What is meant by Shadow prices?

Shadow price or dual price is a quantitative technique to analyze the improvement in the contribution or costs by having one additional unit of a resource which is causing a bottleneck. This analysis basically helps management in deciding whether a struggle to uplift the constraint is worthwhile or not.

Before we look at the definition of shadow prices, it will be good if we first talk about constraints as because of these, we have the concept of shadow prices.

We can understand that nothing is favourable to infinity. Everything is limited in one way or another, at one level or another. Same thing applies to business world. Everything that business do, produce, buy, sell has its limits. The resources used by the business are also limited. But one of all such limiting factors, will cause our activities to halt earliest. The resource that is first to stop our activities is called limiting factor or constraint or bottleneck or barrier.

Now stoppage of business activities (like manufacturing, sales etc) means stoppage of flow of profits. And thus every business will strive to get more and more of the limiting factor to further the business activity.

For example, labour hours are the limiting factor. The maximum available hours are 2,000. If business somehow manages to squeeze one additional our then this additional hour can be used to make more profits. And the way to have this one additional labour is that we BUY this hour.

But at what price? What is the maximum price we can pay for this one additional hour? Well, its a pretty straight forward question. The maximum price a prudent person can agree to pay is equal to the maximum benefit he is going to get out of this one additional hour.

Suppose, by having this one additional hour, the maximum benefit that can be rendered is of Rs. 10 then the maximum cost to get this benefit should never be more than Rs. 10. Because if Rs. 11 is incurred to earn Rs. 10 then its a loss.

So, we understand that management has to decide about the value of this one additional unit of limiting resource.

Shadow price is the improvement in total value generated by the business activity, which is constrained by of a certain factor (limiting factor), by gaining access to one additional unit of such (limiting) factor provided all the other variables are kept constant.

And by knowing the monitory value of such improvement, the management can decide about the maximum cost at which such improvement must be accepted.

Improvement does not only mean increase in revenue or contribution, but also decrease in costs.

Shadow price does not mean retail price of the finished goods. This analysis is brought up for management decision making purposes only.


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