Reconciling Cost Theory with Cost Accounting Practices

Abstract

Despite its critical importance in the theory of the firm, marginal cost is unobservable in most production settings. Most cost accounting practices substitute average cost estimates for the unobservable marginal cost; moreover, some cost accounting measures include fixed costs as a component of unit cost whereas others do not. Because of the critical role that marginal cost plays in the theory of the firm, it is essential that economics instructors be aware not only of various cost accounting practices, but how these practices may bias the short-run pricing and output decisions of firms.

Keywords: Marginal cost, direct cost, indirect cost, absorption costing, variable costing, externalities, activity-based costing

JEL Classification: A22, A23, M40, M46