Preface

The purpose of this book is to help managers make better decisions. Balance sheets and income statements reflect the results of past decisions. They do not evaluate individual decisions, nor do they provide definitive insights into decisions the firm may undertake in the future. But maximizing the value of the firm only occurs if each individual decision adds to its profits. Therefore, the manager must focus on the revenues and costs that will change if a decision is implemented.

Take, for example, a simple pricing decision. A manager is asked to quote a price to a prospective customer who may purchase up to three units. He realizes that if his quote is too high, he will lose the order to a competitor. If his quote is too low, the profit from the transaction may be inadequate. The firm could even incur a loss if the quote is too low. To make the proper quote, the manager may rely on prices quoted on previous orders or the prices quoted by competing firms on lost orders. The manager must also consult unit cost estimates passed along by cost accountants.

Let’s assume that the unit cost estimate is $700. The manager logically assumes that each unit of output costs $700 to produce. Hence, the manager could not quote a price below $700 without incurring a loss. But in a recent request for proposal, the unit cost estimate was also $700 and the firm lost the order to a competitor that quoted $680. How could that have happened? Is the competitor more efficient? Does it have a cheaper supplier of raw materials? Is it incurring a short-term loss as part of a larger strategic initiative? Or is it simply guilty of bad decision making?

Perhaps the fault lies with the cost accountant? He has an accounting degree, but maybe he’s careless. Is he allocating costs improperly, causing the firm to lose orders?

In all likelihood, the competitor is not more efficient, does not have a cheaper supplier, and is not incompetent. Nor is cost accounting likely to be the source of the problem. The cost accountant is probably using widely accepted practices and there is nothing inherently suspect in the numbers. Furthermore, it is quite likely that the manager from the competing firm has unit cost estimates that are very nearly the same as this firm. So what gives?

The answer may be embedded in economic theory. Economic theory provides insights that can help a manager make better decisions. Consumer choice theory describes the underpinnings of demand, which is the essence of pricing and purchasing behavior. Under what circumstances does the manager need to match the competitor’s price? Is it possible to land the order with a price that is higher than those quoted by competitors? When can the firm undercut the competitor’s price and still lose the order? Similarly, production and cost theory provide the basis for understanding unit cost. If the unit cost estimate is $700, is it logical to assume that each unit costs $700 to produce?

One major insight that emanates from economic theory is that unit cost estimates do not necessarily reflect the actual cost of each individual unit. This does not imply that the cost accountant has done anything wrong or that a new method of accounting would provide more accurate estimates. Rather, economic theory suggests that each unit of output has its own unique cost: the cost of producing the first unit differs from the cost of producing the second unit, which differs from producing the 1,276th unit. It would be prohibitively expensive, and in fact, it may be impossible for cost accounting to adopt a method that would accurately measure the cost of producing each individual unit. For this reason, cost accounting methods estimate average unit costs over ranges of output as the best available estimate for the cost of an individual unit.

But if the unit cost estimate is an average, is it possible that the actual unit cost figure is higher or lower than the estimated figure? This is clearly important because the manager relies on these estimates in quoting a price in our example. If the difference between the estimated and actual unit costs was due to random error, the manager could still rely on them because the actual unit cost is equally likely to be underestimated or overestimated.

In fact, however, unit costs are expected to follow patterns described by economic theory. This could result in unit cost estimates that systematically over- or underestimate actual unit cost over a given range of production. This can best be shown by going back to our original example. Recall that a prospective customer is considering purchasing up to three units and wants the manager to quote a price. Cost accounting supplies a unit cost estimate of $700, so the manager sets a price of $750. This implies a profit of $50/unit, or a total profit of $150.

But suppose theory suggests that the cost of producing each individual unit is rising. Specifically, the cost of producing the first unit is $600, the cost of producing the second unit is $700, and the cost of producing the third unit is $800. The cost accountant was correct in asserting that the average cost of producing three units is $700. But the manager incorrectly inferred that each unit costs $700 to produce. Consequently, the firm spent $800 to produce the third unit while selling it for only $750. Again, our contention is not that the cost accountant erred, or that there is a better way to estimate unit costs. Rather, because it is impossible to devise a system that accurately imputes the cost of producing individual units, the cost accountant did the next best thing: supplying a unit cost estimate that is, in fact, an average. Nonetheless, the manager’s failure to reconcile unit cost estimates with the economic theory of cost resulted in underpricing the third unit.

Suppose unit cost is constant across all three units. If this is the case, the manager can quote a price of $750 without fear of underpricing. But we stated that the firm lost the order to a competitor that quoted $680. Does the competitor have lower unit costs or is it destined to lose money at the winning quote? Quite conceivably, the answer is neither. Assume both firms have identical cost structures. The manufacturing plants for both firms produce multiple goods and the respective cost accountants follow the common practice of allocating the production supervisor’s salary as part of the unit cost estimate. Suppose the allocated salary comprises $50 of the unit cost estimate. What happens to the plant supervisor’s salary if the firm gets the order? Presumably, nothing. If not, then if the firm lands the order, its expenses will rise by $650/unit, not $700/unit. This means the firm that quoted a price of $680 made the right decision, and the manager who was reluctant to quote a price below $700 for fear of losing money missed out on a chance to land a profitable order.

This book was co-authored by an economist and an accountant to fill a perceived gap in most managerial economics and managerial accounting textbooks. Few economists are schooled in cost accounting. Managerial economics textbooks invariably assume that managers know the cost of producing each and every unit. But they don’t, and it’s unrealistic to assume that they do. At the same time, few accounting textbooks teach the economic theory of cost. Most texts concentrate on implementation: how to estimate unit cost using commonly accepted methods. The fact that it is impossible for the unit cost estimates to accurately reflect actual unit cost is rarely mentioned; yet it is critical to managerial decisions.

This is the niche that our book seeks to fill. Managers need to make decisions that will increase the firm’s profits. In doing so, the manager must anticipate the amount by which revenues will rise if the decision is implemented as well as the amount by which costs will increase. These are referred to as relevant revenues and relevant costs. Economic theory provides valuable insights that will help managers anticipate relevant revenues and costs. Moreover, theory helps to reconcile the economic theory of cost with the inherently imperfect estimates supplied by cost accounting. Different cost accounting methods provide different unit cost estimates and can bias decision making in different ways. Anticipating the difference between the unit cost estimate and actual unit cost can lead to better decisions.

Who should read this book? Our primary target audience is business managers who make decisions that utilize unit cost estimates. They must understand various cost accounting methods and the economic theory of cost and anticipate the likely difference between estimated and actual unit cost. They need to know how misunderstanding the unit cost estimate may lead to poor decisions.

A secondary target audience consists of practicing cost accountants. This is not a “how-to-do-it” accounting text. We assume that accountants who purchase this book already know how to implement absorption, variable, or activity-based costing. However, this book lends unique insights as to how cost accounting practices result in estimates that differ from the numbers they seek to measure.