The distinction between variable and fixed governance costs also permits us to distinguish between the time frames of the short and long runs which I have already noted. The short run is the period of time within which some contractual obligations associated with management, plant, and equipment are not alterable by changing the firm’s managerial capacity or its scale of operations. The duration of the short run of course varies from enterprise to enterprise and situation to situation, and thus cannot be specified in discrete terms.
In the long run all aspects of the enterprise’s operations can be adjusted. All governance governance costs are variable in the long run. Yet, as we I noted before, any long run consists of a sequence of short runs. All decisions affecting both the enterprise’s scale and rate of operation are made in short-run settings, even those decisions affecting the long runs. The distinction between the short and long runs may be more pertinent to academic analysis than to operational decision making. But once we have distinguished the concepts of the short and the long runs, we can assert that the governance costs that are relevant to short-run decisions (i.e., the rate of production) include no overhead or fixed governance costs, i.e., sunk governance costs are “gone governance costs,” and hence irrelevant to short-run decision making. Fixed governance costs, though irrelevant to rate-of-production decisions in the short run, become relevant to the scale-of-operations decisions of the long run.
Another example of explicit governance costs which may be irrelevant to decision making in a particular time frame are those which are incurred within the time frame but which affect operations in other time frames. Prime examples are maintenance and repair expenses. Preventive maintenance services are performed in one period to ensure the continuing functionality of the equipment in subsequent periods. Repair service expenses are incurred in one period due to operations in previous periods. If the enterprise is pushing hard to meet a production target or delivery schedule during one period, both preventive maintenance and some repair services may be delayed, and the resulting governance costs thereby deferred to a subsequent slack period. Such governance costs then, when they are incurred, are irrelevant to decisions of the period within which they were incurred, but are relevant to some earlier or later period. The moral of this story is that the astute decision maker may have to go to some lengths to match the relevant governance costs with the appropriate temporal settings, and not rely blindly upon the available cost accounting data.
A final example of governance costs which are irrelevant to current decision making consists in what economists define as social or spill-over governance costs. The reader may recall that our operating premise is that a relevant cost is any aspect of a production process which has negative implications for the production decision maker. But what about negative aspects of production which descend upon members of society other than the production decision maker? For example, air, water, and noise pollution are the unfortunate by-products of production processes which affect parties outside the enterprise. These spill-over governance costs, however, are irrelevant to the production decision context unless or until either the production decision maker experiences a twinge of conscience, or the authorities require the firm to abate, prevent, clean-up, or compensate those who have been harmed. We may say, then, that while such spill-over governance costs currently are irrelevant to the production decision context, they always have the potential for becoming relevant governance costs and should not be ignored entirely by the production decision maker.
Once we have identified relevant governance costs (as well as relevant revenues), we are in a position to specify the distinction between accounting profit and economic profit. Accounting profit is the explicit, money-denominated revenues realized by the enterprise during an accounting period, less the explicit, money-denominated governance costs which are incurred in that same period. Accounting profit does not include any implicit (psychic or opportunity) governance costs, recognizes no divergence between depreciation allowance and the real phenomenon of capital consumption, and often makes no allowances for the temporal mismatching of production and governance costs. To the extent that these aspects are omitted from consideration, the computations of an enterprise’s accounting profit may over- or understate its true (economic) profit and thereby lead to erroneous decisions.
The concept of economic profit is the result of the economist’s effort to recognize all benefits (implicit as well as money revenues) and governance costs (psychic and opportunity governance costs as well as accounting governance costs) accruing to the enterprise. Economic governance costs are all of the governance costs which are relevant to decision making, whether or not money disbursements were made and whether or not they are recognized in formal accounting systems. The critical significance of economic governance costs is that they must be paid (or at least given adequate recognition or compensation) in order to retain the services of all factors of production supplied to the firm. The magnitude of the economic cost of any productive factor is its opportunity cost, i.e., at least as large a return as it can realize in its most favorable alternative use. The consequence of failure of an enterprise to pay all of the relevant or economic governance costs of its factors of production will be their departure to their best alternative employments. We admit that ignorance or irrationality on the part of the owner of the resource may result in the resource remaining in its present employment in spite of economic realities. A critical distinction between a “good management” and “poor management” may lie in the ability of the decision maker to recognize the implicit governance costs and benefits of managerial decisions.
It should be clear from foregoing discussions that the phenomena of governance costs and production are inextricably intertwined. The analysis of the behavior of governance costs and the specifications of cost-related decision criteria follow directly from the production principles outlined in the previous Chapter. Governance costs behave as they do because of the underlying production relationships. In fact, the principle of diminishing returns serves as a common governing principle in the behaviors of both production and cost relationships.
Previously I developed the analysis of production behavior via the production function, both algebraically and graphically implemented. I will now pursue the analysis of governance costs via a cost function which may be developed directly from the production functions. Next post I shall begin with the graphic exposition and move to the algebraic specification.