RECONCILING_COST_THEORY_WITH_COST_ACCOUNTING_PRACTICES

RECONCILING_COST_THEORY_WITH_COST_ACCOUNTING_PRACTICES -...

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Electronic copy available at: http://ssrn.com/abstract=1138851 1 RECONCILING COST THEORY WITH COST ACCOUNTING PRACTICES Daniel Marburger Arkansas State University Abstract: Despite its critical importance in the theory of the firm, marginal cost is unobservable in most production settings. Most cost accounting practices substitute average cost estimates for the unobservable marginal cost; moreover, some cost accounting measures include fixed costs as a component of unit cost whereas others do not. Because of the critical role that marginal cost plays in the theory of the firm, it is essential that economics instructors be aware not only of various cost accounting practices, but how these practices may bias the short-run pricing and output decisions of firms. Key words: Marginal cost, direct cost, indirect cost, absorption costing, variable costing, externalities, activity-based costing JEL code: A22, A23
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2 One of the most important elements in cost theory of the firm is marginal cost. Discussions of firm behavior in principles and intermediate level economics textbooks are predicated on the assumption that decision-makers are informed about marginal cost. Ironically, despite its critical importance in the economic theory, marginal cost is unobservable in most real-world production environments. Cost accounting practices develop unit cost estimates that serve as proxies for the unknown marginal cost. Cost accounting typically reports average cost rather than marginal cost, with some methods incorporating fixed costs into the unit cost estimate. Because of the critical role that marginal cost plays in the theory of the firm, it is essential that economics instructors be aware not only of various cost accounting practices, but how these practices may bias the short-run pricing and output decisions of firms. We should begin by distinguishing the simple production/cost model described in most principles of economics textbooks with production in actual manufacturing settings. In most cases, raw materials flow from one department to another. Each worker/machine works on some component of various jobs and then passes them along to the next department for additional work. The firm must accumulate the relevant costs of production and assign them to individual units as the works-in-process move through the various stages of production. Most firms also have service functions that accompany production. These expenditures typically follow a step function; they are fixed within a given range of output, but increase over broader ranges of production. Given the complexities of the production process, it is rarely possible for firms to determine the precise cost of each unit of output. Instead, the relevant costs of production are usually summed and then divided by the number of units produced. Therefore, at best, cost
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This note was uploaded on 10/11/2010 for the course FINANCE 5101144 taught by Professor Hjk during the Spring '10 term at Arab Academy for Science, Technology & Maritime Transport.

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RECONCILING_COST_THEORY_WITH_COST_ACCOUNTING_PRACTICES -...

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