Recessions and Product Costing

Abstract

This paper examines product costing in a recessionary environment where firms have excess capacity and uncertain demand for their products. If a firm wants to determine prices and production quantities for a new product, the theory is straightforward: any incremental cost should be allocated to the product. With a recessionary environment, and uncertain demand for our products, we demonstrate that the incremental costs include fixed costs that are common to several products. However, in contrast to practice, the allocation base should be based on the “relative viability,” or demand for the product and not any measure of the product’s “usage” of the common fixed resources. Thus, it is appropriate to allocate common administrative costs to products, but mature stable products should be allocated more of the administrative costs than novel, new products whose future is uncertain. In addition, in some circumstances it is optimal to allocate fixed costs which are common to one set of products to a product outside of that set; for example, the fixed licensing costs for products A and B may be allocated to new product C. The optimal cost allocation is independent of the market structure; it applies to two firms bidding on a contract, to a monopoly market, or an oligopoly market.