The Differential Impact of Accurate Product Cost Information in Imperfectly Competitive Markets: A Theoretical and Empirical Investigation*

Abstract

Many researchers claim that costing systems that provide materially more accurate or precise cost reports have a strict value‐enhancing effect on decisions (i.e., Cooper 1988, 1995; Cooper and Kaplan 1991; Christensen and Sharp 1994; Rogers. Comstock. and Pritz 1994; Swenson 1995; Gupta and King 1997). However, this study provides theoretical and empirical evidence that the value of more accurate cost information may be dependent upon the firm's competitive market structure, as well as the firm's product market strategy. We extend the theoretical work of Gal‐Or 1986 to incorporate an endogenous imprecise cost signal in two imperfect market structures: Cournot competition and Bertrand competition with imperfectly substitutable products. In addition, we theoretically link market structure to product market strategy. To examine product market strategy, we employ a laboratory markets design that allows for strategic reaction by a rival firm in each of these markets, because the competitive position of a firm is determined by its capacity to produce at low cost, or to differentiate its product from other products (Porter 1985). Consistent with our theoretical work, we argue that firms that compete on the basis of cost leadership (which we demonstrate may be characterized as Cournot competition), benefit through increased profits from increased product cost accuracy, whereas firms that compete on the basis of product differentiation (which we demonstrate may be characterized as Benrand competition) do not benefit from such increased product cost accuracy. Our results are consistent with this contention. That is, profit is higher in the experimental cost leadership markets (operationalized as Cournot markets) when subjects know their true cost, while profit is higher in the experimental product differentiation markets (operationalized as Bertrand markets) when subjects receive uninformative cost reports and make their decisions based on expected costs. These results suggest that the value of more accurate cost reports may be dependent upon the firm's competitive market structure strategy and product market strategy.

Empirical Analysis of Cost Estimation Accuracy in Procurement Auctions

“…In a manner similar to Datar and Gupta (1994) and Christensen and Demski (1995), Callahan and Gabriel (1998) define cost estimation error as the variance of the cost report where those with low variance are considered more accurate. Using theoretical analysis, Callahan and Gabriel (1998) show that firms that compete on the basis of cost leadership (which may be characterized as a Cournot competition) will realize increased profits from more accurate cost estimates. However, firms that compete on the basis of product differentiation (operationalized as Bertrand competition), may not benefit from better product cost estimates.…”

“…In addition, there is also a lack of research as to whether cost estimation accuracy leads to improvement in other managerial decisions as we do in this study. Callahan and Gabriel (1998) examine the impact of accurate product cost information on firm profits in an imperfect market setting and suggest that the value of more accurate cost information may be dependent on the firm's competitive market structure. In a manner similar to Datar and Gupta (1994) and Christensen and Demski (1995), Callahan and Gabriel (1998) define cost estimation error as the variance of the cost report where those with low variance are considered more accurate.…”

“…Callahan and Gabriel (1998) examine the impact of accurate product cost information on firm profits in an imperfect market setting and suggest that the value of more accurate cost information may be dependent on the firm's competitive market structure. In a manner similar to Datar and Gupta (1994) and Christensen and Demski (1995), Callahan and Gabriel (1998) define cost estimation error as the variance of the cost report where those with low variance are considered more accurate. Using theoretical analysis, Callahan and Gabriel (1998) show that firms that compete on the basis of cost leadership (which may be characterized as a Cournot competition) will realize increased profits from more accurate cost estimates.…”

“…These approaches include, for instance, a better cost management system like activity-based costing, a more formal and deliberate cost estimation system, and/or the acquisition of additional supplementary information regarding the project (e.g., Anderson, 1995;De Silva et al, 2008;Gupta & King, 1997;Ittner et al, 2002). However, as there is little evidence in the literature that more accurate cost estimates will necessarily lead to improvements in decisions or overall profits, several researchers have encouraged future studies to examine this relationship (Cooper & Kaplan, 1991;Callahan & Gabriel, 1998;Gupta & King, 1997;Heitger, 2007;Swenson, 1995).…”

“…Lastly, this study sheds light on prior research by using different research methodologies. Prior research in this area are mostly theoretical or/and experimental work (e.g., Callahan & Gabriel, 1998;Gupta & King, 1997;Heitger, 2007), while our study utilizes a large sample of empirical data from practice and provide evidence about the effect of better cost estimation in the bidding process.…”