the item, ii) the value of non-desirable outcomes $V_N$. You can estimate $q$ by dividing the number of times you failed by the number of times you tried. If the non-desirable outcomes are not always the same, $V_N$ can be an average. Again, if you do not know which value to associate, you can take average market prices. In that case, $V_N$ would be on average the money you get from selling the non-desirable outcomes on the market.

There are two possibilities. Either you make the buyer bears the risk, or you cover the risk. In the first case, imagine for instance that you manage to produce the desirable item after 3 trials. The price you will ask to the buyer should be at least $3V_I-2V_N$ because you needed 3 times the inputs but you will keep twice non-desirable outputs. Whether a buyer is lucky or unlucky, it is not your problem. However, you do not have an invariant price of the crafted item.

In the second case, you can ask a fixed price to the buyers (higher for non-members), irrespective of their luck. If you make enough transactions, the lucky buyers will pay for the unlucky ones, and you can make positive profits at the same time. We need some maths to find the expected (or average) cost of producing the item. The average cost is the sum of the values of inputs minus the values of non-desirable outcomes, weighted by the probability of each event.
$$AvCost = \underset{1\ trial}{\underbrace{(1-q)V_I}} + \underset{2\ trials}{\underbrace{q(1-q)(2V_I-V_N)}}+\underset{3\ trials}{\underbrace{q^2(1-q)(3V_I-2V_N)}}+...$$ This writes as $$AvCost = (1-q)\sum_{k=0}^\infty q^k[(k+1)V_I-kV_N].$$ Using $\sum_{k=0}^\infty q^k(k+1)=\frac{1}{(1-q)^2}$, we obtain $$AvCost=\frac{V_I-qV_N}{1-q}.$$

The condition to make positive profits on average is to fix a price $p\geq \frac{V_I-qV_N}{1-q}$. In other words, if you want to be the most generous with members, they have to pay at least $\frac{V_I-qV_N}{1-q}$ so that you make no losses on average. If a buyer comes with some inputs, you reduce this cost by the value of her inputs.

Members vs non-members You can also decide to make losses on average for your members, $p_{member}< \frac{V_I-qV_N}{1-q}$. These losses would be compensated by gains from non-members, $p_{non-member}> \frac{V_I-qV_N}{1-q}$. You have to make sure that the gains compensate the losses.

About being competitive on the market We have established the conditions to make positive profits, but there is no guarantee that you will be competitive on the market. It is possible that the minimum price you ask to a buyer ($\frac{V_I-qV_N}{1-q}$) will still be higher than the price of your competitors. They can produce the inputs more easily for instance, or they can value the fact that the skill to produce will level up.

Answer 2

The concept which you should be looking it is called prime costs. Businesses use prime cost as a way of measuring the total cost of the production inputs needed to create a given output. Usually this would be e.g. material, working hours, machine time and so on; since in your case there are only materials they are the only components you should consider when calculating the price.

So in your example the prime costs would be cost of purchased material + cost of donated material at market price. After this you would have to add a profit margin which you feel comfortable offering to your members.

As you mentioned their might be cases when the prime costs are higher then prices on the open market. In this case the only thing you can do is sell your material and buy the product directly on the market this is classical make or buy decision. If you still want to offer these product at a discount to the market price your only option is to take a loss on every sold item.

Answer 3

A few ideas that can help avoid losses:

1. Make a list the most requested items and raw materials. Keep an eye in the market to buy the most requested ones on discount, and resell them with a tiny margin in the community.
2. List the items that gave you the biggest losses recently. Restrict the requests for them (e.g. a X maximum per month), or keep a look at the market to buy the same item whenever it is at discount.
3. If you must buy items or materials at loss, then offer to buy from your community first. Like this you're making the community wealthier, which is a benefit to be a member.

As to pricing your items, you can set the prices as a percentage of discount from the market price in general, and adjust for a lower discount on the items where you have losses.

Answer 4

It sounds like you want to sell a product:

1. At price less than the market value
2. The product is frequently sold at a monentary loss anyway.

Initial thoughts: You are trying to establish a price ceiling for your members under the market price. You will take an economic loss on this product - it is unavoidable once you consider the opportunity cost, that this product could be sold in the market for a higher price. Sorry for the bad news.

However, the good news is that the economic loss you take is roughly equal to the discount you are providing your members. Most organizations levy taxes or membership fees to provide similar services. You seem to want to operate more efficiently. Here are some simple ideas.

1. You can reduce your costs by assigning production to members who benefit from the task (need to level that particular skill). They will be cheaper sources of labor.
2. It may also be worth considering those with higher skill level can produce faster. In which case you may want to compare the output/$ of low and high skill laborers.
3. You may be able to decrease costs further by providing some sort of public equipment for your organization (perhaps anvils and furnaces for crafting, or double-effectiveness consumables). This will allow workers to produce more effectively at lower cost.