The Use of Cost Information in Pricing Decisions: Empirical Evidence

This study investigates how firms with long-term capacity commitment determine allocated costs in negotiating prices when they experience different levels of capacity utilization and demand stochasticity. The results provide empirical evidence on the debates of full cost pricing versus variable cost pricing; the use of full-cost pricing depends on the existence of opportunity costs on capacity resource. Using service prices of California hospitals, I demonstrate that the level of capacity utilization positively affects the association between price and unit allocated cost. Hospitals with a high level of capacity utilization put a large weight on allocated costs, which measure an opportunity cost of capacity usage. In contrast, hospitals with a high level of excess capacity put no weight on allocated costs since allocated costs are irrelevant to pricing. Furthermore, my findings suggest that hospitals reduce the weight of allocated costs in demand stochasticity since demand stochasticity increases the measurement error of opportunity costs measured by allocated costs.