32.3 – Costing and Going Concerns
Learning Objectives
By the end of this section, you will be able to:
- Explain the concepts of costing, depreciation, and going concerns
- Analyze the difference between profits and expenses using simplified cash basis and accrual accounting methods
The empirical findings presented in the previous section suggest that our standard (orthodox) models of how firms behave and what determines prices are not appropriate for understanding today’s economies. Choosing the profit maximizing level of output does not appear to be relevant to firm behavior. Likewise, frequent price adjustments ‘in the market’ are not characteristic of most real-world markets, in which prices are clearly determined by producers and maintained over relatively long periods of time. All of this suggests that a deeper look into the actual nature of firms’ costs and the actual manner in which prices are determined is necessary. Fortunately, ample information about these processes is available, and it comes from the costing practices of accountants and the pricing practices of management.
Costing is the process of estimating the costs of production before production actually takes place–and, hence, before the actual costs of production are known with certainty. To do this, of course, it would be necessary to have some idea of how much output the business will be producing and selling as well as the direct and indirect expenses that will be involved at that level of production. Making such calculations may be a matter of a simple, educated guess, or it may involve a sophisticated process of research, experiment, and forecasting. What is important, from a theoretical standpoint, is that it is a fundamentally uncertain task which takes place before exchanges occur in the market. This view is consistent with what was suggested above, that firms plan their production processes ahead of time, a topic discussed further in chapter “The Megacorp.”
Depreciation and the Going Concern
A complete review of cost accounting isn’t necessary here, but one particular type of cost, depreciation, is of particular historical and conceptual significance. Depreciation is a way of accounting for the expense of an asset–say, a machine press–over the life of the asset, rather than solely at the time it was purchased. For instance, suppose your machine shop purchases a press (a machine that does exactly what it sounds like it does) for $20,000. If you expect that the press will be in use for the next 4 years before it wears out or becomes obsolete you might account for a depreciation expense of $5,000 per year for the next 4 years.
To understand the significance of depreciation, consider how businesses usually calculated income before the late 1800s. Before then, business enterprise was often treated as a terminal venture, having a clearly defined beginning and end date. Investors would pool money to start a business, purchase materials and capital (say, local goods to be tra