Measuring Cost of Production: Which Costs Matter?

Before we can analyze how firms minimize costs, we must clarify what we mean by cost in the first place and how we should measure it. What items, for example, should be included as part of a firm’s cost? Cost obviously includes the wages that a firm pays its workers and the rent that it pays for office space. But what if the firm already owns an

the firm spent two or three years ago (and can’t recover) for equipment or for research and development? We’ll answer questions such as these in the context of the economic decisions that managers make.

1. Economic Cost versus Accounting Cost

Economists think of cost differently from financial accountants, who are usually concerned with keeping track of assets and liabilities and reporting past perfor- mance for external use, as in annual reports. Financial accountants tend to take a retrospective view of the firm’s finances and operations. As a result account- ing cost—the cost that financial accountants measure—can include items that an economist would not include and may not include items that economists usually do include. For example, accounting cost includes actual expenses plus depreciation expenses for capital equipment, which are determined on the basis of the allowable tax treatment by the Internal Revenue Service.

Economists—and we hope managers—take a forward-looking view. They are concerned with the allocation of scarce resources. Therefore, they care about what cost is likely to be in the future and about ways in which the firm might be able to rearrange its resources to lower its costs and improve its profitability. As we will see, economists are therefore concerned with economic cost, which is the cost of utilizing resources in production. What kinds of resources are part of economic cost? The word economic tells us to distinguish between the costs the firm can control and those it cannot. It also tells us to consider all costs relevant to production. Clearly capital, labor, and raw materials are resources whose costs should be included. But the firm might use other resources with costs that are less obvious, but equally important. Here the concept of opportunity cost plays an important role.

2. Opportunity Cost

Opportunity cost is the cost associated with opportunities that are forgone by not putting the firm’s resources to their best alternative use. This is easi- est to understand through an example. Consider a firm that owns a build- ing and therefore pays no rent for office space. Does this mean the cost of office space is zero? The firm’s managers and accountant might say yes, but an economist would disagree. The economist would note that the firm could have earned rent on the office space by leasing it to another company. Leasing the office space would mean putting this resource to an alternative use, a use that would have provided the firm with rental income. This forgone rent is the opportunity cost of utilizing the office space. And because the office space is a resource that the firm is utilizing, this opportunity cost is also an economic cost of doing business.

What about the wages and salaries paid to the firm’s workers? This is clearly an economic cost of doing business, but if you think about it, you will see that it is also an opportunity cost. The reason is that the money paid to the workers could have been put to some alternative use instead. Perhaps the firm could have used some or all of that money to buy more labor-saving machines, or even to produce a different product altogether. Thus we see that economic cost and opportunity cost actually boil down to the same thing. As long as we account for and measure all of the firm’s resources properly, we will find that:

Economic cost  = Opportunity cost

While economic cost and opportunity cost both describe the same thing, the concept of opportunity cost is particularly useful in situations where alternatives that are forgone do not reflect monetary outlays. Let’s take a more detailed look at opportunity cost to see how it can make economic cost differ from account- ing cost in the treatment of wages, and then in the cost of production inputs. Consider an owner that manages her own retail toy store and does not pay her- self a salary. (We’ll put aside the rent that she pays for the office space just to simplify the discussion.) Had our toy store owner chosen to work elsewhere she would have been able to find a job that paid $60,000 per year for essentially the same effort. In this case the opportunity cost of the time she spends working in her toy store business is $60,000.

Now suppose that last year she acquired an inventory of toys for which she paid $1 million. She hopes to be able to sell those toys during the holiday season for a substantial markup over her acquisition cost. However, early in the fall she receives an offer from another toy retailer to acquire her inventory for $1.5 million. Should she sell her inventory or not? The answer depends in part on her business prospects, but it also depends on the opportunity cost of acquir- ing a toy inventory. Assuming that it would cost $1.5 million to acquire the new inventory all over again, the opportunity cost of keeping it is $1.5 million, not the $1.0 million she originally paid.

You might ask why the opportunity cost isn’t just $500,000, since that is the difference between the market value of the inventory and the cost of its acquisi- tion. The key is that when the owner is deciding what to do with the inventory, she is deciding what is best for her business in the future. To do so, she needs to account for the fact that if she keeps the inventory for her own use, she would be sacrificing the $1.5 million that she could have received by selling the inventory to another firm.1

Note that an accountant may not see things this way. The accountant might tell the toy store owner that the cost of utilizing the inventory is just the $1 mil- lion that she paid for it. But we hope that you understand why this would be misleading. The actual economic cost of keeping and utilizing that inventory is the $1.5 million that the owner could have obtained by instead selling it to another retailer.

Accountants and economists will also sometimes differ in their treatment of depreciation. When estimating the future profitability of a business, economists and managers are concerned with the capital cost of plant and machinery. This cost involves not only the monetary outlay for buying and then running the machinery, but also the cost associated with wear and tear. When evaluating past performance, cost accountants use tax rules that apply to broadly defined types of assets to determine allowable depreciation in their cost and profit calcu- lations. But these depreciation allowances need not reflect the actual wear and tear on the equipment, which is likely to vary asset by asset.

3. Sunk Costs

Although an opportunity cost is often hidden, it should be taken into account when making economic decisions. Just the opposite is true of a sunk cost: an expenditure that has been made and cannot be recovered. A sunk cost is usually visible, but after it has been incurred it should always be ignored when making future economic decisions.

Because a sunk cost cannot be recovered, it should not influence the firm’s decisions. For example, consider the purchase of specialized equipment for a plant. Suppose the equipment can be used to do only what it was originally designed for and cannot be converted for alternative use. The expenditure on this equipment is a sunk cost. Because it has no alternative use, its opportunity cost is zero. Thus it should not be included as part of the firm’s economic costs. The decision to buy this equipment may have been good or bad. It doesn’t matter. It’s water under the bridge and shouldn’t affect current decisions.

What if, instead, the equipment could be put to other use or could be sold or rented to another firm? In that case, its use would involve an economic cost—namely, the opportunity cost of using it rather than selling or renting it to another firm.

Now consider a prospective sunk cost. Suppose, for example, that the firm has not yet bought the specialized equipment but is merely considering whether to do so. A prospective sunk cost is an investment. Here the firm must decide whether that investment in specialized equipment is economical—i.e., whether it will lead to a flow of revenues large enough to justify its cost. In Chapter 15, we explain in detail how to make investment decisions of this kind.

As an example, suppose a firm is considering moving its headquarters to a new city. Last year it paid $500,000 for an option to buy a building in the city. The option gives the firm the right to buy the building at a cost of $5,000,000, so that if it ultimately makes the purchase its total expenditure will be $5,500,000. Now it finds that a comparable building has become available in the same city at a price of $5,250,000. Which building should it buy? The answer is the origi- nal building. The $500,000 option is a cost that has been sunk and thus should not affect the firm’s current decision. What’s at issue is spending an additional $5,000,000 or an additional $5,250,000. Because the economic analysis removes the sunk cost of the option from the analysis, the economic cost of the original property is $5,000,000. The newer property, meanwhile, has an economic cost of $5,250,000. Of course, if the new building costs $4,900,000, the firm should buy it and forgo its option.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.