The empirical findings presented in the previous section suggest that our standard (orthodox) models of how firms behave and what determines prices are not appropriate for understanding today’s economies.  Choosing the profit maximizing level of output does not appear to be relevant to firm behavior.  Likewise, frequent price adjustments ‘in the market’ are not characteristic of most real-world markets, in which prices are clearly determined by producers and maintained over relatively long periods of time.  All of this suggests that a deeper look into the actual nature of firms’ costs and the actual manner in which prices are determined is necessary.  Fortunately, ample information about these processes is available, and it comes from the costing practices of accountants and the pricing practices of management.

Costing is the process of estimating the costs of production before production actually takes place–and, hence, before the actual costs of production are known with certainty.  To do this, of course, it would be necessary to have some idea of how much output the business will be producing and selling as well as the direct and indirect expenses that will be involved at that level of production. Making such calculations may be a matter of a simple, educated guess, or it may involve a sophisticated process of research, experiment, and forecasting.  What is important, from a theoretical standpoint, is that it is a fundamentally uncertain task which takes place before exchanges occur in the market. This view is consistent with what was suggested above, that firms plan their production processes ahead of time, a topic discussed further in chapter “The Megacorp.”

Depreciation and the Going Concern

A complete review of cost accounting isn’t necessary here, but one particular type of cost, depreciation, is of particular historical and conceptual significance.  Depreciation is a way of accounting for the expense of an asset–say, a machine press–over the life of the asset, rather than solely at the time it was purchased.  For instance, suppose your machine shop purchases a press (a machine that does exactly what it sounds like it does) for $20,000.  If you expect that the press will be in use for the next 4 years before it wears out or becomes obsolete you might account for a depreciation expense of $5,000 per year for the next 4 years.

To understand the significance of depreciation, consider how businesses usually calculated income before the late 1800s.  Before then, business enterprise was often treated as a terminal venture, having a clearly defined beginning and end date.  Investors would pool money to start a business, purchase materials and capital (say, local goods to be traded abroad), and contract for a ship and its crew to transport the cargo.  At some predetermined date (perhaps when the ship returned to port) the business would be liquidated: its crew would be paid and any remaining assets would be sold off.  The resulting profit to the investors would, in essence, simply be whatever money was leftover.  In this approach, what was the relationship between the asset (the cargo) and profit?

Profits were simply decreased by the cost of cargo as well as the ship and its crew.

But, accountants in the 1800s asked: is that an appropriate way to think of, say, a railroad company?  Will a railroad lay thousands of miles of line (one of its assets), run trains across it for some predetermined number of years, and then pull up the line to be sold for scrap metal?  Clearly not.  Instead, fixed assets like a railroad’s line (or an airline’s planes, or a commercial property owner’s office building, and so on) are depreciated over the course of their useful life.  Conceptually, this is simply the recognition of the role those assets play in allowing these businesses to generate an income into the foreseeable future.  Most importantly, this accounting method reflects the fact that these businesses are not treated as terminal ventures.  Rather, they are, as are nearly all businesses today, considered going concerns, organizations which are expected to continue to exist into the foreseeable future.

Cash Basis versus Accrual Accounting

To better understand the accounting practice of depreciation and its significance for how businesses operate, let’s go back to the machine shop mentioned above. We’ll do some simplified accounting to see how this business is doing over time. (The actual bookkeeping that you might learn in an accounting class would, of course, be more complex, but the basic concepts covered here are the same.)

Below we’ll look at information from the simplified income statements for this business. An income statement, also known as a profit and loss (or P & L) statement, shows the revenues, costs, and profit of a business for a particular period of time. Figure 1 tabulates the pertinent information for 8 years.

Notice in the above table that revenues and labor costs are constant through the eight years given. This appears to be a very stable business. Yet, when looking at the machine press, which must be replaced every four years, it becomes clear that how we account for that expense makes a big difference for how profit is reported. If that cost is accounted for according to a traditional cash basis, the full cost is reported in the year the machine was actually purchased. As a result the profit for those years is significantly negative (a loss of $12,000).  But in the three years that follow, the business enjoys the use of a ‘free’ machine press, which allows it to post a considerable profit ($8,000).

From the perspective of a small businessperson this wild fluctuation in profits from year to year may not be a major problem. She may simply recognize that some years will show losses that are ultimately necessary to keep the shop operating going forward and she’ll keep cash on hand to pay for these periodic replacements and upgrades. (To see how bank loans fit into this sort of scenario from a heterodox perspective, see section “How Banks Create Money” in Chapter “Money and Banking“.) But, historically and for modern complex enterprises, such an approach to bookkeeping can be problematical. For instance, investors, who typically don’t concern themselves with the physical necessities of operating the business, are likely to see a year of losses as an indication of a failing business, rather than the normal investments necessary to keep the plant running. And they may also look at subsequent years of high profits as justifying higher dividends, rather than as profits catching up from the previous loss.

Accrual accounting fixes these and related issues. A basic principle of accrual accounting is to match in time the revenues brought in with the costs involved in creating those sales. In our example, the machine press is being used to produce goods over a period of four years. From an accrual accounting perspective, then, it would be inappropriate to recognize the entire cost of the press in the year it was purchased when sales stemming from the production done by that machine are taking place over an additional three years. Depreciation, which here simply means recognizing a quarter of the cost of the press over each of the four years, allows the business to better match the costs the business is paying out through time with the revenues it’s bringing in.

You’ll notice that the last two columns in Table 1, above, show the stability of accrual accounting’s approach to reporting profit as compared to a cash basis approach.  As was noted earlier, this is a very stable business, with the exact same revenues and the exact same labor costs every year (we can imagine that they even have the exact same volume of sales every year). This is true regardless of the accounting method used, but it’s only with accrual accounting that the all-important ‘bottom line’—that is, profit—reflects this stability.

And stability is the name of the game for businesses operating as going concerns, as almost all modern businesses are. Of course, current accounting practices are much more complex than what you’ve learned above—we could add here accounts receivable and billable, and a host of other basic concepts—but there is a more important, if more abstract, lesson here: costs (as well as revenues) are not a given thing; they are created, in part according to certain accounting principles developed only in the last couple of centuries. And those principles reflect not a system for computing on a day-to-day basis the maximum profits possible, but rather the general requirements of transparently reporting the health of the enterprise as a going concern.

Socially Recognized Costs

Before moving on to pricing, a final note must be made about costs. As you’ve learned in this section, how costs are understood depends on the accounting standards in use, which are themselves a reflection of the historical needs of business. But looking past those particular needs, we can see that what does and does not count as a cost in the first place is a reflection of broader social norms and history.

For instance, the cost of the energy needed to manufacture a pickup truck will be recognized on the books (that is, the accounting) of the manufacturer. That cost will reflect in part the inputs into the production of the energy, including, often, coal or natural gas. The costs incurred by those who suffer the consequences of the resulting pollution, however, may not show up on anyone’s books. Indeed, to the extent that these processes cause long-term and potentially irreversible changes to the Earth’s climate, it’s not unlikely that these particular costs will be borne by people who aren’t even alive yet.

But they are costs, nonetheless, just not ones businesses account for. This subject is covered in more detail in chapter “Sustainability and Social Costs”. For now it is worth emphasizing that the cost curves we deal with in this chapter don’t necessarily reflect the actual full costs of the production processes under consideration. Instead, we look here only at those costs that the business enterprise recognizes in its accounting. Costs that people outside of the business incur, or that otherwise simply aren’t considered a money expense to the business, aren’t a problem for the business; and we can expect managers to ignore them when making their decisions. Indeed, we could go further and argue that often managers actively seek to shift costs off of the business itself and onto others, whether they be other groups in the community, people in other places, or future generations.

Glossary

Costing

the process of estimating the costs of production before production actually takes place

Depreciation

a way of accounting for the expense of an a tangible asset like a machine over the life of the asset

Going concern

an organization which is expected to continue to exist into the foreseeable future

Income statement

one of the basic financial statements of a business, showing its revenues and expenses

Terminal venture

a form of business enterprise having a clearly defined beginning and end date