Page 195 - Encyclopedia of Business and Finance

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Costs

in the future from those where the firm has already calculate the cost of owners’ equity capital, for vari-
enjoyed the benefits. Accounting distinguishes costs that ous purposes; these are imputed costs. Opportunity
have future benefits by calling them assets and contrasting costs are imputed costs and are relevant for decision
them with costs whose benefits the firm has already con- making.
sumed, by calling them expenses. Other pairs of terms • Average cost versus marginal cost. This is the eco-
involving this distinction are unexpired cost versus expired
nomic distinction equivalent to fully absorbed cost
cost and product cost versus period cost.
of product and variable cost of product. Average
Economists, managers, and regulators make further
cost is total cost divided by number of units. Mar-
distinctions between cost concepts, as follows.
ginal cost is the cost to produce the next unit (or
• Fully absorbed cost versus variable cost. Fully the last unit).
absorbed costs refer to costs where the firm has allo- • Differential cost versus variable cost. Whether a cost
cated fixed manufacturing costs to products pro- changes or remains fixed depends on the activity
duced or divisions within the firm as required by basis being considered. Typically, but not invariably,
generally accepted accounting principles. Variable analysts term costs as variable, or fixed, with respect
costs, in contrast, may be more relevant for making to an activity basis such as changes in production
decisions, such as in setting prices or deciding levels. Typically, but not invariably, analysts term
whether a firm has priced below cost for antitrust
costs as incremental, or not, with respect to an activ-
purposes.
ity basis, such as the undertaking of some new ven-
• Fully absorbed cost versus full cost. In full costing, the ture. Consider the decision to undertake the
analysis allocates all costs, manufacturing costs as production of food processors, rather than food
well as central corporate expenses (including financ- blenders, which the manufacturer has been making.
ing expenses), to products or to divisions. In full To produce processors requires the acquisition of a
absorption costing, the firm allocates only manufac- new machine tool. The cost of the new machine
turing costs to product. Only in full costing will rev- tool is incremental with respect to a decision to pro-
enues, expenses, and income summed over all
duce food processors instead of food blenders, but,
products or divisions equal corporate revenues, once acquired, becomes a fixed cost of producing
expenses, and income.
food processors. Consider a firm that will incur
• Opportunity cost versus outlay cost. Opportunity cost costs of direct labor for the production of food
refers to the economic benefit forgone by using a processors or food blenders, whichever the firm pro-
resource for one purpose rather than another. If the duces. Assume the firm cannot produce both. Such
firm can sell a machine for $200,000, then the labor is variable with respect to production meas-
opportunity cost of using that machine in opera- ured in units, but not incremental with respect to
tions is $200,000 independent of its outlay cost or the decision to produce processors rather than
its book cost or its historical cost. blenders. This distinction often blurs in practice, so
• Future cost versus past cost. Effective decision making a careful understanding of the activity basis being
analyzes only present and future outlay costs, or out- considered is necessary for understanding of the
of-pocket costs. Optimal decisions result from using concepts being used in a particular application.
future costs, whereas financial reporting uses past
costs. Analysis of operating and manufacturing activities
uses the following subdivisions of fixed (historical) costs.
• Short-run cost versus long-run cost. For a given con- Fixed costs have the following components:
figuration of plant and equipment, short-run costs
vary as output varies. The firm can incur long-run
costs to change that configuration. This pair of Fixed = capacity + programmed
costs costs costs
terms is the economist’s analogy of the accounting
pair, above, variable and fixed costs. The analogy is
inexact because some short-run costs are fixed, such
semifixed fixed standby enabling
as property taxes on the factory. costs + portions costs costs
• Imputed cost versus book cost. Imputed costs do not of semi-
variable
appear in the historical cost accounting records for costs
financial reporting. The actual cost incurred is "pure"
fixed
recorder and is called a book cost. Some regulators costs

172 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION