Expert answer:Discuss how accounting, economic, and social costs
Answer & Explanation:I use turnitin to check work. Please use original content!!!!Appendix 4A provides a detailed discussion of cost concepts in transportation, including accounting, economic and social costs. Review these costs, and in a three- to four-page paper in APA format, be sure to address the following:Discuss how accounting, economic, and social costs can be used in transportation to mitigate risks associated with these costs.Analyze how the company’s focus can impact these costs and impact risks.Provide at least one recommendation for each cost area that could mitigate the risks of those costs.Your paper must be three to four pages in length (not including the title and reference pages) and must be formatted according to APA style as outlined in the approved APA style guide. You must cite at least three scholarly sources in addition to the textbook.appendix_4a_cost_concepts.docx
appendix_4a_cost_concepts.docx
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APPENDIX 4A Cost Concepts
Accounting Cost
The simplest concept or measure of cost is what has sometimes been labeled accounting
cost, or even more simply as money cost. These are the so-called bookkeeping costs of a
company and include all cash outlays of the firm. This particular concept of cost is not
difficult to grasp. The most difficult problem with accounting costs is their allocation
among the various products or services of a company.
If the owner of a motor carrier, for example, was interested in determining the cost
associated with moving a particular truckload of traffic, all the cost of fuel, oil, and the
driver’s wages associated with the movement could be quickly determined. It might also be
possible to determine how much wear and tear would occur on the vehicle during the trip.
However, the portion of the president’s salary, the terminal expenses, and the advertising
expense should be included in the price. These costs should be included in part, but how
much should be included is frequently a perplexing question. The computation becomes
even more complex when a small shipment is combined with other small shipments in one
truckload.
Some allocation would then be necessary for the fuel expense and the driver’s wages.
Economic Cost
A second concept of cost is economic cost, which is different from accounting cost. The
economic definition of cost is associated with the alternative cost doctrine or the
opportunity cost doctrine. Costs of production, as defined by economists, are futuristic and
are the values of the alternative products that could have been produced with the resources
used in production.
Therefore, the costs of resources are their values in their best alternative uses. To secure
the service or use of resources, such as labor or capital, a company must pay an amount at
least equal to what the resource could obtain in its best alternative use. Implicit in this
definition of cost is the principle that if a resource has no alternative use, then its cost in
economic terms is zero.
The futuristic aspect of economic costs has special relevance in transportation because,
once investment has been made, one should not be concerned with recovering what are
sometimes referred to as sunk costs.1 Resources in some industries are so durable that they
can be regarded as virtually everlasting. Therefore, if no replacement is anticipated, and
there is no alternative use, then the use of the resource is costless in an economic sense.
This is of special importance in the railroad industry.
Railroads have long been regarded as having durable and therefore costless resources.
That is, some of the resources of railroads, such as concrete ties, some signaling equipment,
and even some rolling stock, are so durable and so highly specialized that they have no
alternative production or use potential. So the use of such resources, apart from
maintenance, is costless in an economic sense. Consequently, in a competitive pricing
situation, such resources could be excluded from the calculation of fixed costs. Also, such
specialized resources can be eliminated in comparing cost structures.2
Although the economic logic of the above argument on the use of durable, specialized
resources is impeccable, it is frequently disregarded by pricing analysts and regulators. In a
sense, the elimination of such costs from pricing calculations defies common sense. From
the money or accounting cost perspective, these costs usually should be included.
The conclusion that must be drawn is that economic costs differ from money or
accounting costs. Money costs are by their very nature a measure of past costs. This does
not mean that money costs do not have any relevance in the economic sense. Past costs do
perform a very important function because they provide a guide to future cost estimates.
However, complete reliance should not be put upon historical costs for pricing in the
transportation industry.
Social Cost
A third category of costs—social costs—might also be considered. Some businesses might
not concern themselves with social costs unless required to do so by law. These costs take
into consideration the cost to society of some particular operation and, in fact, might
outweigh money cost. For example, what is the cost to society when a company releases its
waste materials into a stream? Today many regulations and controls are administered by
various regulatory agencies to protect society from such costs. These agencies make the
business organizations responsible for social costs. (For example, strip-mine operators are
customarily required to backfill and plant.) In spite of such controls, however, there are still
instances when chemicals or other hazardous materials are discharged or leak out and
society has to bear the cost of the cleanup operations as well as the health hazards.
This discussion is not trying to castigate business organizations or suggest that all
investment decisions result in negative social costs because, in fact, there can be social
benefits from business investments. However, to ensure that the discussion is complete,
social costs must be considered.
Analysis of Cost Structures
There are two general approaches to an analysis of a particular cost structure. Under one
approach, costs can be classified as those that are directly assignable to particular segments
of the business (such as products or services) and those that are incurred for the business as
a whole. These two types of cost are generally designated as separable and common costs,
respectively. Usually, common costs are further classified as joint common costs or
conjoint common costs. Separable costs refer to a situation in which products are
necessarily produced in fixed proportions. The classic example is that of hides and beef.
Stated simply, the production or generation of one product or service necessarily entails the
production or generation of another product. In terms of transportation, joint costs occur
when two or more services are necessarily produced together in fixed proportions. One of
these services is said to be a by-product of the other. The most obvious illustration is that of
the backhaul situation; the return capacity is the by-product of the loaded trip to the
destination.3
It is a generally accepted fact that large transportation companies, especially railroads,
have a significant element of common costs because they have roadbed, terminals, freight
yards, and so on, the cost of which is common to all traffic. However, the only evidence of
true jointness appears to be the backhaul.4 Nonjoint common costs are those that do not
require the production of fixed proportions of products or services. Nonjoint common costs
are more customary in transportation. For example, on a typical train journey on which
hundreds of items are carried, the expenses of the crew and fuel are common costs incurred
for all the items hauled (see Figure 4A-1).
Figure 4A-1
Directly Assignable Cost Approach
A technique for allocating costs directly to activity centers has been implemented in both
the carrier and shipper communities. Activity-based costing (ABC) identifies costs
specifically generated by performing a service or producing a product. ABC does not
allocate direct and indirect costs based on volume alone; it determines which activities are
responsible for these costs and burdens these activities with their respective portion of
overhead costs.
One application for ABC today by both carriers and shippers is the calculation of
customer profitability.5
Under the other basic approach to analyzing a particular cost structure, costs are divided
into those that do not fluctuate with the volume of business in the short term and those that
do. The time period here is assumed to be that in which the plant or physical capacity of the
business remains unchanged, or the short run. The two types of costs described are usually
referred to as fixed and variable costs, respectively.
In the first approach, the distinction between common and separable costs is made with
the idea that costs can be traced to specific accounts or products of the business. In the
second approach, the distinction between fixed and variable is made to study variations in
business as a whole over a period of time and the effect of these variations upon expenses.
In other words, with fixed and variable costs the focus is on the fact that some costs
increase and decrease with expansion and contraction of business volume, whereas other
costs do not vary as business levels change.
Because of the two different approaches to studying costs, it is possible that a certain cost
might be classified as common on one hand and variable on the other, or common under
one approach and fixed under the other, and so on, for all the possible combinations.
Therefore, the only costs directly traceable or separable are the variable costs, which are
also separable. For example, fuel expense is generally regarded as a variable cost, but it
would be a common cost with a vehicle loaded with LTL traffic.
The second approach of cost analysis—namely, fixed and variable costs—is
important and should be discussed further. As indicated previously, total fixed costs are
constant regardless of the enterprise’s volume of business. These fixed costs can include
maintenance expenses on equipment or right-of-way (track) caused by time and weather
(not use), property taxes, certain management salaries, interest on bonds, and payments on
long-term leases. Fixed costs per unit of output decline as more volume is allocated to a
fixed cost asset.
A business has a commitment to its fixed costs even with a zero level of output. Fixed
costs might, in certain instances, be delayed, or to use the more common term, deferred.
The railroads frequently delay or defer costs. For example, maintenance of railroad rightsof-way should probably be done each spring or summer, particularly in the northern states.
Freezing and thawing, along with spring rains, wash away gravel and stone (ballast) and
may do other damage. Although this maintenance can be postponed, just as, for example,
house painting might be postponed for a year or two, sooner or later it has to be done if the
business wants to continue to operate. There is a fixed commitment or necessity that
requires the corrective action and associated expense.6 The important point is that total
fixed expenses occur independently of the volume of business experienced by the
organization.
Variable costs, on the other hand, are closely related to the volume of business. In other
words, firms do not experience any variable costs unless they are operating. The fuel
expense for trains or tractor—trailers is an excellent example of a variable cost. If a
locomotive or vehicle does not make a run or trip, there is no fuel cost. Additional
examples of variable costs include the wear and tear on tractor—trailers and the cost for
tires and engine parts. Thus, variable cost per unit remains constant regardless of the level
of output, while total variable costs are directly related to the level of output.
Another related point is that railroads and pipelines, like many public utility companies,
are frequently labeled as decreasing cost industries. The relevance of this phenomenon to
pricing was discussed earlier in this chapter, but it also deserves some additional
explanation now. Railroads and pipelines have a high proportion of fixed costs in their cost
structures. There is some debate about the percentage, but the estimates range from 20 to
50 percent. Contrast this with motor carriers whose average is 10 percent. As railroads
produce more units, the proportion of fixed costs on each item will be lower. More
importantly, this decline will occur over a long range of output because of the large-scale
capacity of most railroads.
An example of the above situation is useful here. Assume that a particular railroad incurs
$5 million of fixed costs on an annual basis. In addition, assume that the railroad is
analyzing costs for pricing purposes between Bellefonte, Pennsylvania, and Chicago. In its
examination of cost, the railroad determines that the variable cost on a carload is $250
between Bellefonte and Chicago.
Although it might be unrealistic, assume that the railroad only moves 10 cars per year.
The cost would be as follows:
Fixed cost $5,000,000
Variable cost $2,500 (10 cars × $250)
Total cost $5,002,500
Average cost $500,250 per car
If it moves 1,000 cars, the cost would be:
Fixed cost $5,000,000
Variable cost $250,000 (1,000 cars × $250)
Total cost $5,250,000
Average cost $5,250 per car
If it moves 100,000 cars, the cost would be:
Fixed cost $5,000,000
Variable cost $25,000,000 (100,000 × $250)
Total cost $30,000,000
Average cost $300 per car
The relationship is easy to see. If the number of cars increased in our example, the
average cost would continue to decline. Theoretically, average cost would have to level out
and eventually increase due to decreasing returns, but the important point is that the high
proportion of fixed costs and the large capacity cause the average cost to decline over a
great range of output (see Figure 4A-2). There would be a point, however, at which
additional cars would require another investment in fixed cost, thus shifting the average
cost curve.
The significance of the declining cost phenomenon to a railroad is that volume is a very
important determinant of cost and efficiency. Furthermore, pricing the service to attract
traffic is a critical factor in determining profitability, particularly where there is
competition from alternate modes of transportation.
Figure 4A-2
Average Cost and Output
Another cost concept that is of major importance in this analysis is marginal cost,
because of its key role in understanding pricing decisions. Marginal cost can be defined as
the change in total cost resulting from a one-unit change in output, or as additions to
aggregate cost for given additions to output. This latter definition probably makes more
sense in transportation because of the difficulties of defining the output unit. Marginal cost
also can be defined as the change in total variable cost resulting from a one-unit change in
output, because a change in output changes total variable cost and total cost by exactly the
same amounts. Marginal cost is sometimes referred to as incremental cost, especially in the
transportation industry.
There is one other type of cost that should be mentioned because of its importance in
price decision—out-of-pocket costs. Out-of-pocket costs are usually defined as those costs
that are directly assignable to a particular unit of traffic and that would not have been
incurred if the service or movement had not been performed. Within the framework of this
definition, out-of-pocket costs could also be eith58er separable costs or variable costs.
Although the above definition states that out-of-pocket costs are specifically assignable to a
certain movement, which implies separable costs, they can definitely be considered as
variable costs because they would not have occurred if a particular shipment had not been
moved. The definition also encompasses marginal cost because marginal cost can be
associated with a unit increase in cost.
The vagueness of the out-of-pocket costs definition has left the door open to the types of
cost included as a part of the total cost calculation. The difficulty lies in the fact that from a
narrow viewpoint, out-of-pocket costs could be classified as only those expenses incurred
because a particular unit was moved. For example, the loading and unloading expense
attributable to moving a particular shipment, plus the extra fuel and wear and tear on
equipment (relatively low for railroads) could be classified as out-of-pocket costs. On the
other hand, a broad approach might be used in defining out-of-pocket costs in regard to a
particular shipment, thereby including a share of all of the common variable expenses
attributable to a particular movement between two points.
The confusion surrounding the concept of out-of-pocket costs would seem to justify
elimination of its use. However, the continued use of the term would be acceptable if its
definition was made synonymous with the definition of one of the particular economic
costs that its definition implies—marginal costs—because this term is important in price
and output decisions and evaluations of pricing economics. Typically, out-of-pocket costs
are most important to the firm’s accounting system because they are payments that must be
made almost immediately as an operating expense. The out-of-pocket cost concept is useful
in that it is used as a way to estimate the amount of liquid funds that a transportation firm
must keep on hand for daily operations.7
Figure 4A-3 gives a good breakdown of the methods of cost analysis. It illustrates the
close relationship between the three cost concepts of variable, marginal, and outof- pocket
costs.
Although attention is devoted to cost structure in the separate chapters dealing with each
of the modes of transportation, some consideration will be given in this section to an
analysis of modal cost structures. Such discussion is useful and necessary background to
the analysis of the approaches to pricing.
Figure 4A-3
Short-Run Cost/Volume Output Approach
Rail Cost Structure
One of the characteristics of railroads, as previously noted, is the level of fixed costs
present in their cost structures. It is a commonly accepted fact that a relatively large
proportion of railway costs are fixed in the short run. At one time it was believed that more
than half of rail costs were fixed, and some individuals estimated that these costs ran as
high as 70 percent of total cost. The exact proportion of fixed expenses is subject to some
debate; however, it is generally accepted that fixed expenses constitute a significant portion
of railroad total costs, ranging from 20 to 50 percent. The high proportion of fixed costs
can be explained by railroad investment (in such things as track, terminals, and freight
yards), which is much larger than the investment of motor carriers, for example. For this
reason, railroads are generally regarded as having increasing returns, or decreasing costs
per unit of output.8
As has been indicated, a significant amount of railroad costs also include common
expenses because replacement costs of a stretch of track are shared by all traffic moving
over it. This is also true with respect to other items of cost, including officers’ salaries.
Some of these common costs are also fixed costs, while others are variable costs (refer to
Chapter 6, “Railroads”).
Motor Carrier Cost Structure
The motor carrier industry is exemplified by a high proportion of variable costs. It has been
estimated that variable costs in the motor carrier industry are 90 percent or more of total
costs.9 This high degree of variability is explained to a large extent by the fact that motor
carriers do not have to provide their own right-of-way because roads are publicly provided.
It is true that motor carriers do pay fuel taxes and other taxes to defray the cost of providing
the highways, but these expenses are variable because they depend on the use made of the
highway.
The economic concept of the “long run” is a shorter period in the motor carrier industry
than in the railroad industry. The operating unit, the motor carrier vehicle, has a shorter life
span than the rail operating unit. It is smaller and therefore more adaptable to fluctuating
business conditions. The capital investment required is smaller too, and fleets can be
expanded and contracted more easily.
The motor carrier situation varies greatly with respect to common costs. Companies that
specialize in LTL traffic will have a significant proportion of common cost, whereas
contract carriers with only two or three customers who move onl …
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