L.S.E. Essays on Cost

What follows is a shortened version of a series of twelve articles published in the
Accountant from 1 October to 17 December 1938 under the title ‘Business Organization and the Accountant’. The omissions largely consist of illustrations of the argument and a discussion of the problems of estimating costs in practice. The suggestion for writing this series of articles came from R. S. (now Sir Ronald) Edwards. Originally the intention was to take a number of problems of business administration and to show how such problems should be tackled. It was on this basis that I began writing in the summer of 1938. However, comments from Edwards on the draft of a section dealing with vertical integration suggested that readers of the
Accountant would find my discussion hard to follow without some account of the approach I was using. I therefore decided to write an introductory section in which I explained the basic concepts being employed. In the event the introductory section took up the whole of the series. This explains why the title of the series is not wholly appropriate to its contents.

Unless receipts to be received from the sale of the output are more than these avoidable costs, it will not be profitable to produce that output. So far we have only considered the total avoidable costs of an output. In economic literature another concept is often employed, that of marginal cost, which may be defined as the avoidable cost of an additional unit. If one considers the figures in the table, this avoidable cost of an additional unit is the increase in the total avoidable costs when the output is increased by one. The avoidable cost of producing one unit is £10, the avoidable costs of producing an output of two units are £19; it follows that the marginal cost of the second unit is £9. Similarly, since the avoidable costs of an output of two units are £19 and of three units £27, it follows that the marginal cost of the third unit is £8. Table 5.2 sets out the marginal costs of the various units.

Up to the present my chief aim has been to emphasize the importance to business policy of concentrating on variations in costs and/or receipts. It goes without saying that within the business organization information must be made available which enables these variations to be estimated. Before tackling the practical problem of how this information is to be obtained and presented, there are certain analytical difficulties which need to be faced. These difficulties centre around the fact that costs and receipts cannot be expressed unambiguously in money terms since courses of action may have advantages and disadvantages which are not monetary in character, because of the existence of uncertainty and also because of differences in the point of time at which payments are made and receipts obtained.

This lack of objectivity must necessarily be disturbing to those who wish to employ the normal technique of accounting for the solution of many business problems. However a vital factor is apparently being ignored if estimates of costs and receipts make no reference to the probability of these estimates being correct. There is, of course, the extremely difficult problem of whether any
numerical value can be given to the probability of the forecast being correct. If it cannot, and it would surely not be denied that in most cases this is so, the most useful way of presenting information is probably to produce several different sets of figures, each one relating to a particular group of assumptions about the course of events in the future. Just as monetary calculations become less realistic as they are applied to a more personal entity, so it is that we find that the single-figure costs and receipts of the cost-accounting textbooks become less significant the more uncertain is the future.

The difficulties which have been examined up to this stage have been common both to the measurement of costs and receipts. Some attention must now be paid to the nature of costs, since their derived and indirect character is liable to cause difficulty. In this article the notion of costs which will be used is that of ‘opportunity’ or ‘alternative’ cost. The cost of doing anything consists of the receipts which could have been obtained if that particular decision had not been taken. When someone says that a particular course of action is ‘not worth the cost’, this merely means that he prefers some other course -the receipts of the individual, whether monetary or non-monetary, will be greater if he does not do it. This particular concept of costs would seem to be the only one which is of use in the solution of business problems, since it concentrates attention on the alternative courses of action which are open to the businessman. Costs will only be covered if he chooses, out of the various courses of action which seem open to him, that one which maximizes his profits. To cover costs and to maximize profits are essentially two ways of expressing the same phenomenon. In practice it is probably better to regard the cost of doing anything as the highest alternative receipts that might have been obtained rather than vaguely as all the alternatives that are open.

Having explained the meaning of the concept of ‘opportunity’ or ‘alternative’ cost, I now turn to the question of its application to the solution of business problems. It will be assumed that an attempt is being made to calculate the minimum price at which it pays to accept a particular job. This minimum price is, of course, the total avoidable cost of that job. In working out this total avoidable cost, the calculation of the cost items, materials, depreciation, and interest on capital will be considered as examples of the use of the ‘opportunity’ -cost concept in the solution of such a problem. Much that I have to say may appear obvious, but it is necessary to secure agreement on simple matters before proceeding to consider more complex questions.

If the contract were not carried out and the materials were sold, the figures of receipts and payments would then be as shown in Table 5.4.

A point that does not need much emphasizing is that the cost-accounting methods for the pricing of materials which were discussed earlier do not give one the ‘opportunity’ cost of materials. Most of the methods—for example, the use of the price of the oldest stock or of an average price paid for materials in stock—are determined by past payments or payments which have been agreed upon in the past. As we have seen, there is no reason for supposing that the price one has paid for materials, or a figure derived from a calculation based on the prices one has paid, will give one the ‘opportunity’ cost of using materials. Even the method by which materials are charged out at market prices, and which implies a break with the idea that cost calculation must be linked up with payments, is unsatisfactory. On the one hand it ignores the expenses involved in reselling materials one has purchased—expenses which may be quite considerable; on the other hand it does not take into account the value of the materials if used for some other job. I do not wish to suggest that there may not be many purposes which are served admirably by modern cost-accounting methods. My sole aim in this section is to point out that these methods do not give one ‘opportunity’ costs and do not enable one to calculate avoidable costs. This being so, it seems to me that any claim that modern cost accounting (at any rate in the form in which it is to be found in the textbooks) enables unprofitable lines to be discovered and eliminated is misleading. It is only possible to discover whether or not a particular activity is profitable by comparing the avoidable costs with the receipts. And this, as I understand it, is a task which modern cost-accounting methods do not enable one to perform.

Let us now return to our problem. The choice between using or not using a machine, or between using a machine for one purpose and using it for another, will be influenced by the effect such uses have on future payments and receipts. It is possible to calculate the present value of future receipts and payments by discounting them by a rate of interest, a process that I have already described. The cost which we are considering is measured by the change in the present value of an asset which results from use. Examples of this cost can easily be found. If a machine is used in the present instead of leaving it idle, it may well be that its life is shortened. This means that profits that would have been earned at the end of its life will now no longer be received. This loss of profits in the future through the use of a machine in the present is a cost of using the machine which must be taken into account. Similarly the increased use of a machine may imply higher costs of maintenance in the future, or may render the machine unsuitable for purposes which otherwise it would have served and thus raise costs and/or lower receipts on jobs on which it is employed. These are examples of depreciation through use. It is clear that this cost is dependent on estimates of the future. Since, however, the future is uncertain, the allowance that will be made for this factor will be partially dependent on the attitude to risk-taking of the businessman. Although it will to some extent depend on subjective factors, depreciation through use is a cost which will have to be taken into account in calculating ‘opportunity’ cost.

The fact which Mr Paish brings out, namely that in the case of a mine an increase in output will reduce future receipts, is one which has to be taken into account when output policy is being considered. A numerical example is bound to be somewhat of a simplification, but it may clarify the argument. We shall suppose that we are considering the output to be produced from a given mine. One assumption that will be made is that each additional ton produced in the current year reduces the output that can be produced in the tenth year by one ton. The net receipts from production in the tenth year accrue at the end of that year. We shall also assume that the estimates that are made are regarded with certainty. Marginal cost may be taken to be the cost of an additional ton and marginal receipts the receipts from the sale of an additional ton (see Table 5.5).

Before proceeding to consider the more fundamental question, we must take account of those technical problems which have made many writers on cost accounting decide on the exclusion of interest from their calculations. First of all there is the belief that if interest is to be included it will not be possible to do so within the framework afforded by double-entry book-keeping. This if I understand him right, is the view of Mr W. W. Bigg. He says:

A subsidiary objection to the inclusion of interest as a cost, which seems connected with the point we have just discussed, is that cost accounts should deal with actual money payments. It may, of course, be true that cost accounts in fact only deal with actual money payments; it may even be true that the particular technique employed is incapable of any modification to enable interest to be included. What it does not determine is whether interest is a cost. It is also said that to include interest on capital (when this is not paid to someone outside the business) would mean anticipating profits in the valuation of stocks. There seems, however, to be no reason why the procedure adopted for the valuation of stocks should in any way depend on the answer given to the question we are examining.

I stated earlier that I would illustrate the ‘opportunity’-cost concept by considering the three items of cost, materials, depreciation and interest on capital. The ‘opportunity’ cost of using materials in stock we found to be either the price if sold minus the cost of selling, or the expense that would be avoided if the material were used on some other job. Depreciation considered as an ‘opportunty’ cost could be taken to be depreciation through use or the present value of the future profits lost through use. Interest on capital, if it is to be interpreted as ‘opportunity’ cost, must be regarded as the alternative net receipts that could be obtained by the use of the machinery.

Let us start with the piece-goods department. In the case of the particular department store we are considering, we may assume that it is one which attracts many customers to the store and that a most important result of closing down the piece-goods department would be that fewer customers come to the store. The effect of this is so great that in spite of the additional room that is available for display, it is estimated that the sales of all the remaining departments would fall. The estimated operating results if the piece-goods department were closed down are shown in Table 5.8.

It will be seen that the total sales would be £2,480 and the total expenses £2,420. The profits would therefore be £60. As the profits including the piece-goods department were £520, the profits resulting from having that department are £460.

The total expenses would be £2,500, while sales would amount to £2,590; a profit of £90 would be shown. The profits contributed by the men’s and women’s wear department would therefore seem to be £430.

The profit under these circumstances would be £35, since sales are estimated at £2,545 and expenses at £2,510. The furniture department therefore adds to profits a sum of £485.

And now we come to a consideration of the last department, the restaurant. The loss of this department would mean, it is estimated, a slight fall in the sales of the others. But it would also result in a large fall in general and miscellaneous expenses. The estimated figures after the close of the restaurant are set out in Table 5.11.

The profits in this case would be much higher; actually they would be £210. Sales would be £2,580 and expenses £2,370. The amount of the profits that seem to be attributable to the existence of the restaurant is £310.

A final example (Table 5.12) will, I hope, make this quite clear. suppose that we are examining a manufacturing business which is producing unbranded radios and refrigerators. We may also assume that sales would remain the same whether the production of these two products is combined or not.

The total of other expenses may be taken to be £2,500 if the manufacture of these two products is combined but £2,000 for each product if either of them is produced separately. Thus profits are £1,500 if manufacture is combined, but no profits at all would be earned if production were separate. How is it possible to say how much of the profits are contributed by each department? Without either of them there would be no profits. As will be seen from this example, the mere fact that one could discover the profits of a department if it were run as a separate business does not enable one, if there are economies in having several departments, to say how much is contributed to profits by each department if in fact they are combined within a single business.

It will perhaps indicate most clearly the nature of the approach to business problems discussed if emphasis is placed on its close connection with the making of decisions. The technique which has been examined is one which aims at aiding businessmen in making decisions. One can discuss the meaning of the term ‘avoidable costs’ but what costs
are avoidable and their actual measurement can only be determined with reference to a particular decision. It is for this reason that I dislike a classification of costs which divides them into ‘fixed’ and ‘variable’ costs—depreciation, interest on capital and the managing director’s salary being, for example, regarded as fixed costs while wages and the cost of materials are regarded as variable costs. Instead of speaking of fixed and variable costs, some writers use the terms overhead and prime costs while others distinguish between indirect and direct costs. The difficulty of using such a rigid classification is that whether a particular category of cost is likely to vary depends solely on the decision which is being taken. If the effect of enlarging a certain department is being considered, the costs that will prove to be variable are likely to be quite different from those that would vary if the introduction of a new product is being contemplated. It seems best therefore not to make any attempt to segregate costs into the classes ‘fixed’ and ‘variable’ but merely to try to discover what costs would be avoidable if a particular course of action were taken or, looking at the problem the other way round, what additional costs would be incurred if that action were carried out. The same procedure applies of course to receipts.

If the price of a 100-ton lot is £150, it is clear that for all amounts shown in the table, the total avoidable costs are less than the expense involved in buying these quantities on the open market. On the other hand, it would not be profitable to produce more than 1,200 tons, since, if 1,300 tons were produced, the extra 100 tons would have involved the business in additional expenses of £169 whereas the same quantity could be obtained for £150 by purchase on the open market.

One correspondent suggested that it would be preferable for the undertaking to produce that output at which average costs are at a minimum. If, however, the cost of purchasing additional units of output on the open market is grater than the costs of producing these units from the undertaking’s own mine, it seems clear that it will pay to expand production whatever happens to average costs.