Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Accounting Theory Main Page
| Relevant Cost Main Page
Accounting and economics may appear to include two separate sets of concepts related to cost and value, but according to Solomons there is only one set of concepts. Accounting concepts that are at odds with economics are suspect and are usually found to be flawed. However, rising price levels and the increasing complexity of management have caused the development of a wide range of concepts for a wide range of needs. Some of these concepts are more useful in economics while others are more useful in accounting. The purpose of this article is to discuss a number of concepts including: Historical cost, market value, value to the owner, replacement cost, opportunity cost, sunk cost, variable cost, fixed cost, incremental cost, user cost, cost of ownership, avoidable cost, and controllable cost.
The Relation of Cost to Value
A cost is a sacrifice usually made to secure benefits. Value represents the worth, or desirability of something. All cost are values, but not all values are costs. In some cases value may be created without incurring cost, e.g., when a piece of property becomes valuable as a result of a change in zoning laws. In other cases a cost is the best measure of value, e.g., the replacement cost of an asset. When a property is acquired, its cost is a measure of value to the acquirer, and in accounting, historical cost takes the place of value.
Historical Cost
Historical cost has a special position in accounting because of its' quality of objectivity, i.e., the idea that an exchange transaction provides objective, verifiable evidence of an established value. However, exceptions occur when assets are acquired through barter, or as part of a basket purchase. The case where assets are held to be converted into other assets presents another problem for historical cost. Because it is usually not possible to identify materials with a particular purchase, cost flow assumptions (fifo, lifo etc.) are used for attaching cost to inventories. There is nothing objective about these procedures. Another problem is presented by overhead costs. Many overhead cost have to be allocated to periods before they can be allocated to products, so the judgment and estimation involved dilutes the claim of objectivity. Historical cost is even less impressive as an objective measure in the case of joint products, i.e., those produced in farming or in the oil and gas industry. Using the cost principle (recording assets at historical cost) as a value measurement is based on the realization principle, i.e., that changes in the value of assets are not recorded until realized. Although the realization principle has been criticized by economists, the cost principle has remained an important concept in accounting. There are however alternatives to historical cost that should be examined.
Market Value
Market value is one challenger to historical cost although accountants have limited its use to the lower-of-cost-or-market rule for valuing inventories. The concept of market value is not as simple as it appears and is not synonymous with price. For example, the market value of assets is the amount of money that a particular quantity of assets can be exchanged under appropriately specified conditions. The conditions depend on geographic location, whether the transaction involves wholesalers, retailers, or final consumers, whether the transaction is cash or credit, includes free delivery, installation, or a guarantee. The market value of an asset also varies based on whether the transaction refers to the amount the asset can be sold for, or the cost to purchase it. The gap between these entry values and exit values may be large when buyers and sellers are not well informed.
In The Theory and Measurement of Business Income (1961) Edwards and Bell provide a theory of income measurement based on either input current entry values or output current exit values. The first method would use current cost at the accounting date of sale, not original cost of acquisition, but would retain valuation of assets at cost until they were sold. The second method would substitute realizable values for original cost, and realized profit would only reflect the value of converting inventories into salable profits rather than the combination of value gained by holding inventory as well as the value derived from the conversion process.
Value To The Owner
Historical cost represents the value of an asset at the moment the asset is acquired. But what value does this reflect? The "value to the owner" appears to be the logical answer, but it's not that simple. The value of an asset to its owner is "the adverse value of the entire loss, direct and indirect, that the owner might expect to suffer if he were to be deprived of the asset." "The value of an asset is the money-equivalent of its' service potentials." This is the sum of the future market prices of all the streams of service to be derived from its use, discounted to their present value. This concept of value is frequently difficult to implement and may be approximated by other value concepts. In a collection of complementary assets where each asset can be replaced separately, the upper limit on value is set by the cost of replacing an asset. The upper limit to value to the owner is an asset's replacement cost.
Replacement Cost as the Upper Limit
Although there are incidental cost associated with being deprived of an asset, replacement cost may be set as an upper limit on value to the owner. But determining replacement cost is not as simple as it might appear. Is replacement cost the cost of an equivalent used asset or the cost of a new asset? Is it the cost of a similar somewhat obsolete asset or the cost of a more modern version of the asset? The answer to both questions is that replacement cost is the minimum cost of replacing the stream of services provided by the asset that measures the loss by deprivation. Therefore the relevant replacement cost of a used asset is the cost of a new asset less an appropriate amount for depreciation of the old asset. If the cost of replacing the asset exceeds the discounted value of its expected future service potential, then the lower amount of discounted value determines the value to the owner.
The Lower Limit and Summary of Decisions Related to an Asset's Value to the Owner
Replacement cost sets the upper value to the owner while the asset's net realizable value sets the lower limit.
The relationships and related decisions can be summarized as follows where:
NRV = net realizable value of the asset.
PV =
present value of expected net receipts for the asset.
RC = replacement
cost of the asset.
VO = the asset's value to the owner.
1. If RC > NRV > PV the asset should be sold and VO = NRV.
2. If NRV > PV > RC the asset should be bought for resale as long as this relationship holds. In this case VO = RC.
3. If NRV < PV the asset should be held for use, not sold.
3a. If NRV < PV and PV > RC the asset should be replaced if lost. In this case VO = RC.
3b. If NRV < PV and PV < RC the asset should not be replaced if lost. In this case VO = PV.
Given NRV < PV, VO = RC or PV whichever is the lower.
Does Historical Cost Ever Represent Value to the Owner?
An underlying assumption of the view that historical cost measures value to the owner at the moment of acquisition is that no one would pay more for an asset than it was worth to them, and if they could purchase it for less than it was worth they would purchase more until the value of the marginal unit purchased was equal to its price. This assumption is true for assets that can be purchased in small units like bottles of wine. But there are many situations where assets have to be purchased in large units (blast furnaces or steam shovels) where the last unit purchased is worth more than it cost, although a further unit would be worth less. There are other situations where historical cost and the value to the owner may not be the same. For example where a purchaser is required to buy a package that contains items that he could do without.
How strong is the identity of historical cost and value to the owner at the time the asset is acquired? Is it enough to justify the use of historical cost as the principle basis of valuation in accounting? The longer an asset is held the more likely its' value will vary from its original cost. Does historical cost serve the purposes of accounting? From the perspective of accounting as a function of stewardship and primarily as a recording of past events, historical cost appears to be appropriate. But emphasizing these functions limits the usefulness of accounting and points out the serious limitations of historical cost. One author makes a distinction between embodied cost and displacement cost. Embodied cost includes the technical factors of production that go into producing a product. Displacement cost represents what is given up for something. Embodied cost is related to historical cost, while displacement cost refers to shutting out alternative opportunities.
Opportunity Cost
Displacement cost is a synonym for opportunity cost. The idea is that the cost of committing resources to a particular use is determined by the value of using the resources in their next best alternative. Opportunity cost is the highest alternative use value of resources used up or committed to a particular use. (See two examples adapted from Solomons example on page 128).
Is Opportunity Cost an Operational Concept?
Opportunity cost is an important concept in economics. For example, it is useful in explaining the relative prices of goods. However, some believe opportunity cost is of little use in decisions related to practical business problems because it involves circular reasoning. To rank alternatives one must know the opportunity cost, but to know the opportunity cost one must know the value of the next best alternative, and this requires ranking the alternatives. In many cases this is not a problem. Where there are a number of alternative uses for a collection of resources no cost is required. It is only necessary to compare the revenues from each possible use for them. But a cost is needed for decisions when certain resources involve a number of alternative uses and require a different set of other resources for each alternative use. In this case an opportunity cost is not needed for the common resources, only the noncommon resources. This allows opportunity cost to be applied in a noncircular manner.
The Determination of Opportunity Cost - Materials
Where resources that are used more or less when they are purchased at current prices, accounting cost (historical cost) and economic cost (opportunity cost) are often the same thing. Most labor cost, and a large percentage of materials cost fit this category. A second case is where materials are used from stock or where their prices are fixed based on long-term contracts. It is their value at the time of use rather than the current purchase price that represents their opportunity cost. In this case there are three possible uses for the materials. 1. Use for their intended purpose now or at a later date. 2. Use as a substitute for a different material. 3. Dispose of the materials in their unprocessed state. The most valuable of these alternatives determines their opportunity cost, i.e., their replacement cost or their net realizable value, whichever is greater. For example, the opportunity cost of using up the material now is equal to the discounted value of its expected future replacement cost, less the discounted value of the storage and carrying cost its retention would require.
The Opportunity Cost of Labor
The accounting cost and the opportunity cost of labor are usually the same thing since there can not normally be a time lag between the purchase and use of labor.
The Occupancy of Premises as an Opportunity Cost
The accounting cost of occupancy will only rarely adequately represent the opportunity cost of occupying industrial or commercial property. If buildings are owned there is no rent, and if a piece of property is rented, the amount may have been fixed under a lease in a previous year. If a property is not being used for its original purpose, the opportunity cost is the value to use it for some other activity or the amount it could generate from being rented. In some cases there are no alternative uses for a building because of its location, or because it was designed for a specific purpose, or a lease places restrictions on how it can be used. In these cases the opportunity cost of occupying the building is zero.
Opportunity Cost, Sunk Cost, and Fixed Cost
Occupancy cost are often sunk cost as in the case above in that they are unavoidable and therefore not relevant to decisions related to the use of the asset. The opportunity cost of a decision is limited to its variable or incremental cost. Fixed costs are irrelevant to decisions if a choice between two or more alternatives involves the same fixed costs.
User Cost
Long-lived assets lose value because they wear out or are used up, or decay through age or exposure, or simply become obsolete. Some of these losses in value result from owning them and some from using them. Net user cost is the difference made to the value of the firm's assets by the decision to produce one more unit of output. Holding an asset also includes the retainer cost of the asset, i.e., the opportunity cost of lost interest on an alternative investment as well as the loss resulting from obsolescence. Adding user cost to retainer cost provides the gross user cost.
User Cost and Accounting Depreciation
User cost can be divided into variable cost (net user cost) and fixed cost (retainer cost) but dividing accounting depreciation into variable and fixed components is not possible as long as it is limited to the function of writing off historical costs.
Cost of Ownership
Although part of retainer cost includes the loss of interest from the best alternative investment of the capital locked up in an asset, financial statements usually do not show any remuneration for the capital or services contributed by owners as expenses. In the decision to buy an asset, the interest that could otherwise be earned on the capital if invested in some other way is relevant. But once the decision is made, the interest on capital is not relevant because it will be the same however the asset is used, or if it is not used at all.
Cost Behavior
Marginal cost became an important concept in economics after the development of the theory of imperfect competition. Marginal cost is defined as the rate of change in total cost with respect to an infinitesimal change in the volume of output. Although marginal cost is very useful in developing microeconomic theory, accountants have not found it to be useful because the smooth and continuous cost curves of economic theory are not found in practice, and applying the concepts of single-product firms to the multidivisional multiproduct firms of the real world is not practical.
Accountants have identified direct cost with variable costs and indirect costs with fixed cost. They have also recognized that cost may be continuously variable, or discontinuously variable (i.e., jumps at certain critical levels of output), or may be wholly fixed at any level of output. Cost may also be traceable directly to a product, product group, or a function, department, division, or not traceable at all beyond the entire business, e.g., the president's salary. In some cases, variable cost are not traceable as in the case of joint products, e.g., refinery products.
Incremental and Avoidable Cost
The incremental cost of adding an activity is the difference between the cost to the firm from engaging in the activity or not engaging in the activity. If the activity is discontinued, the relevant cost is the avoidable cost since some of the incremental cost of adding it may not be avoided. Incremental cost includes both variable costs and traceable fixed costs.
Controllable Cost
Cost can also be classified according to the level of authority for the purposes of preparing flexible budgets and cost control. Controllable cost is a key concept in the area of responsibility accounting.
Conclusion
Solomons tells us that it seems improbable that there will be any fundamental future changes in the concepts of cost and value. But note this article was written several years before the development of activity-based costing, throughput costing, value stream costing, and other concepts related to the theory of constraints and lean accounting.
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Related summaries:
Hendriksen, E. S. 1977. The Methodology of Accounting Theory. Chapter 1. Accounting Theory. 3rd. ed. Richard D. Irwin, Inc. (Summary).
Leininger, W. E. 1977. Opportunity costs: Some definitions and examples. The Accounting Review (January): 248-251. (Summary and JSTOR link).
Martin, J. R. Not dated. Management accounting terminology. Management And Accounting Web. (Management Accounting Terminology).
Martin, J. R. Not dated. What is a business valuation? Management And Accounting Web. (Business Valuation).
Moonitz, M. 1961. The Basic Postulates of Accounting. Accounting Research Study No. 1. AICPA. (Contents and the 14 basic accounting postulates).
Oser, J. 1963. The Evolution of Economic Thought. Harcourt, Brace & World, Inc. See Wieser in Chapter 13. (Summary).