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Product Costing And Pricing Under Long Term Capacity Commitment

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Executive Summary

This white paper discusses about a model that is developed to analyze optimal product costing and pricing decisions when a firm must make long term commitments to some activity resource capacities. The problem is complex because of interactions between the initial capacity choices and adjustments in product costs and prices in subsequent periods. Price adjustments are required in a dynamic information environment where new information about demand and cost parameters is revealed each period. Though the optimal solution to this model does not admit the economic sufficiency of activity based costing as in Banker and Hughes? (1994) single period model, their benchmark price are obtained when the firm must commit to the same price in all periods, and are equal to the average of the expected optimal prices when the prices can be adjusted optimally each period based on new information. The optimal prices are based on product costs that are adjusted each period to reflect changes in expected variable costs as well as changes in the fixed activity resources. The charge for each fixed resource is a monotonically increasing function of the expected unit cost for that resource in each period, and it is higher than the expected unit cost for that resource if and only if the expected optimal slack in that resource exceeds the benchmark slack in that period. Finally, a two period version of the model is investigated to show the optimality of carrying idle capacity in the first period when the firm expects growth in some of its products in the second period. The optimal change for the fixed capacity to product costs in the first period is strictly less than that in the second period. An analogous result is obtained when the firm expects the demand to decline.

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