[OPTIMIZATION OF FULL COST PRICING IN CAPACITY PLANNING WITH STOCHASTIC DEMAND

] S.Y. 2011-2012

Chapter 2

REVIEW OF RELATED LITERATURE

The review of related literature for this research was done mostly through online journals with detailed information acquired from several organizations on this particular problem or topic and that information gathered are all from foreign sources.

Full-cost Pricing Pricing of products has long been of interest of researchers as set prices are essential for the continued existence of a firm in its own industry. According to the study of Hsingwen Sylvia Hsu (2005), an important task of managerial accountants is to provide product costs and assist managers in making pricing decisions. Management accounting literature examines the proper treatment of costs associated with resources committed to support activities and design product-cost systems, and hence improve firms pricing decisions. However, economics theory suggests profit-maximizing firms set the price equal to marginal cost times price elasticity of demand; hence, variable cost pricing is recommended for a profit-maximizing firm since variable costs are viewed as a surrogate for marginal costs. Fixed costs which are usually allocated to individual products should not play a role in a manager s decisions since these costs are sunk CHAPTER 2 | Review of Related Literature 2-1

[OPTIMIZATION OF FULL COST PRICING IN CAPACITY PLANNING WITH STOCHASTIC DEMAND

] S.Y. 2011-2012

costs, which are irrelevant for decision-making. But survey studies report that, in practice, instead of using variable costs, managers typically set prices based on full costs, which are the sum of allocated fixed costs and variable costs. Survey research has suggested that full-cost-based pricing is widely used among industries. These studies, looking at survey data, highlight not only the theoretical debate, but also the tensions between theoretical models and practices. To resolve the apparent conflict between theory and practice, a substantial amount of literature analyzes the appropriateness of firms use of full costing in making their pricing decisions. (Govindarajan and Anthony 1983; Shim and Sudit 1995)

In the module of Noellette Conway-Schempt (n.d.), she stated that full cost pricing implies that all the private and social costs associated with a product or activity (determined using full cost accounting) is included in the price of the activity. Full cost pricing would extend this concept to the consumer. In her example, if all the environmental costs associated with cup manufacturing were included in the price of paper and plastic cups, one would expect the least environmentally damaging to have the lowest price. Thus, the consumer can make an environmental choice based on price or can choose the more environmentallydamaging alternative at a higher price, knowing that the additional environmental costs have been paid for. It is important to remember that currently we (society) do pay the full social cost of activities and products however, much of the costs are

paid to government agencies or less directly, in the form of increased health costs or reduced living quality. The use of full-cost pricing depends on the existence of CHAPTER 2 | Review of Related Literature 2-2

[OPTIMIZATION OF FULL COST PRICING IN CAPACITY PLANNING WITH STOCHASTIC DEMAND

] S.Y. 2011-2012

opportunity costs of existing capacity resources; when firms have idle capacity; allocated capacity costs are irrelevant to pricing decisions.

Some researchers hold a positive perspective on the usefulness of full costs. A product s full cost, which includes allocations of fixed costs associated with capacity resources, is a measure of a firm s long-run manufacturing costs (Cooper and Kaplan 1998).

For long-term survival, a firm needs to recover all the cost of committed resources. Furthermore, because the use of a resource causes other users of that resource to wait and incur delay costs, these delays may represent an opportunity cost to the firm. The opportunity costs associated with delays and queuing are difficult to observe and quantify; however, allocating capacity costs according to actual usage may serve as a useful proxy in such cases (Zimmerman 1979).

Capacity planning Hsu (2005) studied the process of determining the

production capacity needed by an organization to meet changing demands for its products. In the context of capacity planning, "capacity" is the maximum amount of work that an organization is capable of completing in a given period of time. His dissertation shows that a discrepancy between the capacity of an organization and the demands of its customers results in inefficiency, either in under-utilized resources or unfulfilled customers. The goal of capacity planning is to minimize this discrepancy. Demand for an organization's capacity varies based on changes in CHAPTER 2 | Review of Related Literature 2-3

[OPTIMIZATION OF FULL COST PRICING IN CAPACITY PLANNING WITH STOCHASTIC DEMAND

] S.Y. 2011-2012

production output, such as increasing or decreasing the production quantity of an existing product, or producing new products. Capacity planning is long-term decision that establishes a firms' overall level of resources. It extends over time horizon long enough to obtain resources. Capacity decisions affect the production lead time, customer responsiveness, operating cost and company ability to compete. Inadequate capacity planning can lead to the loss of the customer and business. Excess capacity can drain the company's resources and prevent investments into more lucrative ventures. The questions of when capacity should be increased and by how much are the critical decisions.

Assumptions about the types of capacity constraints, the budget horizon of capacity constraints and stochastic demand have all been identified as important factors affecting the efficiency of full-cost pricing (Banker and Hansen 2002; Balanchandran et al. 1997; Gx 2000).These three types of assumptions will affect how firms set their capacity, and hence, influence the level of capacity utilization. As a result, the association between price and cost information differ under these settings because the relevance of capacity cost on price decisions depends on the level of capacity utilization. The fundamental principle of pricing decisions is that when excess capacity exists, firms should ignore capacity cost in deciding prices and include only variable costs because fixed capacity is a sunk cost. However, when there is no excess capacity, the opportunity cost of using the firms capacity (i.e. allocated capacity costs) should be included in price decision. CHAPTER 2 | Review of Related Literature 2-4

[OPTIMIZATION OF FULL COST PRICING IN CAPACITY PLANNING WITH STOCHASTIC DEMAND

] S.Y. 2011-2012

Early studies on optimal pricing considered the pricing decision under a setting of full capacity. The studies assumed that firms set their capacity at the level of expected demand. For example, when there is unlimited demand, a firm will have no excess capacity. Under the condition of unlimited demand, Baker and Hansen (2002) conclude that the optimality of full-cost pricing is valid in setting a project s hurdle rates. Buckman and Miller (1987) approached the issue of pricing decision using a queuing theory which implicitly assumes infinite demand. The inclusion of capacity costs provides economically sufficient information to set prices. As demand is stochastic, firms face a tradeoff between whether to incur costs for the installation of additional capacity or to pay a premium for purchasing additional capacity. Using full-cost information including allocated capacity cost, the firm can evaluate the tradeoff and simultaneously decide the level of capacity and optimal prices without incurring economic loss (Banker & Hughes 1994). As a result, including allocated capacity cost provides an optimal pricing decision. However, in practice, firms may not relax their capacity easily to purchase temporary capacity from other firms due to asset specificity and the potential opportunism in transactions. (Balanchandran et al. 1996).

Synthesis The review on related literature brought about the conceptualization of this study. Pricing of products is one of the concerns of a firm when it comes to profitability and even long-term survival. Pricing policy ideally should assure longCHAPTER 2 | Review of Related Literature 2-5

[OPTIMIZATION OF FULL COST PRICING IN CAPACITY PLANNING WITH STOCHASTIC DEMAND

] S.Y. 2011-2012

run recovery of costs and a profit, even under adverse conditions. In the literatures given, the use of full cost pricing is employed by firms considering that they are to recover full costs. In this light, this study will also consider full cost pricing. It is always true in an industry that demand fluctuates, causing inefficiency when there appear discrepancies between demand and capacity of the firm. In this study then, capacity planning will also be taken into consideration to backup stochastic demand, with lead, lag and match as strategies in determining the level of output. It is stated in the literature that to include allocated capacity costs provides for an optimal pricing decision. In our study then, not only full costs will be taken into account, but also capacity costs. This study will integrate capacity planning and full cost pricing to come up with the optimal sales price that would give the firm the most profit.

CHAPTER 2 | Review of Related Literature 2-6