Is Assigning Capacity Costs to Individual Products Necessary for Capacity Planning?

Abstract:     
We examine the value of assigning costs of capacity resources to products for capacity planning. It is often argued that a product's full cost, which includes such assignments, is a measure of its long-run manufacturing cost. Hence, full cost is viewed as an appropriate basis for deciding whether a product should be included in the firm's product portfolio, and how much capacity should be installed to manufacture the product. We use numerical examples to demonstrate that when capacity once installed cannot be increased in the short run (i.e., capacity resources impose "hard" constraints), the decision of how much capacity to install initially is a portfolio-level problem and does not generally decompose into product-level problems. Intuitively, unless product demand is constant, the product- mix problem differs across periods when capacity constraints are hard. Consequently, the opportunity cost of a capacity resource also varies across periods because it is determined at the portfolio level. Therefore, using full costs to measure individual product profitability and planning initial capacity levels on a product-by-product basis is sub- optimal.

JEL Classifications: M41, M11

Accepted Paper Series