By: Socred - B.A., SCMP
According to the generally accepted accounting principles, when physical capital is purchased, it is recorded as an asset and expensed over time as the capital depreciates. “Generally accepted accounting principles require expenditures to be capitalized when they will benefit more than one accounting period, and when they are significant in amount, and when they can be measured with reasonable objective evidence. (Financial Accounting, Henry Dauderis, pge. 393) With accrual accounting, revenues and expenses are recorded when they are incurred. Because capital depreciates over time, and has a longer life than the time at which it was purchased, physical assets are depreciated via depreciation expenses in order to better match costs with revenues. This defers financial costs to the future in order to “allocate costs over its (capital's) useful life”.
From an economic perspective, there are two ways of measuring costs: 1) financial costs, and 2) real costs. One of the purposes of cost accounting is to attempt to measure the real cost of production in terms of financial costs. Orthodox economics regard real costs as "the alternative opportunities forgone" (Hischleifer, "Price Theory and Applications, pge. 176). These costs are referred to as "opportunity costs", and this is what economists call the real cost of production. In other words, the real cost of producing something is the opportunity lost to produce something else. This theory of costs is unusable at the macro-economic level because it infers that the real cost of production is all the non-existent production that could have occured. This cost would be impossible to measure, because it would include all production which is non-existent. Douglas proposed that the real cost of production is consumption over an equivalent period of time. In other words, if we produce ten apples, and consume eight in the same period of time, the real cost of producing those ten apples was eight - profit was two apples. These two apples can then be exchanged for other goods in a barter economy. However, in the macro-economic sense, profit is pointless, since macro-economics is concerned with aggregates. As Douglas made explicit, the purpose of production is consumption (otherwise production is waste). In other words, real profit in the aggregate is merely waste, because it would be production which is not meant for consumption.
Now, the only time that exists is the present. The past used to exist, but it is gone. The future exists as possibility. Time flows from past to present, but consciousness can only exist in the present - in the now. Everything that we are concsious of must exist in the present. While this may seem self-evident, it has important economic implications in regards to costs, and the attempt to allocate financial costs over future time periods.
Financial costs are measured in the currency of the nation that is measuring them. For instance, in Canada, we measure costs in dollars. Douglas proposed that the physical currency in which we can measure costs is the “time – energy unit”. The time – energy unit is “potential effort over a definite period of time.” (Economic Democracy, pge. 100) Obviously, as improvements in process reduce the amount of time – energy units used to produce a unit of output, the real cost of production is diminished, because less inputs are used to produce a unit output.
However, if physical costs are associated with the time-energy unit of measurement, this means that time is an important factor in measuring physical costs. Since the only time that exists is the present, the only time energy units which available are present units. And since these are a measure of physical costs, the only physical costs that can exist are present costs. Past time energy units have been expensed, and future time energy units do not yet exist. In other words, the only financial costs that should exist are current costs. Past costs no longer exist.
If past costs no longer exist, then why are we forced to pay for capital that was built previously? How was the real cost of capital expensed at the time it was built?
Currently, we are forced to pay for capital twice. The accountant is mainly concerned with costs and their impact on price, but forgets that the upper limit of price is what an article will fetch on the open market. When capital is built, purchasing power (in the form of wages, salaries, and dividends) is disbursed to individuals who helped construct the capital. These individuals use that purchasing power to purchase current consumer goods coming onto the market. This activity has a tendency to inflate the price of consumer goods as this purchasing power is recouped from retailers who find that the effective demand for their product rising. In this way, the consumer pays for the capital at the time of its construction via the inflation of the price of consumer goods, and once again as the capital is depreciated over time via depreciation expenses. In fact, the inflationary effect of the construction of capital would be far worse if it were not for the negating effect on this process of improvements in efficiency which tends to reduce prices at the same time.
Since one dollar of income is only capable of defraying one dollar of cost(*read "The Alberta Postwar Construction Committee" posted on this blog), consumers eventually find that they do not have income necessary to defray these depreciation expenses in the future, because they have already used this income to purchase consumer goods at or near the time they received the income. This creates a gap between incomes and prices, and necessitates the further production of goods and services that the consumer is unable to consume in order to distribute the necessary income to purchase all of the consumer goods coming onto the market at some future point in time. Douglas exposed this gap in his A+B theorem.
The solution is not to change the way accountants allocate costs over time, because this is an accurate attempt to match costs with revenues, and is likely the only way many businesses would be able to operate at a profit. The solution entails distributing purchasing power to consumers in such a manner that said purchasing power does not form a part of costs, which is exactly what happens with respect to Douglas’s proposal for a compensated price.
The compensated price mechanism cancels costs at retail by reducing prices to consumers. This increases consumers' purchasing power. The mechanism is designed to equate production and consumption, and to allow financial costs to more accurately reflect the real cost of production. In this way, costs that have been capitalized, and really represent past consumption, can be eliminated in the current accounting period.