Activity-Based Pricing in A Monopoly

Activity-Based Pricing in a Monopoly
Author(s): V. G. Narayanan
Source: Journal of Accounting Research, Vol. 41, No. 3 (Jun., 2003), pp. 473-502
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
Stable URL: http://www.jstor.org/stable/3542283
Accessed: 24-01-2018 15:56 UTC
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide
range of content in a trusted digital archive. We use information technology and tools to increase productivity and
facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
http://about.jstor.org/terms
Wiley is collaborating with JSTOR to digitize, preserve and extend access to Journal of
Accounting Research
This content downloaded from 137.204.1.40 on Wed, 24 Jan 2018 15:56:28 UTC
All use subject to http://about.jstor.org/terms
Journal of Accounting Research
Vol. 41 No. 3June 2003
Printed in U.S.A.
Activity-Based Pricing in a Monopoly

V. G. NARAYANAN*
Received 27 December 2000; accepted 1 November 2002
ABSTRACT
In this article, I study the interaction between cost accounting sys

pricing decisions in a setting where a monopolist sells a base pro
related support services to customers whose preference for support
known only to them. I consider two pricing mechanisms-activity-b
ing (ABP) and traditional pricing-and two cost-accounting systems
based costing (ABC) and traditional costing, for support services. U
ditional pricing, only the base product is priced, whereas support ser
provided free because detailed cost-driver volume information on
sumption of support services by each customer is unavailable. Un
customers pay based on the quantities consumed of both the bas
and the support services because detailed cost-driver volume info
available for each customer. Likewise, under traditional costing fo
services the firm makes pricing decisions on cost signals that are no
they are under ABC. I compare the equilibrium quantities of the bas
and support services sold, the information rent paid to the customer
expected profits of the monopolist under all four combinations of c
volume and cost-driver rate information.
I show that ABP helps reduce control problems, such as moral hazard and
adverse selection problems, for the supplier and increases the supplier's ability
to engage in price discrimination. I show that firms are more likely to adop
ABP when their customer base is more diverse, their customer support cost
are more uncertain, their costing system has lower measurement error, an
the variable costs of providing customer support are higher. Firms adopt ABC
when their cost-driver rates for support services under traditional costing are
noisier measures of actual costs relative to their cost-driver rates under ABC
*Harvard Business School. I thank Srikant Datar, Bjorn Jorgensen, Susan Kulp, an anon
mous referee, and the seminar participants at the University of Dartmouth, University
Washington, and Stanford summer camp for their comments.
473
Copyright ?, University of Chicago on behalf of the Institute of Professional Accounting, 20
474 V. G. NARAYANAN
and when the actual costs of support services are inherently uncertain. I als
show that cost-driver rate information and cost-driver volume information for
support services are complements.

Although the prior literature views ABC and activity-based management
(ABM) as facilitating better decision making, I show that ABC and ABP (a form
of ABM) are useful tools for addressing control problems in supply chains.
1. Introduction
In this article, I study the interaction between cost accounting systems and
pricing problems in a setting where a monopolist sells a base product and
related support services to customers whose preference for support services
are known only to them. I consider two pricing mechanisms-activity-based
pricing (ABP) and traditional pricing-and two cost-accounting systems-
activity-based costing (ABC) and traditional costing for support services.
Under traditional pricing, only the base product is priced, whereas sup-
port services are provided free because detailed cost-driver volume infor-
mation on the consumption of support services by each customer is un-
available. Under ABP, customers pay for both base product and support
services because detailed cost-driver information on the volume of support
services consumed by each customer is available. Likewise, under tradi-
tional costing for support services, the firm makes pricing decisions on cost
signals that are noisier than they are under ABC. I compare the equilib-
rium quantities of the base product and support services sold, the informa-
tion rent paid to the customers, and the expected surplus to the monopo-
list under all four combinations of cost-driver volume and cost-driver rate
information.
I show that ABP helps reduce moral hazard and adverse-selection pro
lems for the supplier and increases its ability to engage in price discrimina
tion. I also show that firms are more likely to adopt ABP when their custo
base is more diverse, their customer support costs are more uncertain, the
costing system has lower measurement error, and the variable costs of pro
viding customer support are higher. Firms adopt ABC when their cost-driv
rates for support services under traditional costing are noisier measure
actual costs relative to their cost-driver rates under ABC and when the actual
costs of support services are inherently highly uncertain. These benefits of

ABP and ABC have to be traded off against the implementation costs o
ABP and ABC. I also show that cost-driver rate information and cost-driver
volume information are complements because one is more valuable in

presence of the other.
It is important to keep in mind that I use the term ABC only for notat
convenience. The insights from this study hold as long as the newer
system that a firm adopts provides finer cost-driver rate information than
traditional cost system. The newer cost system need not be activity based.
Section 2 reviews the extant literature on customer profitability measur
ment, ABC, product bundling, and mechanism design. Section 3 prese
the model. In section 4, I analyze several scenarios. First, I consid
ACTIVITY-BASED PRICING 475
setting where the seller can observe the buyer's type, the quantity of goo
and support services consumed by the buyer, and actual cost-driver
This scenario, the first-best case, serves as a useful benchmark for other
scenarios. Second, I consider a setting labeled traditional pricing where the
seller can observe only the quantity of the base product sold to the buyer and
not the buyer's type or consumption of support services. Finally, I consider
a setting labeled ABP where the seller can contract on the consumption
of both the base product and support services by the buyer but not the
buyer's type. Both pricing schemes are analyzed under both traditional cost
accounting and activity-based cost accounting. The section compares tradi-
tional costing and pricing with ABC and ABP and derives conditions under
which a firm might consider adopting activity-based systems. The section
quantifies the incremental value of cost-driver volume versus cost-driver rate
information. I also examine implications for the supply chain as a whole.
Section 5 concludes the paper.
2. Literature Review
This study is related to the mechanism design literature in economics

and accounting. See Baron and Myerson [1982] for a detailed treatment of
mechanism design in the context of regulating a monopolist with unknown
costs, and Tirole [1988] for a textbook treatment of mechanism design in
the context of second-degree price discrimination. I extend this literatur
by examining the value of an additional signal to the monopolist for price
discrimination when the monopolist sells a base product and additional
support services. In the accounting literature, see Kirby et al. [1991] and
Melumad, Mookherjee, and Reichelstein [1992] for applications of mech-
anism design concepts to study delegation and incentives. This study con-
tributes to this literature by addressing the question: "What is the value o
an additional signal for mechanism design?" I show that the principal use
the additional signal to reduce the information rent paid to the agent and
to mitigate the agent's moral hazard problem.
This study is also related to the economics literature on bundling, which
identifies more efficient extraction of consumer surplus as the main reason
for bundling (see Stigler [1968], Adams and Yellen [1976], Schmalensee
[1984], McAfee, McMillan, and Whinston [1989]). When a firm has to
charge one price to all customers, variability in customer valuations reduces
the seller's ability to extract consumer surplus. Thus, bundling, which serves
as a tool to reduce heterogeneity in valuations, helps a monopolist increase
profits as long as the valuations for the products being bundled are not
perfectly positively correlated.
In section 4.2, I study traditional pricing-a form of bundled pricing
where support services are provided for free. However, there is no benefit
from bundling in this study because there is no customer heterogeneity
in the valuation of the base product. By ignoring this beneficial role of
bundling, I may be overstating the benefits of ABP.
476 V. G. NARAYANAN
This study also makes a contribution to the literature on ABC. See Coope
and Kaplan [1988, 1991] for a description of ABC and activity-based m
agement (ABM). Although there are many uses of ABC information,
as process improvement and new product development, I focus on u
ABC information for pricing decisions. Banker and Potter [1993] com
the value of ABC for pricing decisions in a monopoly with its value
duopoly. They find that sometimes, ABC may not be valuable in a duo
setting. Banker and Potter, in contrast to this article, study product profit
ity rather than customer profitability. Moreover, the strategic interactio
the firm in their study is with a rival firm rather than with its customers
Banker and Hughes [1994] also study the role of ABC information
pricing decisions by a monopolist. They model costs associated with
sources committed to support activities, which do not vary proportion
to production once initial capacities have been set. They assume that c
of committed resources will be incurred independent of actual usage
that increasing capacities to handle unexpected demand involves pen
ties above normal costs. They find that in this setting, only normal costs
committed resources enter into pricing rules. Making similar assumpt
about costs as Banker and Hughes, I find similar results. Thus, this st
extends their finding that only normal costs enter pricing rules to a
ting of nonlinear pricing (with and without ABP), uncertainty in costs, an
measurement errors in cost signals. However, unlike Banker and Hugh
model a strategic interaction with customers and consider ABP. That is, th
model traditional pricing decisions based on ABC information (scenar
in this study) but do not model ABP where support activities are separ
priced.' The biggest difference between this study and the prior litera
on ABC and ABM (including Banker and Hughes [1994]) is the use of A
and ABP (a form of ABM) for control purposes rather than for deci
making.
3. The Model
I model a monopolist who sells to customers a base product and ad

tional support services. Customers differ in their valuation of support
vice and their type is indexed by the variable k.2 Let q (k) be the qu
tity of the base product and s (k) the quantity of support service bou
by a customer of type k. Let the tariff charged by the monopolist
T(q (k), s(k), k). The utility for customer type k from consuming qu
tity q of the base product and quantity s of support services is given
P(q, s, k) = acIq - 12q2 + a3ks - a4S2 + a05qs - T. I assume that re
vation utility is 0 for all types of customers. Without loss of generali
1 See Narayanan and Sarkar [2002] for empirical evidence that ABC information is used
pricing decisions.
2 See table 3 for a summary description of notation.
set a2 = a4 = 1. I assume a, a3 > 0 and 0 < Ia < 2. If a5 > 0, the

product and support service are complements, whereas if a5 < 0, the
substitutes. The quadratic expression for customer utility captures t
minishing marginal utility for both the base product and support ser
However, the marginal utility for support service is increasing in k
assumption is variously described in the literature as the single-cro
property or the Spence-Mirrlees condition. This assumption implies
customers who consume more support service are the ones that valu
port service more. Hence, this assumption facilitates price discrimin
and is crucial for the results on price discrimination.
The variable k is assumed to be distributed with density function f(k),
tribution function F (k), and support [k k]. I assume that the inverse haz
rate function h(k) --k) is decreasing in k. That is, h'(k) -dh(k) < 0. This
property is satisfied by many distributions and is widely used in the mecha-
nism design literature. For example, Tirole [1988, pp. 156] says, "This prop-
erty is satisfied by many distributions, including the uniform, the normal, the
Pareto, the logistic, the exponential, and any distribution with nondecreas-
ing density." I denote the profits of the monopolist from customer of type k
by 1I(k) and revenues(tariffs) as T(q (k), s (k), k). When I want to take expec-
tation of a function G(k) with respect to k, I write Ek( G) - fk G(k) f(k) dk.
I use the subscriptj to indicate products with j = s denoting support ser-
vice and j = q denoting the base product. The total cost of manufacturing
the base product and providing support services is i (k) = cqq(k) + css(k).
Furthermore, cj = =j + en,j for j E {q, s} where en,j are random variables
that capture the natural uncertainty in actual costs. From this formulation,
it appears as if all costs are fully variable in output of the two products.
However, as shown in Appendix B, the insights continue to hold in a setting
where cj represents normal costs that include both variable costs of flexible
resources and fixed costs of committed resources. Let the profitability of
customer of type k be I-(k) = T(k) - rt(k).
Next, I describe the product costing and customer costing systems (also
known as product profitability and customer profitability measurement sys-
tems, respectively). The product costing system of the firm produces a signal
Cq = Cq + p,q, where ep,q is a random variable that captures the measure-
ment error of the product costing system. For the customer costing system,
I consider two cost accounting systems for the cost of support services-
traditional and ABC. Under ABC, the firm observes cost signals ^, = c, + eK,S
whereas it observes ^, = c, + E, , under traditional costing, where EK,S and Er,'
are the measurement errors under ABC and traditional costing, respectively.
I assume that En,q, En,s, Spq, EK,S, and er,s are all independent and normally
distributed with expected value 0 and variance aq > 0, cr,2 > 0, c,q > 0,
o2r, > 0, and ao2, > 0, respectively. Thus, all cost systems provide unbiased
but noisy signals of actual cost-driver rates. I assume that the traditional sys-
tem measures cost-driver rates with more error than the ABC system, that
is, a,s > a,,. However, the finer cost-driver rate information under ABC is
478 V. G. NARAYANAN
not free. I assume that it costs the firm wr to implement ABC and obtain the
more precise cost-driver rate information.
When I want to take the expectations of a function L(cq, 9q, cs, Cs) with
respect to 8n,q, En,s, Ep,q, and e8,S, I write ?g(L). Likewise, when I want to tak
the expectations of a function L(cq, Cq, c,, 3 ) with respect to En,q, En,s, Ep,q
and e, s, I write Fi(L). Because cq = Cq + En,q, Cq = Cq + Ep,q, Cs = Cs + n,s
Cs = Cs + ns + EK, and ^s = , +E ,, + ,s, it follows that cq, CS, Cq, ?, and 3

are distributed multivariate normal with the vector of expected values given
by (c-q, C,, Cq , C, ) and the variance-covariance matrix given by
2 0 2 0 0
n, q n,q
Sa2 n, s
is n,
2 s
tn,
2 s
S2
2 0S S2 . _ or 2 2 C )2
F
Observe ofth
costs.Lesser t
relative weigh
measurement
the firm puts
S= an,dq (c p,
(cs )n,, and S(cq q) as =s, 3s, and 3q, respectively.
I also consider two pricing systems-traditional and ABP. Under t
tional pricing, only the base product is priced. Support services are prov
for free to the extent demanded by the customer. Under ABP, support
vices are also priced. ABP is facilitated by an accounting system that me
the cost-driver volume for each customer. This cost-driver volume is used for
contracting (i.e., pricing). I assume that it costs w, to implement the account

ing system that provides contractible cost-driver volume information that is
consumes q units
In this of Ithe
section, base product,
analyze s unitsInofscenario
five scenarios. support1,service, and is
the (cfirm type
knows,
k, tariff T(q, s, k). This allows for the possibility that the tariff is a functio
I also
of theconsidermers two pricing
level of support systemstraditionalve
service supplied to theq andcustomer
ABlso knows thethe
and actualder tradi
customer
type. However, in the absence of ABP, the tariff is independent of the level of
support services supplied to the customer and T(q, s, k) = T(q, k), Vs. Lik
wise, if the customer type is not observable, then T(q, s, k) = T(q, s), Vk
Finally, if neither the customer type nor the extent of customer support is
its customer's type k and can observe q and s. It also knows the actual
TABLE 1
Settings Analyzed
Setting Traditional Costing Activity-Based Costing

Traditional pricing Scenario 2 (t) Scenario 3 (r)
Activity-based pricing Scenario 4 (v) Scenario 5 (a)
This table characterizes the settings of the four scenarios other than the
used to denote the endogenous variables in a scenario is given in parenthes
realization of cost-driver rates cj before choosing

this the first-best case where there are no moral-hazard or adverse-selection
problems and no cost-driver rate uncertainty. All endogenous variables a
subscripted f to denote the first-best case.
Table 1 characterizes the settings of the other four scenarios. The subscrip
used to denote the endogenous variables in a scenario is given in parenthesis
next to that scenario number.
The variable k is also unobservable in scenarios 2 through 5. Under tr

tional pricing, the firm can contract only on q, whereas s is provided for f
to the extent demanded by each customer. The unobservability of k le
to an adverse-selection problem, whereas the unobservability of s leads
moral-hazard problem. I consider two cost accounting scenarios. Under
ditional costing, the firm must choose T(q) after observing cs. Scenario
thus traditional costing and pricing. In scenario 3, the firm has access to th
realization of ABC cost-driver rate information while choosing T(q). Un
ABP, the firm observes all cost-driver volume information and observ
as well as s. In this setting, there is only an adverse-selection problem
scenario 5, the firm observes cs though it does not in scenario 4. Table
summarizes the observability to the firm of different variables. Keep in m
that the customer always knows k, observes T, and then chooses q (k)
s(k).
4.1 FIRST-BEST CASE-SCENARIO 1
The firm solves the following program:

PROGRAM 1.
max f (T(q(k), s(k), k) - cqq(k) - css(k)) f(k)dk

T(q(k),s(k),k),q( ( k),(k)
Subject to:
q(q(k), s(k), k) - T(q(k), s(k), k) > O, Vk
The firm seeks to maximize its profits (tariffs less costs) subject to the
customers' participation constraints.
PROPOSITION 1.
(i) Support provided to customer of type k, sf (k) =- =15 -5 cq - 2cs +2a3k
(ii) Base good provided to customer of type k, qf (k) = 2a, -2c +?5 (st3k - c )
(iii) Tf ((qf(k), sf(k), k) = Of((qf(k), ST4(k), k).
480 V. G. NARAYANAN
TABLE 2
Observability of Variables to the Firm
Observable? Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

k Yes No No No No
q (k) Yes Yes Yes Yes Yes
s(k) Yes No No Yes Yes
Cs Yes No No No No
Cq Yes No No No No
Cq NA Yes Yes Yes Yes
Cs NA
cs
NA Yes
No NA
Yes Yes
No Yes
NA
Table 2 summarizes the obser
in the study. The customer a
All proofs are in A
Observe that sf is i
services more consu
only if a5 > 0. Thus
ments, then as k in
increase in consumpt
vices are substitutes,
increases, and conse
4.2 TRADITIONAL PRICING
This subsection analyzes scenarios 2 and 3 where the firm can contract
only on q and not on s. Moreover, k is not known to the firm. The firm can
proceed along one of two equivalent ways. The firm can announce a menu
of contracts characterized by T(k), q (k), and s(k). Customers can reveal
k and self-select the contract meant for them. Alternatively, the firm can
announce T(q) and delegate the choice of q (k) and s(k) to consumers. I
formulate the firm's program and derive both mechanisms next.
4.2.1. Traditional Pricing and Traditional Costing-Scenario 2. The firm

solves the following program:
PROGRAM 2.
max),s() (T(q(k)) - cqq(k) - cs(k) I q, i,) f(k)dk

T(q(k)),q(k),s(k)
Subject to:
(q (k), s(k), k) - T(q(k)) > 0, Vk
0 (ql(k), s(k), k) - T(q(k)) > b(q(k), -, k) - T(q(k)), Vk, k, s
4.2.2. Traditional Pricing and ABC--Scenario 3. The firm solves the follow-
ing program:
TABLE 3
Notation
Symbol Description
k Customer type
s (k) Quantity of support service consumed by customers of type k
q (k) Quantity of base product consumed by customer of type k
T(q(k), s(k), k) Revenue from customer of type k
0b(q(k), s(k), k) Utility of customer of type k
f (k) Density function for customer types
F (k) Distribution function for customer types
h(k) Hazard rate function h(k) = 1-F(k)
cj Actual cost per unit of product j E s, q
c- Expected per unit cost of productj, ?cj
enj Variation around expected cost for product j, cj =
n2, Variance of unit cost for product j
q (k) Total cost of products consumed by customer of type k
Fl(k) Profits from customer of type k = T(k) - q(k)
(q Report of cost cq under the product costing system
Ep,q Measurement error of product costing system, Cq = Cq + ep
p, q Variance of ep,q
Cs Report of cost cs under ABC
8e s Cost measurement error under ABC. Cs = Cs
'K, s Variance of measurement error under ABC
Cs Report of cost cs under traditional costing
er,s Measurement error under traditional costing cs = cs + E
ars Variance of er,s
car Cost of obtaining ABC cost-driver rate information
wco Cost of obtaining contractible cost-driver volume information
& ( ) Expectations operator with respect to En,s, En,, p,q, and EK,S
( () Expectations operator with respect to en,s, en,q, Ep,q, and er,s
PROGRAM 3.
max f Tf
T(q(k)),q(k),s(k) (T(q(k)) - cqq(k) - c s(k) - or I ^q,' )f(k) dk
Subject to:
d(q(k), s(k), k) - T(q(k)) > O, Vk

/(q(k), s(k), k) - T(q(k)) > 0(q(k), s, k) - T(q(k)), Vk, k,
4.2.3. Equilibrium Under Traditional Pricing. The firm maximizes its ex-
pected profits where the expectations are taken over all possible cost realiza-
tions conditional on the observed cost signal (from the traditional costing
system in program 2 and the ABC system in program 3) and over the types
of customers. Note that the tariff scheme is to be designed conditional on
the observed cost signal.
In both programs 2 and 3, the firm offers a tariff T(q). A customer of
type k will purchase q (k) units of the base product and s (k) units of sup-
port services. The first inequality in both programs represents the participa-
tion constraints for all types, whereas the second inequality represents the
482 V. G. NARAYANAN
incentive compatibility constraints, which require that each type k s

only pick the bundle T(q (k)), q (k) meant for it, and should only con
support services s (k) that it is meant to consume.
To solve these programs, I use the standard mechanism design appr
Accordingly, to ensure that each type picks the bundle meant for it
formation rents would have to be paid for all but the worst types. Le
information rent paid to type k be t(k). The following lemma charact
the solutions to programs 2 and 3 given earlier. Recall that subscript
notes values of endogenous variables under scenario 2, whereas subsc
denotes the values of endogenous variables under scenario 3.
LEMMA 1.
(i) Support provided to customer of type k, st (k) 2a (al - ) - (ah(k) +s) +a3k
2(4-c5)
and sr (k) = 2as(at - cq) -Cr(Ut3sh(k)

2(4- cr2) + c) + 4ak
(ii) Base good provided to customer of type k, qt (k) =- 2(al i- q) +a5(a3(k- h(k)) - :,)
4-a4-
and q,(k) = 2(at - ) +a5(a3(k- h
(iii) The information rent paid to

and tr(k) = fk3(sr (k))dik.
(iv) Tariff charged Tt(k)= 4
and Tr(k) =-(qr(k), s,(k), k)
PROPOSITION 2. Under traditi
systems:
(i) The quantity of the base product is increasing in customer type k and the
quantity of the base product (support service) is decreasing in the expected
cost and reported cost signal of support service (base product) if, and only if,
a5 > O. That is, t > 0, > 0, < 0, ?< r < , d < 0 dsr < , < 0,
Adk dk d d-, s cdq d q d0 ,
< 0 < 0 and - < 0 if and only if a5 > 0.
(ii) The quantity of support service is increasing in k and the quantity of the
base product (support service) is decreasing in the expected cost and reported
cost signal of the base product (support service). That is, ? < 0, d < 0,
d dcq
dk A dk ddF ds deq dC d 'd
ds > 0, r > 0, A, < 0, <s< 0, q '< 0, < 0 , <ds 0,
Observe that the type k earns zer
vation utility. All types k > k ear
customers consume more suppo
base product are complements (
buy more (less) of the base prod
and the quantity of support ser
costs and decreasing (increasing
(substitute). We can compute T(
customer less his or her respectiv
monotonic in k, we can invert
T as a function of q as well. It is a well-known result in the mech

sign literature that communication and delegation are equivalent.
customers can reveal k and pick the bundle, T(k), q (k), and s (k)
nication approach), or the firm can announce T(q) and decentra
choice of q and s to its customers (delegation approach). Both a
are equivalent.
It is instructive to compare the equilibria characterized earlier with the
equilibrium in the first-best case. In the first-best case, the firm has no moral-
hazard problem in the consumption of support services, and customers have
no private information.
PROPOSITION 3.
(i)E c(St-
(ii) )Sf)
i(qt - qf) =2-Sf)
= S(qr - qf) = c-- zh
a3h(k)
Comparing the expected consumption of support services for each cus-

tomer under traditional costing with that under the first-best case, we se
that there are two factors that determine the difference between them.
Because support services are not priced (that is T is independent o

there is a free-rider problem under traditional pricing and customer
sume more support services relative to the first-best case. As S,, the exp
unit cost of support services c, increases, the free-rider problem gets w
The other factor is the distortion in the consumption of support se
induced by the firm to prevent the higher k types from choosing the b
meant for the lower k types. The firm accomplishes this by reduci
support services meant for the lower k types. Observe that for the h
type k, h(k) = 0, and there is no distortion induced. Also note that t
tortions, relative to the first-best case, on account of adverse selection a
moral hazard go in opposite directions.
It might seem counter-intuitive that the firm can reduce the supply o
port service to its customers when it cannot even observe how much sup
service they consume. The way this reduction in supply is accompli
subtle. The firm reduces (increases) the supply of the base product
the base product and support services are complements (substitutes)
is the intuition behind Proposition 3(ii).
From Proposition 3 we see that Sc (st) = S~ (Sr) and Sc (qt) = S (qr).
E (tt - t,) = 0. Because there is no difference in expected information
or the consumption of the base product or support services between
nario 2 and Scenario 3 for any customer, it might be tempting to co
that cost-driver rate information has no value. As the following proposi
shows, this conclusion is incorrect.
PROPOSITION 4. Under traditional pricing, the expected value of cost-driv
information2asnn
Sk(Ir,
and(k)
in2-and
-t1u2(k)) = (16 4 , + ,) - m, which i
creasing in l2f and increasing in aY,,, rn .
484 V. G. NARAYANAN
Gross of the measurement cost wr, the firm earns strictly greater
under ABC than under traditional costing. Although the expect
sumption of the base product and support services is the same un
traditional and activity-based costing, the actual consumption de
the cost realization under the accounting system in place. Thus, c
are more likely to consume more (less) of the support services when
(high) under ABC than under traditional costing. The firm achie
atively better matching of consumption with costs under ABC by
T(q) appropriately, based on the realization of c,, while the prici
traditional costing is based on CS. Thus, the value of ABC informatio
from better pricing. Moreover, the more the noise in the cost signals
traditional costing, relative to ABC, the greater the value of ABC for
pricing decisions. ABC is also more valuable when the actual uni
support service is inherently more uncertain. When the actual cos
port service is fairly certain, independent of the cost accounting sys
place, the firm can base its pricing decisions by putting more weight
expected cost F. As the actual costs become more uncertain, the firm
rely more on its cost accounting system. Thus, reducing measuremen
in cost signals is more important when the underlying costs themsel
very uncertain.
The following proposition analyzes properties of the optimal n
pricing schedule.
PROPOSITION 5.
(ii) d is increasing in cq. If and only if, s > 0, T is increasing in c, but

decreasing in k.
(iii) "r is increasing in cq. If and only if, a5 > O, is increasing in C, bu

decreasing in k.
Proposition 5(i) shows that the price of the marginal unit of the bas
product d (q,) is decreasing in the quantity of the base product. That is
the firm offers quantity discounts. This result is independent of whethe
the base product and support services are complements or substitutes. Th
traditional reasons offered for quantity discounts are diminishing marginal
costs or lower costs to serve larger volumes. Here, we find that even though
the firm has constant marginal costs and the cost to serve might be higher
for higher volumes (when the base product and support services are com
plements), the firm still offers volume discounts. The firm offers volum
discounts because the customers exhibit diminishing marginal utility fo
the base product. The extent of volume discounts is affected by the firm
adverse-selection
volume discount as the problem.
customer'sIftype
andincreases.
only if dahk) < 0, the firm increases the
Propostions 5(ii) and 5(iii) show how the marginal price charged by the
firm is decreasing in the cost signals produced by the costing system. Thus,
when the reported cost of the base product qq increases, we know

proposition 2 that the quantity of the base product supplied decreas
decrease is accomplished by an increase in the marginal price char
customers.
4.3 ABP
This subsection considers the case where the firm can contract on both
q and s. I present two programs-one under traditional costing and

under ABC.
4.3.1. ABP and Traditional Costing-Scenario 4. The firm solves the fo

ing program:
PROGRAM 4.
max (kSi(ET(k)
T(q(k),s(k)),q(k),s(k) f - cqq(k) - cs(k) - w, I q, ^)) f(k) dk
Subject to:
k(q (k), s(k), k) - T(k) > 0, Vk
0 (q(k), s(k), k) - T(k) > q0(q(k), s(k), k), k) - T(k), Vk, k

4.3.2. ABP and ABC-Scenario 5. The firm solves the following program:
PROGRAM 5.
max [ ( T(k) - Cqq(k) - css(k) - ar - a), I cq, Cs) f (k)dA

T(q(k),s(k)),q(k),s(k) k) ) -c f((k)d
Subject to:
r(q(k), s(k), k) - T(k) > 0, Vk
4(q(k), s(k), k) - T(k) > P(q(k), s(k), k), k) - T(k), Vk, k

In both programs 4 and 5, the firm offers a bundle T(k), q (k), s(k). A cus-
tomer of type k will purchase q (k) units of the base product and s(k) units of
support services. In both programs, the first constraint is the participation
constraint for all types while the second constraint is the incentive compati-
bility constraint that each type k should only pick the bundle T(k), q (k), s(k)
meant for it.
4.3.3. Equilibrium Under ABP. The following lemma characterizes the so-
lution to the programs given earlier. Recall that I subscript endogenous
variables with v for ABP under traditional costing, and with a for ABP under
ABC.
LEMMA 2.
(i) Supportprovided to customer of type k, sv (k) = a5(al - "q) -2(as(h(k) -k) +

(4- a )
(4_ 0k)
and s_(k) - ka"5('L-C)-2(ot3(h(k)-k)+cs)
486 V. G. NARAYANAN
(ii) Base good provided to customer oftype k, q, (k) = 2(ai - ) +as(a(k -
and qa(k) = 2(atL - q) +as(as(k- h(k))- ~,)
(iii) The information rent paid to customer of type k, tv(k) = 3fk a

and ta(k) = fkS 3(Sa(k)) dk.
(iv) Tariff charged T(k) = (qv (k), sv (k), k) - ti (k) and Ta(k) =
sa(k), k)- ta(k).
Note that all the comparative statics results in proposition 2 for traditional
pricing hold for ABP as well with the subscripts v and a substituted for t
and r, respectively. Note also that the lemma characterizes the mechanism
involving communication of k. An equivalent mechanism where the firm
announces T(q, s) and customers are delegated the choice of q(k) and
s(k) can also be solved for. The following proposition compares q and s
under ABP and the first-best case.
PROPOSITION 6.
(i) S4(sa - sj) = Eg(s5 - sI) = 2(4< 0.

-t5a3h(k)
(ii) S (qa - qf) = Sc(qv - qf) = 4-a < 0 if and only if, o5 > 0.
Because h(k) = 0 only for k = k, ? (sa) = &E(s,) = 8E(sf) and ?4(qa) =

'g(qv) = gSe(qf) only for the highest type. Thus, even though both q and s
are observable and contractible for the firm, it has to pay information rents
on account of unobservability of k. To lower the information rent paid to the
higher types of k, the firm chooses to distort the q and s consumed by lower
types of k. Note that this distortion, in contrast to the distortion characterized
in proposition 3, is independent of any cost variables. This independence is
because the free-rider problem in the consumption of support services has
been solved by the observability of s. I next compare traditional pricing with
ABP.
PROPOSITION 7.
(i) (se - Sr) =- ?(Sv - St) h(k)ot3+cs < 0.

(ii) 8(qa - q,) = St(q, - qt) - 0.
(iii) (a - r ) = -- ) k --a3 h(k)2-+t 0 dk < 0.

Thus, compared with traditional pricing, when ABP is used, the firm al-
lows each type of customer to consume strictly less support services. This
reduction is on account of two factors. There is no longer any free-rider
3 To observe this, note that sa(k) is monotone increasing in k and is thus invertible. We
have two differential equations from the customer optimizationa T = a - 2q + a5ss and =7T
a3k constant
The - 2s +asq. From these
of integration twobeequations,
0 can T(q, the
solved for from s) =fact
fo assa1 (s)ds
that the - s2type
lowest +cs5qs +alqno- q2 +0.
k earns
information rent and Ta (k) = ' (qa (k), sa (k), A)
problem in the consumption of support services by the customer. The h

the expected unit cost of support service -,, the greater the saving
ABP on account of reduction in the free-rider problem. There is
duction in support services supplied on account of reduction of inf
tion rent paid to the agent. The higher the value of as, the higher
reduction. There is, however, in expectation no change in the exp
quantity of the base product that is supplied to the customer. The
mation rent paid to customers is strictly less under ABP than trad
pricing for all customers except the lowest type for whom there is no
mation rent under either accounting system. The information rent
equal to customer surplus (customer utility less tariffs paid to the
Thus, customer surplus is strictly less under ABP for all types of custo
other than the lowest type, who earns no surplus under either acco
system.
I next turn to the question of which type of customer is the most profitable
for the firm under the various scenarios.
PROPOSITION 8.
(i) Under traditional pricing, expected customer profitability is decreasing in

h(k) -(1-h'())a
if, and only if > 4h( h'(k))t3t32
(ii) Under ABP, expected customer profitability is increasing in customer types

because ES(lak) =(dv(k) = 2h(k)(1-h(k))t2 >
(iii) By switching to ABP from traditional pricing, profitability of customers
increases more for the higher type customers because S~ ( d(F (k)a - r(k)) )
(d(,(k)- ,(k))) (h(k)(1 - h(k)) + s) > 0.
d-k 2r , (k)) 2
Under traditional pricing, support services are provided for free. Hence,
we might expect customers with a high value of k, who consume a lot of
support services, will be highly unprofitable for the firm. However, customers
with a high value of k who do consume more support services for free may
actually be more profitable. Because support services are worth more to
customers with a high value of k, the firm is able to charge them higher tariffs
even after paying them information rents to reveal their true type. However,
if c is too high, customers with a high value of k become relatively less
profitable because the moral hazard problem begins to dominate. Under
ABP there is no moral hazard problem, and hence, customers who value
customer support more (high values of k) are relatively more profitable
under ABP.
Although the expected increase in customer profitability in switc

from traditional pricing to ABP, gross of implementation costs fo,, is
negative, customer profitability increases more for higher k types. The f
has a bigger free-rider problem in the consumption of support services a
pays more information rent to customers who value customer support hi
(high values of k). Thus, it is in dealing with these customers that the fir
gains more under ABP.
488 V. G. NARAYANAN
4.4 COST-DRIVER RATE VERSUS VOLUME INFORMATION
In this subsection, I evaluate the value of the cost-driver rate and volume
information for the firm and the supply chain as a whole. I define supply
chain surplus as the sum of the expected firm profits and the expected
surplus of all its customers. Thus, supply chain surplus X = Sk$ ((I (k) +
t(k))).
PROPOSITION 9.
(i) Under ABPE the expected value of cost-driver rate (ABC) information for the
or 4 2s)
firm Sk(c(7ra(k) -7r,(k))) = (o,-oK,) - o . This also

equals the expected surplus for the supply (4 _ Xa
chain 2)(a"!,s
+a2)(0.s +a2 (_r. This also
- Xv.
(ii) Under traditional pricing, the expected value of cost-driver rate
(ABC) information Sk (Ec (7 (k) -rt (k ) )) = Sk ( (a (k) - 7r, (k))) -
4(n,I2
chain Xr -+a2
Xt. )(002 +a2,) . This also equals the expected surplus for the supply
In a result similar to proposition 4, I now establish that gross of the mea-

surement cost Wr, the firm earns strictly greater profits under ABC than tra-
ditional costing when it engages in ABP. Proposition 9(ii) shows that ABC
is more valuable for a firm engaging in ABP than it is for a firm practicing
traditional pricing. Equivalently, the cost-driver volume information that is
necessary for ABP is more valuable for a firm that already has ABC infor-
mation. That is, the cost-driver rate and cost-driver volume information are
complements, and one is more valuable in the presence of the other. Under
both traditional pricing and ABP, a firm with ABC is more likely to allow its
customers to consume more support service when c, is low and will allow
customers to consume less support service when c. is high. The firm adjusts
the level of customer support it allows its customers to consume through
the pricing schedule it announces. Under traditional pricing, however, the
firm is constrained to make its pricing only a function of q, whereas under
ABP, the price is a function of both q and s. Thus, the firm is able to make
more use of the cost-driver rate information provided by ABC under ABP
than under traditional pricing. Under both ABP and traditional pricing,
the value of ABC information is decreasing in a,2 and increasing in oa2
and oa,. That is, ABC information is more valuable when the traditional
costing system has higher measurement errors, when ABC has lower mea-
surement errors, and when the cost of support services is inherently more
uncertain.
We know from propositions 3 and 6 that ABC leaves the expected con
sumption of support services and base product and the information ren
paid to each customer unchanged. Thus, it does not affect customer sur
plus, and all the benefits from ABC accrue to the firm. I next turn to t
value of cost-driver volume information.
PROPOSITION 10.
(i) Under traditional costing, the expected value of cost-driver volum
information (ABP) 8k(. (v, (k) -irt(k))) = fk (as(k)+ f(k) dk +

r4
4(o ) - ow, and it is increasing in o, and decreasing in ,s

(ii) Under ABC, the expected value of cost-driver volume information (ABP)
?k(8e (7ra(k) -7rr(k))) =4k(Sc (r, (k) -.7t(k))) + S4(, ,s)(a+azS)

andofitcost-driver
(iii) The value is increasing in o n, and
volume information (ABP)decreasing
for the supplyin o; un-
chain 2,s
der traditional costing X,-Xt = Ek (_- (ah())2 ) 4(? ,)-4w~-and(0t3- Wh and
under ABC Xa X - r = Sk ( - (ash(k))24 4(
-4 ) +4(a2a2),s ~+ O Vr,)
COROLLARY 1. If the firm has traditional costing and traditional pricing, the
value of implementing ABC with traditional pricing exceeds the value of ABP with
traditional costing if and only if
5a s- )f(-cxhr >(k) + f(k) dk

(16 - 4a ) (c ,s + ,)(af + as) k
+ + -
The value of the cost-driver volume information derives from its use in
ABP. This value is clearly increasing in cs, the expected cost of providin
customer support service. This is because ABP mitigates the moral-hazar
problem in the consumption of support services. Hence, the greater the cost
of providing support services, the greater the value of ABP. The value of AB
is decreasing in the measurement error of the accounting system. Becau
the ABC system has less measurement error than the traditional system, ABP
is more valuable when the firm has ABC. As seen in proposition 9(ii), th
cost-driver volume information is more valuable for a firm that already has
cost-driver rate information. Moreover, this incremental value of ABP under
ABC relative to its value under traditional costing is increasing in ao,, an
na2,, and decreasing in oK ,. That is, the more noisy the firm's cost signa
about its cost of support services under traditional costing relative to AB
and the more the inherent variability in the cost to serve, the greater is the
incremental value of ABP under ABC relative to traditional costing. Observe
that gross of the measurement cost, wo, cost-driver volume information has
strictly positive value under both ABC and traditional costing.
Corollary I compares the value ofABP with ABC for a firm that has neithe
cost-driver rate nor volume information. Because the value ofABC for a firm
with traditional costing and pricing is increasing in the measurement error
of the traditional costing system while the value of ABP for a firm with
traditional costing and pricing is decreasing in the measurement error of
490 V. G. NARAYANAN
the traditional costing system, we might expect firms with high measu
error in their traditional costing systems to adopt ABC whereas firms
lower measurement error might adopt ABP. The measurement erro
ABC does not affect the desirability of ABP for a firm with neit
nor ABP, but lower measurement error under ABC strictly incre
desirability of ABC.4
The impact of ABP on supply chain surplus is ambiguous. The re
in moral hazard helps the supply chain. More efficient price discri
by the firm under ABP, relative to traditional pricing, results in the
tion in consumption of support services by customers. This distortion
customer and supply chain surplus. The net effect of the moral ha
duction and increased price discrimination on supply chain surplu
go in either direction.
To obtain greater insight into the value of ABP, I consider the case w
k has a uniform distribution.
PROPOSITION 11. When k is distributed uniform [lAk - crk, I-k + Ok]
(i) Under traditional costing, the expected value of cost-driver volume informa-
tion (ABP) k (S (7v (k) - 7t (k))) = 3 +6sa3k +44a12 4(42 +)

()v.
(ii) Under ABC, the expected value of cost-driver volume information

a,, - 2(s)
(iii) d(Ek(c(rra(k)- Tr(k))))
dAk _ d(Sk(E-(Irv(k)-7r
d (k))))
k_ acs2+ 2ak3
>0
(iv)di
d(dA
Ek(
k
(7ra (k) -
(v) The value of cost-d
-2 2 o4
der traditional
4 3 + costing X -
ABC Xa - Xr = Xv - Xt + 4(o2 , + 2(a2, +fr2,) *

From proposition 11 we can see that in the case of the uniform distribu-
tion, the value of ABP for the firm under both ABC and traditional costing
is increasing in the diversity of customer types (as measured by Tk) but is not
affected by the average preference for support services (gtk). The value of
ABP for the supply chain, however, is decreasing in the diversity of customer
types. Thus, if Uk is high, ABP becomes attractive to the firm but ends up
hurting the overall supply chain.
4 It is important to keep in mind that the value of finer cost-driver rate information from
the ABC system might not be as high in a multiperiod setting. Each period, the firm could
observe aggregate cost-driver volume and total cost even under traditional costing. Using this
information, through a process of Bayesian updating, the firm can update its priors on cost-
driver rates. Thus, a firm with access to a long history of aggregate information on driver
volumes and total costs, a mature portfolio of products, and stationary cost structure would be
able to estimate its cost-driver rates pretty accurately without adopting ABC.
5. Conclusions
In this article, I show how and when ABC and ABP are useful in contrac
with customers who buy a base product and support services. As mig
expected, ABC helps the firm price its products and services better. Perh
less apparent, ABP also helps reduce the information rent paid to custome
and their free riding on support services. Moreover, after the adopt
ABP, high users of customer support become the most profitable custome
for the firm. I show that ABP is more useful to the firm when the costs
associated with support services are more uncertain, measurement err

the costing system are less, and when the types of customers the firm d
with are highly diverse. ABC is more useful when the firm's cost signals
traditional costing are noisier relative to the signals under ABC, and the
associated with support services are more uncertain. The firm has to
off these benefits of ABP and ABC against their respective implemen
costs.
It is important to keep in mind that I use the term ABC only for
convenience. The insights from this study hold as long as the newe
tem that a firm adopts provides finer cost-driver rate information
traditional cost system. The newer cost system need not be activity
show that it is the cost-driver volume information, rather than the
rate information, that helps the firm improve its price discrim
mitigate customer moral hazard. Cost-driver rate information, on t
hand, is useful for selecting the appropriate quantity of the ba
and support services through an appropriate choice of prices. Ho
cost-driver rate information and cost-driver volume information are com-
plements, and the marginal value of one increases with the availabili
the other.
It is shown in the prior literature that the firm's ability to engage in price
discrimination is reduced, although not eliminated, in the presence of com-
petition (see Stole [1995]). Moreover, the firm's ability to mitigate its cus-
tomer's moral-hazard problem and its ability to price its products appropri-
ately would be valuable even in a competitive setting. Thus, we would expect
many of the insights from this study to hold in competitive settings as well.
What is an open and interesting research question is how well a firm can
use prices in a competitive market setting to infer information about its own
costs without investing in an expensive ABC system to estimate its cost-driver
rates. I leave that question for future research.
APPENDIX A
Proofs
Proof ofProposition 1. The participation constraint needs to hold for each

type k. Suppose to the contrary, that the constraint does not bind for some
types. Let the types for which the participation constraint does not bind
in equilibrium be the set K'. Consider an alternate mechanism where the
firm maintains q(k) and s(k) as before, but increases T(q(k), s(k), k) so
492 V. G. NARAYANAN
that the participation constraint binds for all types k E K'. The princ
objective function clearly increases as T increases. Thus, a mechanism whe
participation constraint does not bind in equilibrium for a set of types ca
be an equilibrium.
Thus, we can convert the firm's program into an unconstrained optimiz
tion program as follows:
max f ((q (k), s(k), k) - cqq(k) - c,s(k)) f(k)dk

q (k), s (k)
This program can be optimized pointwise. Furthermore, = = -2

and - ~ ) = 4(- 2 > 0. Hence, first-order conditions are nec-
essary and sufficient for a unique global maximum. Solving = - cq and
= cs, and using the subscript f to denote equilibrium values in the first-
best case, we have sf = ala5 -as 2c, +22ask and qf = 2al -2cq +cts(atsk- cs) . We
get o4(k) by substituting sT and qf for s and q, respectively. We get Tf(k)

by setting Tf(k) = Of5(k) because the participation constraint binds for all
types.
ProofofLemma 1. I begin by solving program 2 first. I show that the partic-

ipation constraint needs to be satisfied only for the lowest type of customer.
Consider the participation constraint for the lowest type A.
0(q(kA), s(kA), k) - T(q(A)) > 0 (Al)

If equation (Al) is satisfied, a type k customer (k > k) also realizes
surplus, because they can always choose the type k's bundle and obtai
of
alq(A) - q(k)2 +a3ks(A) - s(A)2 +Uasq()s(k) - T(k)
> alq(k) - q(A)2 + 3asks (A) - s(k)2 + a5 q (k)s((A) - T(k) > 0

Hence, if the participation constraint is satisfied for the lowest type, it is
automatically satisfied for all other types.
Observe that d2k -=-2. Hence, setting d = 0, we get s = .3k+(,q. Substi-
tuting into 0, we get
ak k2 + 2asaskq(k) + q(k)(4a - (4 -_ a)q(k))

(q (k), k) = 4(A2)
The incentive compatibility c
?(q(k), s(k), k) - T(q(k)) >

become
4(q(k), k) - T(q(k)) > ?(q(k), k) - T(q(k)), Vk, k

We can replace the incentive compatibility constraints with the followin
first-order condition.
do_ d T
-= 0 (A3)
dq dq
It remains to be verified that the second-order conditions are satisf
and globally and I shall do so later.
To derive the optimal q (k) and s (k), I write the utility of custom
as t (k). From the incentive compatibility constraint,
t(k) = 4(q(k), s(k), k) - T(q(k))

k
= max 4(q(k), s(k), k) - T
From the envelope theorem, d = A since =' L dA
= 0. Thus,
- ak aq as
dt
= ass(k) (A4)
dk
Integrating equation (A4), we can express the utility of type k customers as
t(k) = fk as(k) dk + (k) = fkas(k)dk
The last equality follows from the participation constraint binding for the
lowest type. Because T(q(k)) = /(q(k), s(k), k) - t(k), the firm's objective
function can be rewritten as
Ek (17 = (k)))= (0(q (k) , s(k), k) - f as(k)dk - cq)q(k)
+ (c,)s(k) I ^q, ,)f() dk (A5)

Integrating by parts yields
Sk(S?(nI(k))) = f ((q(q(k), s(k), k) - cqq
+ c,s(k))f(k)- a3s(k)(1 - F(k) I q
Substituting for s into equation (A6), we get

(q(k), k) - cqq(k) +) f(k) - a~ () (1 -
The maximization of 8k (S (l (k)) with respect to
term under the integral be optimized pointwise fo
a3k
ai - 2q +as = Cq +
+ s-asq
+ a3
2 2 a
f(k) U
2 1 - F(k) a
2(a, - tildecq) +
4 - .2
ask + asqt(k) 2
j st(k) = =
2 2(4 - a2 )
a_ _ =
s(k) 4 as
--(K) dk =
494 V. G. NARAYANAN
Because t(k)= 0 - T, we can write T(k) =(qt(k), st(k), k

()d
- a((4- 1)a-
Because
5a2 <dh 0A
by assumption,
dA dk) is mono
k. dqt(k) > 0 if as > 0

tonic in k, we can inv
function of q as well. C
and s (k) (communicat
decentralize the choic
Both approaches are e
Now, I verify the local
Let (k, k) denote the uti
of a consumer of type
t(k, k) = aq(k) -
- T(q(k))
> St(k, k) = k2 + k)
i(h, 22askq(k) + =-T(q())
q(k) (4al - (4- a2)q(k))
4
The first-order condition is for all k, aL(kk) = 0. Differentiating the first-order

condition with respect to k gives a2(k,k) a t(k,k) . Thus, the local second-
8kak 8k k
order condition is equal to a2t(k,k) > 0. But, a2(kk) = 2
a k k --k-k dk " w
dqk> 0 if and only if as > 0. Thus, we have a2(kk) > 0.
To check the global second-order condition, suppose that t(ki, k2)
t(ki, kl) for some k, and k2. This implies'k1
that
dkfk2 dt(k,x) dx > 0. Sup
k2 >the
use hk.first-order
Because 2t(k'k)> kdak- dkA --d d ow-- -'
0, we
condition. Wehave
thus di(ki,x) < dt(x,x) = 0 Similarly
have a contradiction. for > kl, for
where I
k1 > t2.
The solution method for program 3 is analogous.
Proof of Proposition 2. Proposition 2 follows directly from lemma 1 and

noting that ?, is increasing in ^, and -,, , is increasing in C, and -s, and Jq
is increasing in cq and -q.
Proof of Proposition 3. Proposition 3 follows from subtracting the expected

values of sf and qf characterized in lemma 1 from the values of st and qt
characterized in proposition 2, where the expectation is taken with respect to
measurement errors and cost uncertainty for the base product and support
service.
Proof of Proposition 4. Proposition 4 follows from substituting st, qt, t t, Sr,

q,, and tr derived in lemma 1 into the objective functions of programs 2 and
3 and then subtracting Ik(k(Ht(k))) from $k ($(1-r(k))).

Proof of Proposition 5. We know from equation (A3) that d= d. Differ-
entiating equation (A2) with respect to q, we get
dT, dq5(q)
-dq
-= dq
2ota35k + 4a1 - 2(4 - _ a2)q(k) (A7)
q (k) is characterized in lemma 1, and we know from
q (k) is strictly monotonic in k and is hence invertibl
d1-= 2aasqtq(q(k)) + 4a, - 2(4-c

dq
d2T dq '(q(k)) (9)
= -2(4 - _ a) +2a3s dqt (A9)
dq2 dq
d2 dk
=
dq2 d2
dq(k) -2
We know from lemma 1 that
2(ac - jq) + at5(a3(k - h(k)) - =s)

qt(k) = 4 - a2
dqt(k) a3as d(k - h(k))
dk 4 - a dk
dd 2 h' a2)
=t2(4- ( ) (k)
dq2 1 - h' (k) <0
The proof for S (d ) is similar.
I next prove proposition 5 (ii).
d2 t _ d2 T dqt
dqtdaq dq 2 dCq"
We know from proposition 2(ii)
dqthat ? < 0. Hence, d2 > 0. Simi
'dqtdq
using proposition 2(i) i is incr

if, a5 > 0.
Proof of proposition 5(iii) is analogous.
ProofofLemma 2. First, I solve program 5. As in the proof of lemma 1, the

participation constraint needs to bind only for the lowest type of customer.
I replace the incentive compatibility constraints with two first-order local
conditions.
do dT
=0
dq dq
do dT
ds ds
-=0
I take Sk (E(lI(k))) as characterized in equat

respect to the schedules s(k) and q(k). From
get
al - 2q + ass = Jq (All)
496 V. G. NARAYANAN
1- F(k)
ask - 2s + asq = cs + Ua (A12)
f(k)
Solving equations (All) and (A12) simultaneously, we get
asa(k) = 5(a - jq) - 2(a3(h(k) - k) + Es)

(4- a4)
2(ai - Cq) + as (as3(h(k) - k) + cs)
qa(k) = 4 - ao2
a M(k)= Ik as a ) A = k 013 (U5(O - ?q ) -2(k)](4 k-) + i) dk
Ta(k) = ((qa(k), sa(k), k) - ta(k) because t(k) = 4 - T
I skip the proofs for the local and global second-order conditions being
satisfied as the proof is analogous to that in the proof of lemma 1. The
solution method to program 4 is analogous.
Proof of Proposition 6. Proposition 6 follows from subtracting the values

of sf and qf characterized in proposition 1 from the values of sa and qa
characterized in lemma 2.
ProofofProposition 7. Proposition 7 follows from subtracting the expected

values of sa, qa, and ta characterized in lemma 2 from the values of st, qt
and tt characterized in lemma 1 where the expectation is taken with respect
to cost uncertainty.
Proof of Proposition 8. First, I write l t (k) = Tt(k) - (Cqqt (k) + c,st(k)).

Next, I substitute for Tt, qt, and st from lemma 1. I then take expectations
with respect to the cost measurement errors. Finally, I take the derivativ
with respect to k to get ~( dn(k) )= -3(h(k)( - h'(k))a3a ) + B Similarly for

Hr (k). Hence, proposition 8(i) follows.
To prove proposition 8(ii), I write -fl(k) = Ta(k) - (cqqa(k) + cssa(k))
Next, I substitute for Ta, qa, and s, from lemma 2. I then take expectation
with respect to cost measurement errors. Finally, I take the derivative with
2h(k)(1 - h'(k))Wa2
respect to k to get --------2 . Similarly for I-, (k). Hence, proposition
8(ii) follows.
Proposition 8(iii) follows from propositions 8(i) and (ii).
Proof of Proposition 9. We can write HITa(k) = Ta(k) - (cqqa(k) + c,sSa(k))

Substituting for Ta,qa, s5, and ta from lemma 2 and taking expectations with
respect to cost variables and then k, we get Sk ($(tIa (k))). We can similarly
write down ?k ((HI,(k))). Subtracting the two, we get the desired result.
Xa - Xv follows by adding the expected difference in information rents
Proposition 9(ii) follows similarly by substituting endogenous v

from lemma 1.
Proof of Proposition 10. First, I write 7t, (k) = T, (k) - (cqqv (k) + cs s, (k))
and irt(k) = Tt(k) - (cqqt(k) + csst(k)). I substitute for T,,q,, and s, fro
lemma 2 and for Tt, qt, and st from lemma 1. Next, I take expectations wit
respect to the cost variables to get
Eg(fl ,(k) - (k)) = (t(k) -t(k)) + - (h(k)a )2

or4
+ 1n, (A13)
4( 2s + o 2
(k)f ah(k) + a3d, + - (h(k)U3)2

k 2 4
o4
+ n, s (A14)
4(r2 , + C2,s)
Sk(S((fIlv(k) - lt(k))) = d
+ c - (h(k)a3)2 )dK + n,
4 f 4(a2s + a2
Where equation (A14) follows from substituting for to
2 and lemma 1, respectively. Using integration by parts, th
of the equation above can be simplified as follows
fkL h(k) + c3Cs, a h(k) + asc5
(-(1 - F(k)) Adk

(h(k)a3)2 - 2 or 4
- 4 f(k))dk + -+ ns
4 4 4(U2 + 02 )
The first term under the outside integral vani

we can further simplify the expression as
fk 4(03h(k))2 h(k)a3
+ a ) -s__
+ +- f (k)dk + n,s
2 4 4 (a 2
Through a similar process, it can b
k((l'a(k) -- Hr(k)))
4(os + o4,)
498 V. G. NARAYANAN
(S? 4( 1(fa(k) -- Jlr(k))) = Ek(E-(Flv(k) - 10(k)))
4(+ , + , )( +?oS)
Proposition 10(iii) can be proved as follows. Xv - Xt = 8k(8c(1H
tv (k) - nt(k) - tt(k))). Ii(k) + t (k) = T,(k) - (cqqv(k) + c,sv
1-t1(k) + lt(k) = T(k) - (cqqt(k) + csst(k)). I substitute for T,(k
s, (k), Tt(k), qt(k), and st (k) from lemmas 2 and 1. I then take exp
with respect to the cost measurement errors to derive Xv - Xt. Likew
Xa - Xr-
ProofofCorollary 1. Corollary 1 follows from proposition 10(i), proposition

9(i), and proposition 9(ii).
Proof of Proposition 11. When k is distributed uniform [Ak -- Ok, ik + k]

f(k) = and h(k) = lk + Uk - k.
Proposition 11(i) follows from proposition 10(i) after substituting for
f(k) and h(k). Proposition 11(ii) follows from proposition 10(ii) after
substituting for f(k) and h(k). Propositions 11(iii) follows from taking
derivative with respect to ak from propositions 11 (ii) and 11(i). Although
proposition 11 (iv) follows from taking derivative with respect to ftk from
propositions 11 (ii) and 11(i), proposition 11(v) follows from proposition
10(iii) after substituting for h(k).
APPENDIX B
Extension to a Setting with Flexible and Committed Resources
In this appendix, I extend the model to consider the case wh

of the resources of the firm are flexible and others committed ahead of
time. See Cooper and Kaplan [1992] for the distinction between fle
and committed resources. In the case of flexible resources, the spen
incurred when the demand for the resource arises. Thus, the costs assoc
with spending on flexible resources are completely variable and vary
the output. Committed resources, on the other hand, have to be ac
before the demand for the resource is realized. Even if the realized demand
for the resource is less than the capacity of the committed resource,
costs associated with the full capacity of the resource have to be incur
However, if the demand for the resource exceeds the committed capaci
following Banker and Hughes [1994], I assume that the firm has to pay
penalty beyond normal costs. An example of such penalty would be overtim
pay for labor.
Following Banker and Hughes [1994], I model two types of costs. Let
be the variable cost per unit of productj for j E {(q, s). Let vj = -j + E
where E~,j is a normally distributed random variable with expected va
?(Ev,j) = 0. Thus, the expected variable cost per unit of product j is i
Let x - (xl ...., xi, ...., x) represent a vector of capacities committ
to resources i = 1,..., I. Let mi be the cost per unit of capacity fo

source i. Let mi = mi + Emi, where Em,i is a normally distributed
dom variable with expected value S(Em,i) = 0. Thus, the expect
mal cost per unit of resource i is mi. I assume that Emi and Ec,j a
independent.
The demand for resource i is given by zi = Sk(Iti,qq(k) + pi,,s(k)
where ,i,j is the number of units of resource i required to suppor
unit of productj, and yi is a random variable with expected value S
density function fy, (Yi), and distribution function Fyi (yi). Thus, yi is
dom disturbance term that affects the total demand for resource i and
tures the uncertainty in the manufacturing process and consump
resources. Although Banker and Hughes [1994] introduce uncertai
the consumption of resource through uncertainty in product deman
troduce uncertainty in the consumption of resources through unce
in the manufacturing process. If the consumption of resources we
tain, the firm could choose xi = zi; that is, the supply of capacity c
the consumption of resources. However, because of uncertainty in t
sumption of resources, if zi < xi, the firm has excess capacity in re
but still has to incur mi xi to supply the resources. However, if zi >
firm has to supply additional resources beyond originally planned c
at cost Oimi (zi - xi) where Oi represents a factor to reflect the penalty
exceeding capacity of resource i. For instance, it can represent overtim
for indirect labor.
Following Banker and Hughes [1994], I define the cost-driver rate per
unit of product
incurred per unit joutput
to be will
cj = differ
v- + [=1 miti,j
from the for j E {q,
normal s}. The cost
cost-driver rate actuall
when
zi differs from xi. Although Banker and Hughes assume that the firm knows
its true ABC cj, I assume, as explained in section 3, that the actual costs ar
random and that the firm observes its actual cost with error and the magni-
tude of the error depends on the type of cost accounting system in place.
I assume that n, = Em, ii,j + Ev,j, and hence, cj = Vj + Z=1 mili, j

for j E {q, s}).
In the first stage, the firm chooses capacities and then chooses prices in
the second stage. I will solve the firm's program under ABP and ABC. The
other scenarios considered in the main body of the paper can be solved for
analogously.
The firm solves the following program.
PROGRAM 6.
max ?k (S(I ((k))

T(q(k),s(k)),(k),s(k)k),q(),s(),x
= 'E(Sk(T(q(k), s(k), k) - Vqq(k) - vs(k)

I I 00
- i=ymixi - Zqq (imi

1 i=1 xi-li. k) -- (zi
iss ( -
k) xi) fyi (yi) dyi | 9, Is))
500 V. G. NARAYANAN
Subject to:
?(q(k), s(k), k) - T(q(k)) > 0, Vk
?(q(k), s(k), k) - T(q(k)) > 0(q(k), 9, k) - T(q(k)), Vk, k, s

From first-order conditions for the capacity choices we get
ak((k)) -mi +Oimi fy (yi()dyi = 0

xXi xi-ti,,qq(k)-tti,ss(k)
=0 if fy,(yi) dyi = 1
xi-Ai,qq (k) -qiss(k)
1
= 1 - Fi, (xi - Ii,q~k(q(k)) - i,slk(s(k))) =
= F71 1( - +Aii,qEk(q(k)) +IAi,sk(s(k)) = x1

where x* represents the optimal capacity choice for resource i. Analogous
to equation (A6) in Appendix A, I write the firm's objective function as
Ek((S(n (k))) = fS(0(q(k), s(k), k) - vqq(k) - vss(k) - mixi

- i=1
I 00oo
-L Oimi (zi - Xi) fyi (yi)dyi

i=1 xi-Vitqq(k) - i,(ss(k )
- 3s(k) (1 - F(k)) dk
Recall that 0(q, s, k) = alq - q2 + o3ks - s2 +a5qs - T. The maximiza

tion of Sk(S?(1-(k))) with respect to q(k) and s(k) requires that the term
under the integral be optimized pointwise for all k. Hence, we get
ai - 2q + ass
= , vq +i=1
+ xi-1-i,q
Oimici,q fyi
q(k)- i,s s(k) (yi))dyi q, Cs))
as3k - 2s + a5q
= vs + +? Oimiis fyi (yi)dyi I q, Cs

i=1 xi-Ai,qq(k)- i, ss(k)
as (1- F(k))
f(k)
Because I show that Bi fx~-isqq(k)_,ss(k) fY (yi) dy1 = 1, the previous equa-

tions simplify to
ot- 2q + s5s -= (vq +- mizi,q Cq, C
a3k- 2s +t5q = vs + miis iEq, 3s f-F(k)
a a - 2q + U5S = Eq (A15)
= ask - 2s + a5q
f(k) = , + Ufs (A16)
Solving equations (A15) and (A16) simultaneously, we get
S( a (a - ( q) - 2(cg3(h(k) - k) + cs)
sa (k) = ( 2)(4 -_ 0)
2(a1 - cq) +a5 (Y3(h(k) - k) + Js)
qa(k) =4-a2
t-a(k) = 0 13Sa(k) dA= k U3(a5( 1 - -q) ~ 2( 3(h(k) - k) + cs)) A
where) =F2 +2 I^(c

ssq) --52q) +2
+. dBe-
cause t(k) = 4- T, we can write T(k) = Q4(qt(k), st(k), k) - tt(k). Th
when the firm sets its pricing schedule T(k), the firm bases its pricing deci-
sion only on the costs reported by the cost accounting system. These co
include not just the variable costs but also the fixed costs of committed
sources. Thus, I have extended an analogous result in Banker and Hugh
[ 1994] to a setting of nonlinear prices, uncertain costs, and a cost accountin
system with measurement errors.
REFERENCES
ADAMS, W.J., ANDJ. L. YELLEN. "Commodity Bundling and the Burden of Monop
Journal ofEconomics (August 1976): 475-98.
BANKER, R., ANDJ. HUGHES. "Product Costing and Pricing." The Accounting Revi
479-94.
BANKER, R., AND G. POTTER. "Economic Implications of Single Cost Driver Systems." Journal
Management Accounting Research (Fall 1993): 15-32.
BARON, D. P., AND R. B. MYERSON. "Regulating a Monopolist with Unknown Costs." Econometri
(July 1982): 911-30.
COOPER, R., AND R. KAPLAN. "Measure Costs Right: Make the Right Decisions." Harvard Busine
Review (September-October 1988): 97-98.
COOPER, R., AND R. KAPLAN. "Profit Priorities from Activity-Based Costing." Harvard Busine
Review (May-June 1991): 130-35.
COOPER, R., AND R. KAPLAN. "Activity-based Systems: Measuring the Costs of Resource Usage
Accounting Horizons (September 1992): 1-13.
KIRBY, A.J.; S. REICHELSTEIN; P. K. SEN; AND T. K. PAIK. "Participation, Slack, and Budget-Base
Performance Evaluation." Journal of Accounting Research (Spring 1991): 109-38.
MCAFEE, R. P.; J. MCMILLAN; AND M. D. WHINSTON. "Multi-product Monopoly, Commodit
Bundling, and Correlation of Values." QuarterlyJournal of Economics (May 1989): 371-84.
502 V. G. NARAYANAN
MELUMAD, N., D. MOOKHERJEE; AND S. REICHELSTEIN. "A Theory of Responsibility C

Journal of Accounting and Economics (December 1992): 445-85.
NARAYANAN, V. G., AND R. SARKAR. "The Impact of Activity-Based Costing on Manage
cisions at Insteel Industries--A Field Study." Journal of Economics and Management S
(Summer 2002): 257-88.
SCHMALENSEE, R. L. "Gaussian Demand and Commodity Bundling."Journal ofBusiness (J
1984): S211-S230.
STIGLER, G.J. "A Note on Block Booking." in The Organization oflndustry, edited by G.J.
Homewood, IL: Irwin, 1968: 165-70.
STOLE, L. "Nonlinear Pricing and Oligopoly." Journal of Economics and Management Str
(Winter 1995): 529-62.
TIROLE, J. The Theory of Industrial Organization. Cambridge, MA: MIT Press, 1988.

Activity-Based Pricing in A Monopoly

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Activity-Based Pricing in A Monopoly

Uploaded by

Copyright:

Available Formats

Activity-Based Pricing in a Monopoly

Activity-Based Pricing in a Monopoly

Received 27 December 2000; accepted 1 November 2002

In this article, I study the interaction between cost accounting sys

Copyright ?, University of Chicago on behalf of the Institute of Professional Accounting, 20

support services are complements.

costs of support services are inherently highly uncertain. These benefits of

volume information are complements because one is more valuable in

This study is related to the mechanism design literature in economics

I model a monopolist who sells to customers a base product and ad

set a2 = a4 = 1. I assume a, a3 > 0 and 0 < Ia < 2. If a5 > 0, the

Cs = Cs + ns + EK, and ^s = , +E ,, + ,s, it follows that cq, CS, Cq, ?, and 3

contracting (i.e., pricing). I assume that it costs w, to implement the account

Setting Traditional Costing Activity-Based Costing

realization of cost-driver rates cj before choosing

The variable k is also unobservable in scenarios 2 through 5. Under tr

4.1 FIRST-BEST CASE-SCENARIO 1

The firm solves the following program:

max f (T(q(k), s(k), k) - cqq(k) - css(k)) f(k)dk

q(q(k), s(k), k) - T(q(k), s(k), k) > O, Vk

(i) Support provided to customer of type k, sf (k) =- =15 -5 cq - 2cs +2a3k

(iii) Tf ((qf(k), sf(k), k) = Of((qf(k), ST4(k), k).

Observable? Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5

All proofs are in A

4.2 TRADITIONAL PRICING

4.2.1. Traditional Pricing and Traditional Costing-Scenario 2. The firm

max),s() (T(q(k)) - cqq(k) - cs(k) I q, i,) f(k)dk

(q (k), s(k), k) - T(q(k)) > 0, Vk

0 (ql(k), s(k), k) - T(q(k)) > b(q(k), -, k) - T(q(k)), Vk, k, s

d(q(k), s(k), k) - T(q(k)) > O, Vk

incentive compatibility constraints, which require that each type k s

and sr (k) = 2as(at - cq) -Cr(Ut3sh(k)

(iii) The information rent paid to

T as a function of q as well. It is a well-known result in the mech

Comparing the expected consumption of support services for each cus-

Because support services are not priced (that is T is independent o

PROPOSITION 4. Under traditional pricing, the expected value of cost-driv

(ii) d is increasing in cq. If and only if, s > 0, T is increasing in c, but

(iii) "r is increasing in cq. If and only if, a5 > O, is increasing in C, bu

when the reported cost of the base product qq increases, we know

q and s. I present two programs-one under traditional costing and

4.3.1. ABP and Traditional Costing-Scenario 4. The firm solves the fo

k(q (k), s(k), k) - T(k) > 0, Vk

0 (q(k), s(k), k) - T(k) > q0(q(k), s(k), k), k) - T(k), Vk, k

max [ ( T(k) - Cqq(k) - css(k) - ar - a), I cq, Cs) f (k)dA

r(q(k), s(k), k) - T(k) > 0, Vk

4(q(k), s(k), k) - T(k) > P(q(k), s(k), k), k) - T(k), Vk, k

(i) Supportprovided to customer of type k, sv (k) = a5(al - "q) -2(as(h(k) -k) +

(ii) Base good provided to customer oftype k, q, (k) = 2(ai - ) +as(a(k -

and qa(k) = 2(atL - q) +as(as(k- h(k))- ~,)

(iii) The information rent paid to customer of type k, tv(k) = 3fk a

(i) S4(sa - sj) = Eg(s5 - sI) = 2(4< 0.

Because h(k) = 0 only for k = k, ? (sa) = &E(s,) = 8E(sf) and ?4(qa) =

(i) (se - Sr) =- ?(Sv - St) h(k)ot3+cs < 0.

(iii) (a - r ) = -- ) k --a3 h(k)2-+t 0 dk < 0.

problem in the consumption of support services by the customer. The h

(i) Under traditional pricing, expected customer profitability is decreasing in

(ii) Under ABP, expected customer profitability is increasing in customer types

Although the expected increase in customer profitability in switc

4.4 COST-DRIVER RATE VERSUS VOLUME INFORMATION

firm Sk(c(7ra(k) -7r,(k))) = (o,-oK,) - o . This also

In a result similar to proposition 4, I now establish that gross of the mea-

(i) Under traditional costing, the expected value of cost-driver volum