Economic Costs and Profitability • 19

decisions to delay adoption of new technology was economically sound, serving to maximize profits even if it did entail higher operating costs. We will return to the concept of sunk costs throughout the text.

ECONOMIC COSTS AND PROFITABILITY

Economic versus Accounting Costs

The costs in Tables P.1 and P.2 reflect the accountant’s concept of costs. This concept is grounded in the principles of accrual accounting, which emphasize historical costs. Accounting statements—in particular, income statements and balance sheets—are designed to serve an audience outside the firm—for example, lenders and equity investors. The accounting numbers must thus be objective and verifiable, principles that are well served by historical costs.

However, the costs that appear in accounting statements are not necessarily appropriate for decision making inside a firm. Business decisions require the measurement of economic costs, which are based on the concept of opportunity cost. This concept says that the economic cost of deploying resources in a particular activity is the value of the best foregone alternative use of those resources. Economic cost may not correspond to the historical costs represented in Tables P.1 and P.2. Suppose, for example, that the firm purchased its raw materials at a price below their current market price. Would the costs of goods manufactured in Table P.2 represent the economic cost to the firm of using these resources? The answer is no. When the firm uses them to produce finished goods, it forsakes the alternative of reselling the materials at the market price. The economic cost of the firm’s production activities reflects this foregone opportunity.

At a broader level, consider the resources (plant, equipment, land, etc.) that have been purchased with funds that stockholders provide to the firm. To attract these funds, the firm must offer the stockholders a return on their investment that is at least as large as the return that they could have received from investing in activities of comparable risk. To illustrate, suppose that at the beginning of 2012, a firm’s assets could have been liquidated for $100 million. By tying their funds up in the firm, investors lose the opportunity to invest the $100 million in an activity providing an 8 percent return. Moreover, suppose because of wear and tear and creeping obsolescence of plant and equipment, the value of the assets declines by 1 percent over the year 2012. The annualized cost of the firm’s assets for 2012 is then (0.08 1 0.01) 3 $100 million 5 $9 million per year. This is an economic cost, but it would not appear in the firm’s income statement.

In studying strategy, we are interested in analyzing why firms make their decisions and what distinguishes good decisions from poor ones, given the opportunities and the constraints firms face. In our formal theories of firm behavior, we thus emphasize economic costs rather than historical accounting costs. This is not to say that accounting costs have no place in the study of business strategy. Quite the contrary: In assessing the past performance of the firm, in comparing one firm in an industry to another, or in evaluating the financial strength of a firm, the informed use of accounting statements and accounting ratio analysis can be illuminating. However, the concept of opportunity cost provides the best basis for good economic decisions when the firm must choose among competing alternatives. A firm that consistently deviated from this idea of cost would miss opportunities for earning higher profits.