Accounting versus Economics

Chapter 4

Accounting versus Economics

Economics
Abstract model of firm
At this point: complete information

Accounting
Filled with pragmatism
Aggregation
Is a library
Carefully maintained and organized
Purposely restricted
Integrity
2

The reporting firm

C (q; P) =

min

z1 0, z2 0, z3 0

subject to

P1 z1 + P2 z2 + P3 z3

q1 z1 z3
q2 z2 z3
q3 z3

The firm incurs cost of:

P) = P1z1 + P2 z2 + P3 z3
C( q;
Customers pay revenue:

R = P1q1 + P2 q2
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Accounting story

Income without assignment

Income with assignment

Example

Income without assignment

Income with assignment

Unit cost?

10

Costing steps of a recipe

Definition 9 A cost pool is a temporary
collection of factor costs
Definition 10 A product cost pool is a
cost pool that is associated with the firms
products, as opposed to the time period in
which it is incurred

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Costing steps of a recipe

Definition 11 A period cost pool is a cost
pool that is associated with the time period
in which it is incurred, as opposed to the
firms products
Definition 12 A direct product cost pool is
a product cost pool that is associated with
a single product
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Costing steps of a recipe

Definition 13 An indirect product cost
pool is a product cost pool that is not
associated with a single product
Definition 14 A specific products unit
cost is the total cost associated with that
product divided by the number of units of
that product
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The reporting firm - again

C (q; P) =

min

z1 0, z2 0, z3 0

subject to

P1 z1 + P2 z2 (1 + r ) 1 + P3 z3

q1 z1 z3
q2 z2 z3
q3 z3

The firm incurs cost of:

P) = P1z1 + P2 z2 (1+ r)1 + P3 z3

C( q;
Customers pay revenue:

R = P1q1 (1+ r)1 + P2 q2 (1+ r)2

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The multi-period case

15

Valuation and income

Valuation of firm

PV0 = CF1 (1 + r )1 + CF2 (1 + r ) 2

PV1 = CF2 (1 + r )1
PV2 = 0

Income of firm

I 0 = PV0 + CF0
I1 = PV1 PV0 + CF1
I 2 = PV2 PV1 + CF2

Long term perspective

I 0 + I1 + I 2 = CF0 + CF1 + CF2

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Timing of returns
I1 / PV0 = r
I 0 = PV0 + CF0 = 0

I 0 = PV0 + CF0 > 0 ?

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Example

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Accounting income

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20

21

22

23

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Ralphs Juxtaposition
Multi product firm with cost function:
C (q1 , q2 ) = min1z1 + 2 z2 + 3z3 + 4 z4
s.t.
z1 + z2 q1 + 2q2
z3 + z4 2q1 + q2
z1 10
z3 12
zi 0

Economic Foundations

25

Ralphs Juxtaposition
q1

q2

C(q1, q2)

C(q1, q2)

14

10

68

10

10

78(34+44)

10

Economic Foundations

26

Ralphs Juxtaposition
Pool #1: 10*1+12*2 = 34
Pool #2: 12*3+2*4 = 44
What is the cost of product #1
Allocation based upon 22 hours (10+12)
Direct cost:
To #1: 34*2/22 = 3.09
To #2: 34*20/22 = 30.91

Indirect cost
To #1: 44*2/22 = 4
To #2: 44*20/22 = 40

Total
To #1: 3.09 + 4 = 7.09
To #2: 30.91 + 40 = 70.91
Economic Foundations

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Accounting conventions

Zero income at t=0

Life long income equal economic income
Stock assets
Flow income
Accruals
Recognitions rules definitions!
Regulation, judgment, convention and pragmatic
concerns govern accounting
What is accounting cost of product 1?
Aggregation and assignment of cost is used.
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Conclusion
Note differences between economics and
accounting
Language of accounting borrowed from
economics
Aggregation, assignment, convention, judgment,
regulation and pragmatism rules accounting
Accounting is a library that asks for decoding.
Marginal costs and incremental cost are the
decision relevant cost concepts
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