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Profit Maximizing Cost Allocation for Firms Using Cost-Based Pricing

Author

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  • Teresa M. Pavia

    (Department of Marketing, University of Utah, Salt Lake City, Utah 84112)

Abstract

This work develops a profit maximizing cost allocation scheme for firms that allocate all costs to their various outputs and then use these costs to set prices, a process known as fully-distributed cost-based pricing. If the costs incurred by the firm are not easily traced to a particular output (for example, the electric bill for a shared manufacturing plant), the costs must be allocated. The demand for a given output is assumed to be a function of the price. Hence, the cost allocation scheme that is selected will affect both the price and the demand for the output. The allocation of common costs that maximizes the firm's overall profit under these conditions is identified. Frequently, the profit maximizing allocation allocates none of the untraceable common costs to one or more of the outputs. This allocation scheme stands in contrast to common practices of sharing costs equally or proportionally across outputs. Examples explore the implications of such a profit maximizing cost allocation on prices and demand in four scenarios: i) no constraints, ii) constraints on maximum allowable prices, iii) a change in market size, and iv) cost containment incentives.

Suggested Citation

  • Teresa M. Pavia, 1995. "Profit Maximizing Cost Allocation for Firms Using Cost-Based Pricing," Management Science, INFORMS, vol. 41(6), pages 1060-1072, June.
  • Handle: RePEc:inm:ormnsc:v:41:y:1995:i:6:p:1060-1072
    DOI: 10.1287/mnsc.41.6.1060
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    Cited by:

    1. Missbauer, Hubert & Hauber, Wolfgang, 2006. "Bid calculation for construction projects: Regulations and incentive effects of unit price contracts," European Journal of Operational Research, Elsevier, vol. 171(3), pages 1005-1019, June.
    2. Chakravarty, Amiya K., 2005. "Global plant capacity and product allocation with pricing decisions," European Journal of Operational Research, Elsevier, vol. 165(1), pages 157-181, August.

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