History records that the electronic pocket calculator had a product ancestor known as the mechanical desk calculator, first hand powered and later electrically powered. It was a mechanical marvel, prized by those whose jobs required accurate computations and by organizations that needed both accuracy and relatively high productivity in computations not justified for programming on computers.
Calculatron Inc was a major manufacturer of desk calculators and had enjoyed long term profitability. It had a loyal work force of some semiskilled and some highly skilled employees. Although product improvements had continued over the years, the basic design of Calculatron’s product line had been stable for 15 years, and product design changes were carefully implemented to take account of the existing production lines. The market for desk calculators had been an expanding one, and with the advantage of a relatively stable product design, Calculatron had been able to specialize production methods, making continuous improvements in productivity through investments in labor saving equipment. The productivity increases had helped secure the firm’s market position through competitive pricing and had produced profitability and security for both the enterprise and its employees. Employees enjoyed high wages and salaries and excellent pension and other benefits. Employees were organized and affiliated with the AFL – CIO and union management relationships had been generally very good.
Enter electronic mini-circuitry, with micro-circuitry and the “chip” on the horizon. The first electronic desk calculator had just been announced by a competitor. Calculatron was not far behind. It had employed a staff of electronic engineers two years previously and had assigned them the task of producing a revolutionary redesign of the product line. The proto types had already been tested, and the product and production engineers were at work in the production design phase simultaneously, developing preliminary designs of the productive system required to produce the new electronic product line.
Market forecasts indicated a conversion of the former mechanical calculator volume to the electronic with a “kicker” because a large replacement market was available for the faster, quieter, and more capable electronic machines. The one sour note in the market was the prediction that a pocket sized calculator would soon be possible if the research and development of micro-circuits were to materialize. Reports concerning startling technological innovations in micro-circuitry indicated that the probability of a breakthrough was high.
The production engineers are ready to develop final designs of the productive system for the new electronic calculator line. A meeting of the executive committee has been called to examine preliminary plans for production in relation to short and longer term market forecasts and predictions.
Suppose that we are discussing an asset that is used for general purpose, such as an over the road semi-trailer truck. Assume that we own such a truck and that the question is, how much will it cost us to own this truck for one year? These costs of owning, or capital costs, cannot be derived from the organization’s ordinary accounting records. The cost of owning the truck for one more year depends on its current value. If the truck can be sold on the second hand market for $5000, this is a measure of its economic value. Because it has value, we have two basic alternatives: we can sell it for $ 5000 or we can keep it. If we sell, the $5000 can earn interest or a return on an alternate investment. If we keep the truck, we forego the return, which then becomes an opportunity cost of holding the truck one more year. Also, if we keep the truck, it will be worth less a year from now, so there is a second opportunity cost, measured by the decrease in salvage value during the year.
The loss of opportunity to earn a return and the loss of salvage value during the year are the costs of continued ownership. They are opportunity costs rather than costs paid out. Nevertheless, they can be quite significant in comparing alternatives that requires different amounts of investment. There is one more possible component of capital cost for the next year if the truck is retained, the cost of possible renewals or “capital additions”. We are not thinking of ordinary maintenance, here, but of major overhauls, such as a new engine or an engine overhaul, that extend the physical life of the truck for some time. In summary, the capital costs, or the costs of owning the truck, for one more year are as follows:
1) Opportunity costs:
a) Interest on salvage value at beginning of year
b) Loss in salvage value during the year
2) Capital additions or renewals required to keep the truck running for at least an additional year.