Accounting and Economic Costs

Use of an alternative-cost concept leads economists to different cost figures from the ones that businessmen and their accountants work with. These differences arise primarily because the economist includes several items that the accountant ordinarily doesn’t consider as costs when he draws up his profit-and-loss statements.

A simple example is the independent corner grocer, who has bought a store with his own funds and runs it himself. In addition to the regular business costs in the profit-and-loss statement, the economist would say:

“How about a return on your own investment and a salary for yourself? If you didn’t have your money tied up in the store, you could be earning 5 per cent on it in another investment. If you weren’t working in the store, you could earn $5,000 a year working for Krogers. You ought to account as costs a 5 per cent return on your investment and a $5,000 salary for yourself before you compute your profit for the year, because these reflect real alternatives that you’re giving up when you stay in your business.”

If the grocer does not include these costs and finds he’s making a $4,000 annual profit, he may think he’s doing well—but actually he’s kidding himself. The $4,000 doesn’t even give him the salary he could earn working for someone else, much less the return he could get by doing that and investing his money somewhere else.

A similar, though less obvious situation, is found in business corporations. Corporations pay salaries to their officers and employees, so there’s no problem there. And they pay interest to their bondholders, which is considered a cost in computing profits. But what about the interest on the owners’ (stockholders’) investment, just as on the corner grocer’s investment?

The usual accounting calculation of corporation profits omits the alternative cost of using the stockholders’ capital in this firm rather than elsewhere. Profit is calculated before any payment is made to stockholders. The economist, however, includes in the firm’s costs a reasonable rate of return on stockholders’ investment (measuring the alternative return that is foregone elsewhere). He therefore considers as “economic profit” only the excess income over and above this basic alternative cost, because a reasonable rate of return is part of the cost required to keep funds invested in any business.

The accountant’s way of computing profits leads to some inconsistencies. Take two identical corporations, one financed by $1,000,000 of 4 per cent bonds and $1,000,000 of stock, the other by $2,000,000 of stock. Suppose each earns $100,000 after all other costs are covered. Corporation A will now show an accounting profit of only $60,000, because the bondholders’ interest takes $40,000 of the $100,000. Corporation B, identical except for financing arrangements, shows profits of $100,000. Not the least important consequence is the difference in income tax liabilities of the two substantially identical firms, since the law permits firms to deduct bond interest as a cost in calculating profits for income tax liability, but not implicit return on stockholders’ investment.

Through the rest of this book, we shall use the alternative-cost concept. Thus, costs of production will include the reasonable (or “normal”) rate of return on investment necessary to keep the funds invested in any given concern rather than elsewhere. Costs will include the entrepreneur’s own salary if he is self-employed. Broadly, they will include all costs required to get and keep resources in the occupation under consideration. Most costs will be the same as those used by the accountant, but the differences noted above must be kept in mind. Especially, remember that the production-cost data and curves used here include a “normal” return on investment, if you want to avoid some dangerous pitfalls later on.

Cash vs. Economic Profits:
A Managerial Application

A simple managerial example may help show the importance of these distinctions, as well as give you an impression of how basic economic analysis can help in day-to-day business. Suppose you’re in business for yourself, doing miscellaneous repairs (carpentering, electrical wiring, and so on) at a minimum charge of $5 per call and $2 per hour additional after the first hour. Your only equipment is your family station wagon, the back end of which you have converted to carry your working tools. You are prepared to answer calls anywhere in your general area. You’ve spent $20 for an ad in the local paper and for a supply of mimeographed postcards mailed at random to names from the phone book.

After a month, you’ve collected a large amount of experience, considerable boredom waiting for the phone to ring, and $310. Have you made a profit? Should you stay in business?

The answer to the profit question hinges on what your costs have been. If you deduct the original $20 outlay, you have $290 left. Not bad for a summer month. But look again. There is clearly gas and oil for the station wagon. And wear and tear on the same, which may be appreciable from this use. Then, aside from any materials (for which you may have charged extra), there’s the question of your own time.

Suppose gas and oil allocable to this work have cost $40. And you make a rough estimate of $25 a month extra depreciation on the car. That still leaves you $225. Is that more or less than a reasonable wage for your own full time and energy for the month? Here the concept of opportunity cost provides a guide to the answer. What could you hope to make elsewhere, doing work you consider about equally interesting, difficult, and convenient? If the answer is above $225, you’ve made a loss, even with $250 in the bank. If it’s less than $225 you’ve made a profit, though maybe a very small one. Central concepts from economic analysis: the distinction between cash and income, and opportunity cost. Without them you’re apt to pull a real business boner.