Accounting versus Economic Costs
Accountants focus mainly on actual costs (though they disagree regarding how exactly to measure these costs). Actual costs are rooted in the actual, or historical, transactions and operations of a business. Accountants also determine budgeted costs for businesses that prepare budgets, and they develop standard costs that serve as yardsticks to compare with the actual costs of a business.
Other concepts of cost are found in economic theory. You’ll encounter a variety of economic cost terms while reading The Wall Street Journal, as well as in many business discussions and deliberations. Don’t reveal your ignorance of the following cost terms:
Opportunity cost: The amount of income (or other measurable benefit) given up when you follow a better course of action. For example, say that you quit your $50,000 job, invest $200,000 you saved up, and start a new business. You earn $80,000 profit in your new business for the year. Suppose also that you would have earned 5 percent on the $200,000 (a total of $10,000) if you’d kept the money in whatever investment you took it from. So you gave up a $50,000 salary and $10,000 in investment income with your course of action; your opportunity cost is $60,000. Subtract that figure from what your actual course of action netted you — $80,000 — and you end up with a “real” economic profit of $20,000. Your income is $20,000 better by starting your new business, according to economic theory.
Marginal cost: The incremental, out-of-pocket outlay required for taking a particular course of action. Generally speaking, it’s the same thing as a variable cost. Marginal costs are important, but in actual practice managers must recover fixed (or nonmarginal) costs as well as marginal costs through sales revenue in order to remain in business for any extent of time. Marginal costs are most relevant for analyzing one-time ventures, which don’t last over the long term.
Replacement cost: The estimated amount it would take today to purchase an asset that the business already owns. The longer ago an asset was acquired, the more likely its current replacement cost is higher than its original cost. Economists are of the opinion that current replacement costs are relevant in making rational economic decisions.
For insuring assets against fire, theft, and natural catastrophes, the current replacement costs of the assets are clearly relevant. Other than for insurance, however, replacement costs are not on the front burners of decision-making — except in situations in which one alternative being seriously considered actually involves replacing assets.
Imputed cost: An ideal, or hypothetical, cost number that is used as a benchmark against which actual costs are compared. Two examples are standard costs and the cost of capital. Standard costs are set in advance for the manufacture of products during the coming period, and then actual costs are compared against standard costs to identify significant variances.
The cost of capital is the weighted average of the interest rate on debt capital and a target rate of return that should be earned on equity capital. The economic value added (EVA) method compares a business’s cost of capital against its actual return on capital, to determine whether the business did better or worse than the benchmark.
For the most part, these types of cost aren’t reflected in financial reports. They’re mentioned here to familiarize you with terms you’re likely to see in the financial press and hear on financial talk shows. Business managers toss these terms around a lot.