PROFIT MAXIMIZING COST ALLOCATION FOR FIRMS USING COST-BASED PRICING

This work develops a profit maximizing cost allocation scheme for firm s that allocate all costs to their various outputs and then use these costs to set prices, a process known as fully-distributed cost-based p ricing. If the costs incurred by the firm are not easily traced to a p articular output (for example, the electric bill for a shared manufact uring plant), the costs must be allocated. The demand for a given outp ut is assumed to be a function of the price. Hence, the cost allocatio n scheme that is selected will affect both the price and the demand fo r 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 proportionall y across outputs. Examples explore the implications of such a profit m aximizing cost allocation on prices and demand in four scenarios: i) n o constraints, ii) constraints on maximum allowable prices, iii) a cha nge in market size, and iv) cost containment incentives.