4. Cost Accounting
In the calculation of the entrepreneur, costs are the amount of money required for the procurement
of the factors of production. The entrepreneur is intent upon embarking upon those business
projects from which he expects the highest surplus of proceeds over costs, and upon shunning
Projects from which he expects a lower amount of profit or even a loss.
In doing this, he adjusts his effort to the best possible satisfaction of the needs of
the consumers.
The fact that a project is not profitable because costs are higher than proceeds is
the outcome of the fact that there is a more useful employment available for the factors
of production required.
There are other products in the purchase of which the consumers are prepared to allow
for the prices of the factors of production required, but the consumers are not prepared
to pay these prices in buying the commodity the production of which is not profitable.
Cost accounting is affected by the fact that the two following conditions are not always
present.
First, every increase in the quantity of factors expended for the production of a consumer's
good increases its power to remove uneasiness.
Second, every increase in the quantity of a consumer's good requires a proportional
increase in the expenditure of factors of production, or even a more than proportional
increase in their expenditure.
If both these conditions were always and without any exception fulfilled, every increment Z
expended for increasing the quantity M of a commodity G would be employed for the satisfaction
of a need viewed as less urgent than the least urgent need already satisfied by the quantity
M available previously.
At the same time, the increment Z would require the employment of factors of production to
be withdrawn from the satisfaction of other needs, considered as more pressing than those
needs whose satisfaction was foregone in order to produce the marginal unit of M. On the
one hand, the marginal value of the satisfaction derived from the increase in the quantity
and the availability of G would drop.
On the other hand, the costs required for the production of additional quantities of
G would increase in marginal disutility.
Factors of production would be withheld from employments in which they could satisfy more
urgent needs.
Production must stop at the point at which the marginal utility of the increment no longer
compensates for the marginal increase in the disutility of costs.
Now these two conditions are present very often, but not generally without exception.
There exist many commodities of all orders of goods whose physical structure is not homogeneous
and which are, therefore, not perfectly divisible.
It would, of course, be possible to conjure away the deviation from the first condition
One could say, half a motorcar is not a motorcar. If one adds to half a motorcar a quarter of
a motorcar, one does not increase the quantity available. Only the perfection of the process
of production, which turns out a complete car, produces a unit, and an increase in the
and the quantity available.
However, such an interpretation misses the point.
The problem we must face is that not every increase in expenditure increases proportionately
the objective use value, the physical power of a thing to render a definite service.
The various increments in expenditure bring about different results.
There are increments, the expenditure of which remains useless if no further increments of
a definite quantity are added.
On the other hand, and this is the deviation from the second condition, an increase in
physical output does not always require a proportionate increase in expenditure, or
even any additional expenditure.
It may happen that costs do not rise at all, or that their rise increases output more than
proportionately.
For many means of production are not homogeneous either, and not perfectly divisible.
This is the phenomenon known to business as the superiority of big-scale production.
The economists speak of the law of increasing returns, or decreasing costs.
We consider as Case A a state of affairs in which all factors of production are not perfectly
divisible in such a way that full utilization of the productive services rendered by every
further indivisible element of each factor requires full utilization of the further indivisible
elements of every other of the complementary factors.
Then, in every aggregate of productive agents, each of the assembled elements, every machine,
every worker, every piece of raw material, can be fully utilized only if all the productive
services of the other elements are fully employed too.
Within these limits, the production of a part of the maximum output attainable does not
require a higher expenditure than the production of the highest possible output.
We may also say that the minimum size aggregate always produces the same quantity of products.
It is impossible to produce a smaller quantity of products even if there is no use for a
part of it.
We consider as case B a state of affairs in which one group of the productive agents,
E is, for all practical purposes, perfectly divisible.
On the other hand, the imperfectly divisible agents can be divided in such a way that full
utilization of the services rendered by each further indivisible part of one agent requires
full utilization of the further indivisible parts of the other imperfectly divisible complementary
factors.
Then, increasing production of an aggregate of further indivisible factors, from a partial
to a more complete utilization of their productive capacity, requires merely an increase in the
quantity of P, the perfectly divisible factors.
However, one must guard oneself against the fallacy that this necessarily implies a decrease
in the average cost of production.
It is true that within the aggregate of imperfectly divisible factors, each of them is now better
utilized, that therefore costs of production as far as they are caused by the cooperation
of these factors remain unchanged, and that the quotas falling to a unit of output are
decreasing.
But on the other hand, an increase in the employment of the perfectly divisible factors
The values of production can be attained only by withdrawing them from other employments.
The value of these other employments increases, other things being equal, with their shrinking.
The price of these perfectly divisible factors tends to rise, as more of them are used for
the better utilization of the productive capacity of the aggregate of the not further divisible
factors in question.
One must not limit the consideration of our problem to the case in which the additional
quantity of P is withdrawn from other enterprises producing the same product in a less efficient
way and forces these enterprises to restrict their output.
It is obvious that in this case, competition between a more and a less efficient enterprise
producing the same article out of the same raw materials, the average cost of production
Education is decreasing in the expanding plant. A more general scrutiny of the problem leads
to a different result. If the units of P are withdrawn from other employments in which
they would have been utilized for the production of other articles, there emerges a tendency
toward an increase in the price of these units. This tendency may be compensated by accidental
Finally, we consider, as case C, a state of affairs in which the various imperfectly
divisible factors of production can be divided only in such a way that, given the conditions
of the Market, any size which can be chosen for their assemblage in a production aggregate
does not allow for a combination in which full utilization of the productive capacity
of one factor makes possible full utilization of the productive capacity of the other imperfectly
divisible factors.
This case C alone is of practical significance.
How the cases A and B hardly play any role in real business.
The characteristic feature of case C is that the configuration of production costs varies
unevenly.
If all imperfectly divisible factors are utilized to less than full capacity, an expansion of
production results in a decrease of average costs of production, unless a rise in the
The prices to be paid for the perfectly divisible factors counterbalances this outcome.
But as soon as full utilization of the capacity of one of the imperfectly divisible factors
is attained, further expansion of production causes a sudden sharp rise in costs.
Then again, a tendency toward a decrease in average production costs sets in and goes
is on working until full utilization of one of the imperfectly divisible factors is attained
anew.
Other things being equal, the more the production of a certain article increases, the more factors
of production must be withdrawn from other employments in which they would have been
used for the production of other articles.
Hence, other things being equal, average production costs increase with the increase in the quantity
The Planning Entrepreneur is always faced with the question, to what extent are the
To what extent will the anticipated prices of the products exceed the anticipated costs?
If the entrepreneur is still free with regard to the project in question because he has
not yet made any inconvertible investments for its realization, it is average costs that
count for him.
But if he has already a vested interest in the line of business concerned, he sees things
is from the angle of additional costs to be expended.
He who already owns a not fully utilized production aggregate does not take into account average
cost of production, but marginal cost.
Without regard to the amount already expended for inconvertible investments, he is merely
interested in the question whether or not the proceeds from the sale of an additional
and the quantity of products will exceed the additional cost incurred by their production.
Even if the whole amount invested in the inconvertible production facilities must be wiped off as
a loss, he goes on producing, provided he expects a reasonable surplus of proceeds over
current costs.
Reasonable means in this connection that the anticipated returns on the convertible capital
are at least not lower than the anticipated returns on its use for other projects.
With regard to popular errors, it is necessary to emphasize that if the conditions required
for the appearance of monopoly prices are not present, an entrepreneur is not in a position
to increase his net returns by restricting production beyond the amount conforming with
with Consumers Demand, but this problem will be dealt with later in Section 6.
That a factor of production is not perfectly divisible does not always mean that it can
be constructed and employed in one size only.
This of course may occur in some cases, but as a rule it is possible to vary the dimensions
of These Factors. If out of the various dimensions which are possible for such a factor, for
example, a machine, one dimension is distinguished by the fact that the costs incurred by its
production and operation are rendered lower per unit of the productive services than those
for other dimensions, things are essentially identical. Then the superiority of the bigger
The bigger plant does not consist in the fact that it utilizes a machine to full capacity,
while the smaller plant utilizes only a part of the capacity of a machine of the same size.
It consists, rather, in the fact that the bigger plant employs a machine which operates
with a better utilization of the factors of production required for its construction and
Operation than does the smaller machine employed by the smaller plant.
The role played in all branches of production by the fact that many factors of production
are not perfectly divisible is very great.
It is of paramount importance in the course of industrial affairs.
But one must guard oneself against many misinterpretations of its significance.
One of these errors was the doctrine according to which in the processing industries there
prevails a law of increasing returns, while in agriculture and mining a law of decreasing
returns prevails.
The fallacies implied have been exploded above.
As far as there is a difference in this regard between conditions in agriculture and those
in the processing industries, differences in the data bring them about.
The immobility of the soil and the fact that the performance of the various agricultural
operations depends on the seasons make it impossible for farmers to take advantage of
the capacity of many movable factors of production to the degree which conditions in manufacturing
for the most part allow.
The optimum size of a production outfit in agricultural production is, as a rule, much
smaller than in the processing industries.
It is obvious, and does not need any further explanation, why the concentration of farming
cannot be pushed to anything near the degree obtaining in the processing industries.
However, the inequality in the distribution of natural resources over the earth's surface,
which is one of the two factors making for the higher productivity of the division of
labor puts a limit to the progress of concentration in the processing industries also.
The tendency toward a progressive specialization and the concentration of integrated industrial
processes in only a few plants is counteracted by the geographical dispersion of natural
resources.
The fact that the production of raw materials and foodstuffs cannot be centralized and forces
people to disperse over the various parts of the earth's surface enjoins also upon
the processing industries a certain degree of decentralization.
It makes it necessary to consider the problems of transportation as a particular factor of
production costs.
The costs of transportation must be weighed against the economies to be expected from
more thoroughgoing specialization.
While in some branches of the processing industries, the utmost concentration is the most adequate
method of reducing costs.
In other branches, a certain degree of decentralization is more advantageous.
In the servicing trades, the disadvantages of concentration become so great that they
almost entirely overweigh the advantages derived.
Then a historical factor comes into play.
In the past, capital goods were immobilized on sites on which our contemporaries would
not have set them.
It is immaterial whether or not this immobilization was the most economical procedure to which
which the generations that brought it about could resort.
In any event, the present generation is faced with a fait accompli.
It must adjust its operations to the fact, and it must take it into account in dealing
with problems of the location of the processing industries.
Finally, there are institutional factors.
There are trade and migration barriers.
There are differences in political organization and methods of government between various countries.
Vast areas are administered in such a way that it is practically out of the question to choose them as a seat for any capital investment,
no matter how favorable their physical conditions may be.
Entrepreneurial cost accounting must deal with all these geographical, historical and institutional factors.
But even apart from them, there are purely technical factors limiting the optimum size of plants and firms.
The greater plant or firm may require provisions and procedures which the smaller plant or firm can avoid.
In many instances, the outlays caused by such provisions and procedures may be overcompensated by the reduction in costs
costs derived from better utilization of the capacity of some of the not perfectly divisible factors employed.
In other instances, this may not be the case.
Under capitalism, the arithmetical operations required for cost accounting and the confrontation of costs and proceeds
can easily be effected, as there are methods of economic calculation available.
However, cost accounting and calculation of the economic significance of business projects
under consideration is not merely a mathematical problem, which can be solved satisfactorily
by all those familiar with the elementary rules of arithmetic.
The main question is the determination of the money equivalents of the items which are
to enter into the calculation.
It is a mistake to assume, as many economists do, that these equivalents are given magnitudes
uniquely determined by the state of economic conditions.
They are speculative anticipations of uncertain future conditions, and as such depend on the
entrepreneur's understanding of the future state of the market.
The term fixed costs is also in this regard somewhat misleading.
Every action aims at the best possible supplying of future needs.
To achieve these ends, it must make the best possible use of the available factors of production.
However, the historical process which brought about the present state of factors available
is beside the point.
What counts and influences the decisions concerning future action is solely the outcome of this
This Historical Process, The Quantity and the Quality of the Factors Available Today.
These factors are appraised only with regard to their ability to render productive services
for the removal of future uneasiness.
The amount of money spent in the past for their production and acquisition is immaterial.
It has already been pointed out that an entrepreneur who by the time he has to make a new decision
has expended money for the realization of a definite project, is in a different position
from that of a man who starts afresh.
The former owns a complex of inconvertible factors of production which he can employ
for certain purposes.
His decisions concerning further action will be influenced by this fact.
But he appraises this complex not according to what he expended in the past for its acquisition.
He appraises it exclusively from the point of view of its usefulness for future action.
The fact that he has spent more or less for its acquisition is insignificant.
This fact is only a factor in determining the amount of the entrepreneur's past losses or profits and the present state of his fortune.
It is an element in the historical process that brought about the present state of the
supply of factors of production, and as such it is of importance for future action.
But it does not count for the planning of future action and the calculation regarding
such action.
It is irrelevant that the entries in the firm's books differ from the actual price of such
Inconvertible Factors of Production
Of course, such consummated losses or profits may motivate a firm to operate in a different
way from which it would if it were not affected by them.
Past losses may render a firm's financial position precarious, especially if they bring
about indebtedness and burden it with payments of interest and installments on the principal.
However, it is not correct to refer to such payments as a part of fixed costs.
They have no relation whatever to the current operations.
They are not caused by the process of production, but by the methods employed by the entrepreneur
in the past for the procurement of the capital and capital goods needed.
They are only accidental with reference to the going concern.
But they may enforce upon the firm in question a conduct of affairs which it would not adopt
if it were financially stronger.
The urgent need for cash in order to meet payments due does not affect its cost accounting,
but its appraisal of ready cash as compared with cash that can only be received at a later
day.
It may impel the firm to sell inventories at an inappropriate moment, and to use its
It's durable production equipment in a way that unduly neglects its conservation for
later use.
It is immaterial for the problems of cost accounting whether a firm owns the capital
invested in its enterprise or whether it has borrowed a greater or smaller part of it and
is bound to comply with the terms of a loan contract, rigidly fixing the rate of interest
and the dates of maturity for interest and principal.
The costs of production include only the interest on the capital which is still existent and
working in the enterprise.
It does not include interest on capital squandered in the past by bad investment or by inefficiency
in the conduct of current business operations.
The task incumbent upon the businessman is always to use the supply of capital goods
now available in the best possible way for the satisfaction of future needs.
In the pursuit of this aim he must not be misled by past errors and failures, the consequences
of which cannot be brushed away.
A plant may have been constructed in the past which would not have been built if one had
better forecast the present situation.
It is vain to lament this historical fact.
The main thing is to find out whether or not the plant can still render any service, and,
if this question is answered in the affirmative, how it can be best utilized.
It is certainly said for the individual entrepreneur that he did not avoid errors.
The losses incurred impair his financial situation.
They do not affect the costs to be taken into account in planning further action.
It is important to stress this point because it has been distorted in the current interpretation
and justification of various measures.
One does not reduce costs by alleviating some firm's and corporation's burden of debts.
A policy of wiping out debts, or the interest due on them totally or in part, does not reduce
costs.
It transfers wealth from creditors to debtors.
It shifts the incidence of losses incurred in the past from one group of people to another
group, for example, from the owners of common stock to those of preferred stock and corporate
bonds.
This argument of cost reduction is often advanced in favor of currency devaluation.
It is no less fallacious in this case than all the other arguments brought forward for
this purpose.
What are commonly called fixed costs are also the costs incurred by the exploitation of
the already available factors of production, which are either rigidly inconvertible or
can be adapted for other productive purposes only at a considerable loss.
These factors are of a more durable character than the other factors of production required,
but they are not permanent.
They are used up in the process of production. With each unit of product turned out, a part
of the machine's power to produce is exhausted. The extent of this attrition can be precisely
ascertained by technology and can be appraised accordingly in terms of money. However, it
is not only this money equivalent of the machine's wearing out which the entrepreneurial calculation
Man has to consider. The businessman is not merely concerned with the duration of the
machine's technological life. He must take into account the future state of the market.
Although a machine may still be technologically perfectly utilizable, market conditions may
render it obsolete and worthless. If the demand for its products drops considerably or disappears
all together, or if more efficient methods for supplying the consumers with these products
appear, the machine is economically merely scrap iron.
In planning the conduct of his business, the entrepreneur must pay full regard to the anticipated
future state of the market.
The amount of fixed costs which enter into his calculation depends on his understanding
of future events.
It is not to be fixed simply by technological reasoning.
The technologist may determine the optimum for a production aggregate's utilization.
But this technological optimum may differ from that which the entrepreneur, on the ground
of his judgment concerning future market conditions, enters into his economic calculation.
Let us assume that a factory is equipped with machines which can be utilized for a period
of Ten Years. Every year, ten percent of their prime costs is laid aside for depreciation.
In the third year, market conditions place a dilemma before the entrepreneur. He can
double his output for the year and sell it at a price which, apart from covering the
increase in variable costs, exceeds the quota of depreciation for the current year and the
and the present value of the last depreciation quota.
But this doubling of production trebles the wearing out of the equipment and the surplus
proceeds from the sale of the double quantity of products are not great enough to make good
also for the present value of the depreciation quota of the ninth year.
If the entrepreneur were to consider the annual depreciation quota as a rigid element for
For his calculation, he would have to deem the doubling of production as not profitable,
as additional proceeds lag behind additional cost.
He would abstain from expanding production beyond the technological optimum.
But the entrepreneur calculates in a different way, although in his accountancy he may lay
aside the same quota for depreciation every year.
Whether or not the entrepreneur prefers a fraction of the present value of the ninth
year's depreciation quota to the technological services which the machines could render him
in the ninth year depends on his opinion concerning the future state of the market.
Public opinion, governments and legislators, and the tax laws look upon a business outfit
as a source of permanent revenue.
They believe that the entrepreneur who makes due allowance for capital maintenance by annual
depreciation quotas will always be in a position to reap a reasonable return from the capital
invested in his durable producers' goods.
Real conditions are different.
A production aggregate such as a plant and its equipment is a factor of production whose
His usefulness depends on changing market conditions and the skill of the entrepreneur
in employing it in accordance with the change in conditions.
There is in the field of economic calculation nothing that is certain in the sense in which
this term is used with regard to technological facts.
The essential elements of economic calculation are speculative anticipations of future conditions.
Commercial usages and customs and commercial laws have established definite rules for accountancy
and auditing.
There is accuracy in the keeping of books.
But they are accurate only with regard to these rules.
The book values do not reflect precisely the real state of affairs.
The market value of an aggregate of durable producers' goods may differ from the nominal
figures the books show.
The proof is that the stock exchange appraises them without any regard to these figures.
Cost accounting is therefore not an arithmetical process which can be established and examined
by an indifferent umpire.
It does not operate with uniquely determined magnitudes which can be found out in an objective
way.
Its essential items are the result of an understanding of future conditions.
Necessarily always colored by the entrepreneur's opinion about the future state of the market.
Attempts to establish cost accounts on an impartial basis are doomed to failure.
Calculating costs is a mental tool of action, the purposive design to make the best of the
available means for an improvement of future conditions.
It is necessarily volitional, not factual.
In the hands of an indifferent umpire, it changes its character entirely.
The umpire does not look forward to the future.
He looks backward to the dead past and to rigid rules which are useless for real life
and action.
He does not anticipate changes.
He is unwittingly guided by the prepossession that the evenly rotating economy is the normal
and most desirable state of human affairs.
Profits do not fit into his scheme.
He has a confused idea about a fair rate of profit or a fair return on capital invested.
However, there are no such things.
In the evenly rotating economy, there are no profits.
In a changing economy, profits are not determined with reference to any set of rules by which
they could be classified as fair or unfair.
Profits are never normal.
Where there is normality, that is, absence of change, no profits can emerge.