The Economic Significance of Historic Cost

Inferences about the economic cost of a product are frequently based on measures of historic cost. We examine a model in which a firm makes a sequence of overlapping capacity investments. Earlier research has identified particular accrual accounting (depreciation) rules which have the property that on a per unit basis the historic cost of a product captures precisely its marginal cost. Relative to this benchmark, we investigate the direction and magnitude of the bias in reported historic cost that results from alternative depreciation rules, including in particular straight-line depreciation for tangible assets and direct expensing for intangible assets. Our analysis shows that for a reasonable range of parameter specifications the resulting bias is rather small. Our framework lends itself to an analysis of the Accounting Profit Margin and the extent to which this financial ratio is indicative of market power, as measured by the Lange-Lerner index. ∗Graduate School of Business, Stanford University. Email: [email protected]; [email protected]. We would like to thank Julia Nasev and Jim Ohlson for detailed comments on this manuscript. We also acknowledge helpful comments by seminar participants at the following institutions: Chicago-Minnesota Theory Conference, Interdisciplinary Accounting Conference in Copenhagen, Harvard Business School, Stockholm School of Economics, European School of Management and Technology in Berlin and City University, London. Finally, we received valuable research assistance from Ian Gow, Alexander Nezlobin and Yanruo Wang.