On The Nature of Cost and Profit

An Essay by Bob Castleman

copyright 2011 Bob Castleman

Given the critical function of costing as a business activity, it is not too large a leap to assume that a
fully objective and quantitative system for evaluating cost is desirable. This essay develops a
theoretical model that creates just such a system and proceeds to evaluate the consequences of such a
model.

Stripping business activity down to it's most atomic form, the transaction, the simplest equation
possible is Profit=Price – Cost. Every transaction is defined by this equation. Control cost, and profit is
maximized. Controlling cost requires the capacity to measure all of the components necessary to bring
a product or service to the point in time where the transaction takes place. Typically, these are things
such as materials, labor, marketing, overhead and a myriad of other aspects of running a business. A
cost function for a specific product is simply a sum of the cost of each component:

C= c 1c 2 ...c n

Any truly quantitative and objective costing system would necessarily require that each component of
the cost function was also fully and objectively quantified. An interesting property of objective and
quantitative measurement is that it is independent of the units used. When measuring distance, whether
inches or centimeters, the distance measured is the same. Quantifying mass requires choosing
kilograms or pounds, but the mass measured is invariant. As such, any quantitative and objective
measurement of any property gives the same result regardless of the system of units being used. This is
fortunate because a costing system so devised becomes truly independent of the units of measure. This
leads us to the equivalence of costing systems.

Theorem 1) Equivalence Objectified Cost:

Any two fully quantified and objective costing systems

are equivalent.

What remains is to devise such an objectified system. This would require each element of the costing
function to have objectively measurable properties. Materials might use mass, labor could use time.
Each might have various multipliers that weight the cost component in some way. But assuming each
component has an objective measure is the key point. Another interesting artifact is that since each
component ultimately measures cost, the specific units each component uses are irrelevant as they are
all converted to cost. Whatever formula used for a component, it is ultimately expressed in some unit of
exchange.

Theorem 2) Equivalence of Component Cost

Measure:
 Any two fully quantified and objectively costed
components can be expressed in terms of each others
basic units.

For example if a labor component cost is $100 (4 hrs @ $25/hr) and a material
component cost is $100 (4 grams at $25/gram) the two are equivalent. Mathematically,
the time and mass units drop out leaving $100=$100, or alternatively, $100 of labor is
equal to 4 grams of material, or relevant to cost, 4 hours of labor is equivalent to 4
grams of amterial. This allows us to determine an objective, quantifiable measure for
any cost component and validly apply it to all other components.

For simplicity, let us choose a material component of the cost equation. The total cost of
a material component on first blush might seem best tied to mass such as a price per
gram. But a more interesting metric is energy. It is not simply the mass of the material
that effects the cost, but also things like the transport, manipulation and acquisition of
the materials. As Einstein has neatly provided us with mass energy equivalence via
E=MC2 we can express the entire chain of events that bring the material to the point of
trade as a function of the total energy of each link in the chain, whether the energy is the
more commonly understood forms such as electricity and fossil fuels, or the more pure
forms as described in physics. Everything can be expressed as energy. Which leads us to

Theorem 3) Costing Systems are Energy Systems:

All fully objectified and quantified systems of

assigning cost can be expressed in terms of energy,
either utilized or entrained in the mass of the cost
component.

This follows directly from theorems 1 and 2. By establishing energy as a valid cost
metric for materials, Theorem 2 states we can use this metric for all components.
Theorem 1 states that this system of energy costing is equivalent to all others objective
and quantifiable systems.

Having constructed a suitable costing system, let us now examine some of its
consequences.

First, let us establish an energy exchange. This exchange serves as the system that
mediates the exchange of energy within the system. For any economic activity to take
place, an agent must have the appropriate credits of energy to represent the cost of his
activity. If a business man desires to bring a product to market, he must have access to
the appropriate number of energy credits to cover the cost. Having a fully objective cost
function, when the product is traded, the businessman can now know precisely,
objectively and quantitatively evaluate his cost and determine his profit.

Let us allow the profit. So at the beginning of his venture he starts with 100 credits of
energy. He realizes a 10% profit and now has 110 credits. He can take his additional 10
credits and apply it to further ventures over and above his original 100 credits. Which
leads to

Theorem 4) Profit either violates Conservation of

Energy, is inflationary, or forces other agents to a
loss.

This follows from a bedrock principle in physics. Mass and energy can neither be
created nor destroyed, they can only change state. The energy exchange devised above
is a monetary representation of the energy in the system. This energy is constant so the
sum total of energy represented is constant. For our business man to realize his 10
credits of profit one of three things must happen. Energy in the system must increase,
OR his ten credits must come from another agent, whereupon that agent loses those
credits, OR the total assigned to represent the energy must increase by the amount of the
profit. The first option is impossible. Either the second or third must happen.

This implies that either no objective, quantifiable system of costing exists or that profit
is the driver of inflation, not cost. If no such objective system exists, then no economic
system can ever be fully, objectively and quantitatively scientific.