Product Costing and Pricing under Long Term Capacity Commitment

Abstract: We develop a model to analyze optimal product-costing and pricing decisions in a dynamic information environment under long-term-capacity commitment. The arrival of new information about demand and cost parameters each period makes the problem complex. The optimal prices and capacity choices in our model cannot be decoupled as in Banker and Hughes’ (1994) single-period model. The optimal prices are based on product costs that are adjusted each period to reflect changes in expected variable costs as well as utilization of fixed activity resources. The charge for each fixed resource is monotonically increasing in the expected demand for that resource in each state given the optimal capacity choice. The average optimal prices across periods and states are similar to Banker and Hughes’ (1994) benchmark prices. Finally, we investigate a two-period version of the model to explore the optimality of carrying idle capacity. The optimal product-cost charge for fixed capacity is strictly less in the first period than in the second period when the firm expects demand growth.