The concepts of incremental cost, opportunity cost, sunk cost, and cost allocation are identified and discussed in the c
Posted: Sun Jun 05, 2022 5:15 pm
The concepts of incremental cost, opportunity cost, sunk cost,
and cost allocation are identified and discussed in the context of
early U.S. foreign policy. The case is derived from an authentic
exchange of views between Thomas Jefferson and John Adams on how
the United States should protect its merchant shipping against the
Barbary Pirates. Both men compare the cost of waging war against
the pirates with the cost of paying ransom for captured U.S. seamen
and bribes to protect future shipping. Adams quantifies the
opportunity cost associated with not taking any action against the
pirates. Jefferson articulates an incremental costing argument, on
the assumption that the U.S. should build a navy regardless of U.S.
policy towards the Barbary States. The case constitutes a brief
introduction to management accounting by illustrating different
cost concepts, and also lends itself to a discussion of the
historical origins of management accounting. "The beginning of
wisdom in using accounting for decision-making is a clear
understanding that the relevant costs and revenues are those which
as between the alternatives being considered are expected to be
different in the future. It has taken accountants a long time to
grasp this essential point". R. Parker (1969) The Barbary Pirates
Throughout the 17th and 18th centuries, the North African Barbary
States of Morocco, Algiers, Tunis and Tripoli engaged in piracy of
European merchant shipping. The Barbary pirates routinely captured
and confiscated ships and cargo, and enslaved or ransomed their
crews and passengers. England, France and Spain entered into
treaties with the Barbary States, in effect, paying “protection
money” for their merchant shipping. These powerful European nations
preferred bribery to war, 3 because they perceived an economic
benefit from the threat the pirates posed to the merchant shipping
of other European nations. Until the Revolutionary War, merchant
ships from the American Colonies were protected by the British
Royal Navy and by the treaties between England and the Barbary
States. American shipping lost this protection in 1783, and within
the next two years three American ships were captured, one by
Morocco and two by Algiers. Morocco soon freed the American crew in
exchange for a ransom of $25,000. The crews held by the Algerians
were captive throughout 1786 and for some time thereafter.
Historical Background The capture of American ships by the Barbary
pirates created an early and important foreign policy crisis for
the United States. The U.S. response to the Barbary crisis was
strongly influenced by two factors, one military and the other
financial. The military consideration was that the U.S. had no
navy. The Continental Navy of the Revolutionary War was disbanded
in 1784, and the navy was not reestablished until 1798. During the
intervening years, the United States had minimal naval power.
Disbanding the Continental Navy was primarily a cost-savings
measure. However, there were also important non-financial arguments
for and against the navy. Some Americans who favored reestablishing
close ties with England feared that the presence of a U.S. navy on
the high seas would lead to confrontations with the British Navy.
Other Americans, including John Adams, viewed a strong navy as the
best national defense against foreign threats. Many Americans
preferred the prospect of building a navy over an army due to their
general distrust of standing armies—the result of their experience
with the British occupation in America during the latter part of
the Colonial Era. The financial factor that influenced the U.S.
response to the Barbary pirates was that any effective response
would require a significant expense relative to the government’s
available funds. The U.S. government found itself in a precarious
financial condition in the years immediately following the
Revolutionary War. The Continental Congress and individual states
borrowed over $40,000,000 to finance the war, including about
$6,000,000 from France. From 1781 to 1788, the period during which
the United States operated under the Articles of Confederation, the
federal government did not have the power to tax its citizens, levy
tariffs, or regulate commerce. The cost of operating the 4
government during this time was about $500,000 annually, not
including funding the debt. Some income was generated by the post
office and from sales of public lands, but the two principal
revenue sources available to the government were requesting support
from the states and issuing paper money. State contributions to the
federal government constituted only a small fraction of what was
needed, and issuing paper money was an inflationary measure that
had already been used extensively during the Revolutionary War. The
financial plight of the new nation was sufficiently acute that
during this period, the government borrowed from foreign sources
just to meet the interest obligations on existing foreign debt. The
ratification of the Constitution in 1788 greatly enhanced the
powers of the Federal government, and allowed the new Congress to
levy and collect duties and taxes. However, the ability of the new
government to actually enact and enforce revenue-generating
measures was untested, and evolved over time. In 1786, during the
Confederation period, and again in 1794, during Washington’s
presidency, popular opposition to taxation led to civil unrest. The
first incident, Shays’ Rebellion, arose in Massachusetts when the
State Legislature levied taxes to pay off the war debt. The second
incident, the Whiskey Rebellion, occurred in Western Pennsylvania
when the federal government imposed an excise tax on distilled
liquor. Also, although the Federal government had more potential
resources under the Constitution than under the Articles of
Confederation, it soon had more obligations. In 1790, under a plan
advanced by Secretary of the Treasury Alexander Hamilton, the
federal government assumed the remaining war debts that were owed
by the individual states. However, despite financial tribulations
at both the state and federal levels, economic conditions in the
United States during this period were generally good. A short
recession that occurred after the Revolutionary War was followed by
a period of economic growth. The strong economy led to increased
federal revenues, and that fact, combined with the success of
American leaders in keeping the nation out of the growing conflict
between England and France, enabled the government to become
current on its obligations under the national debt during
Jefferson’s administration. The Adams-Jefferson Correspondence In
1786, John Adams was the leading U.S. diplomat in London, and
Thomas Jefferson was the U.S. ambassador to France. A few years
earlier, in 1784, the Continental Congress had authorized Adams and
5 Jefferson to negotiate treaties with the Barbary States.
Consequently, the responsibility to negotiate the release of the
captured American seamen, and to establish U.S. foreign policy that
would protect U.S. shipping in the Mediterranean, fell largely to
these two men. Against this backdrop, Adams sent Jefferson a letter
that included the following analysis: Adams to Jefferson Letter
Dear Sir, "The first Question is, what will it cost us to make
Peace with all five [Barbary States]? Set it if you will at five
hundred Thousand Dollars, though I doubt not it might be done for
three or perhaps for two. The Second Question is, what Damage shall
we suffer, if we do not treat. Compute six or Eight Per Cent
Insurance upon all your Exports, and Imports. Compute the total
Loss of all the Mediterranean and Levant Trade. Compute the Loss of
half your Trade to Portugal and Spain. These computations will
amount to more than half a Million dollar a year. The third
Question is what will it cost to fight them? I answer, at least
half a Million dollar a year without protecting your Trade, and
when you leave off fighting you must pay as much Money as it would
cost you now for Peace. The Interest of half a Million Dollar is,
even at Six Per Cent, Thirty Thousand Guineas a year. For an Annual
Interest of 30,000 dollars then and perhaps for 15,000 or 10,000,
we can have Peace, when a War would sink us annually ten times as
much". In the last paragraph of the excerpt, Adams states interest
expense in terms of guineas. A guinea was worth about one dollar.
Jefferson responded to Adams a few weeks later: Dear Sir, "I ask a
fleet of 150 guns, the one half of which shall be in constant
cruise. This fleet built will cost $ 450,000. Its annual expense is
$300 a gun, including everything: this will be $45,000 a year. Were
we to charge all this to the Algerine war it would amount to little
more than we must pay if we buy peace. But as it is proper and
necessary that we should establish a small marine force (even 6
were we to buy a peace from the Algerines,) and as that force laid
up in our dockyards would cost us half as much annually as if kept
in order for service, we have a right to say that only $22,500 per
year should be charged to the Algerine war". Adams and Jefferson
exchanged numerous letters in old age, after both men had retired
from public life. One of these letters is relevant to the current
discussion, because it reveals Jefferson’s attitude towards the
Navy, and more specifically, his assessment of the economic life of
a ship: Jefferson to Adams Dear Sir, "Yet a navy is a very
expensive engine. It is admitted that in 10 or 12 years, a vessel
goes to entire decay; or, if kept in repair costs as much as would
build a new one. And that a nation who could count on 12 or 15
years of peace would gain by burning its navy and building a new
one in time".
Case Two Questions:
1. Adams calculates costs under three alternative policies: (1)
negotiate with the Barbary States; (2) wage war against the Barbary
States; and (3) do nothing. Under the first two scenarios, his cost
calculation represents projected cash outflows for the U.S.
government. The “do nothing” scenario, however, includes some
“costs” that would require no cash outlay by either the government
or its citizens. What is the relevance of this 3 rd cost
calculation, and what is the relationship of the cost of “doing
nothing” to the other two costs calculated by Adams?
2. How does Jefferson derive the amount of $22,500 per year, and
what does he mean by the statement: “we have a right to say that
only 22,500 dollars should be charged to the Algerine War”?
3. Evaluate Jefferson’s reasoning in his 1822 letter. Do you
agree with his logic? This letter does not specifically identify
the cost of building the fleet, but it does compare the
construction cost to the cost of maintaining the fleet. If the U.S.
had taken Jefferson’s advice, and burned its fleet in 1822, the
cost to build a new one might have differed from the cost of
building the original fleet. What is the relevance of each of these
costs in the decision of whether to burn the fleet?
4. Calculate the annual cost of fighting the pirates, based on
the information Jefferson provides, using the accounting technique
of asset capitalization and depreciation. First calculate the
annual depreciation expense of the fleet by capitalizing the cost
of construction, and depreciating this cost over the useful life of
the ships. (Ignore the possibility that the pirates might sink any
ships.) Then add to the depreciation expense the annual operating
costs.
5. A complete cost-benefit analysis of the alternative courses
of action for responding to the pirates requires a consideration of
non-financial factors. What non-financial factors can you identify
that you think Adams and Jefferson should consider in weighing the
pros and cons of fighting the pirates?
and cost allocation are identified and discussed in the context of
early U.S. foreign policy. The case is derived from an authentic
exchange of views between Thomas Jefferson and John Adams on how
the United States should protect its merchant shipping against the
Barbary Pirates. Both men compare the cost of waging war against
the pirates with the cost of paying ransom for captured U.S. seamen
and bribes to protect future shipping. Adams quantifies the
opportunity cost associated with not taking any action against the
pirates. Jefferson articulates an incremental costing argument, on
the assumption that the U.S. should build a navy regardless of U.S.
policy towards the Barbary States. The case constitutes a brief
introduction to management accounting by illustrating different
cost concepts, and also lends itself to a discussion of the
historical origins of management accounting. "The beginning of
wisdom in using accounting for decision-making is a clear
understanding that the relevant costs and revenues are those which
as between the alternatives being considered are expected to be
different in the future. It has taken accountants a long time to
grasp this essential point". R. Parker (1969) The Barbary Pirates
Throughout the 17th and 18th centuries, the North African Barbary
States of Morocco, Algiers, Tunis and Tripoli engaged in piracy of
European merchant shipping. The Barbary pirates routinely captured
and confiscated ships and cargo, and enslaved or ransomed their
crews and passengers. England, France and Spain entered into
treaties with the Barbary States, in effect, paying “protection
money” for their merchant shipping. These powerful European nations
preferred bribery to war, 3 because they perceived an economic
benefit from the threat the pirates posed to the merchant shipping
of other European nations. Until the Revolutionary War, merchant
ships from the American Colonies were protected by the British
Royal Navy and by the treaties between England and the Barbary
States. American shipping lost this protection in 1783, and within
the next two years three American ships were captured, one by
Morocco and two by Algiers. Morocco soon freed the American crew in
exchange for a ransom of $25,000. The crews held by the Algerians
were captive throughout 1786 and for some time thereafter.
Historical Background The capture of American ships by the Barbary
pirates created an early and important foreign policy crisis for
the United States. The U.S. response to the Barbary crisis was
strongly influenced by two factors, one military and the other
financial. The military consideration was that the U.S. had no
navy. The Continental Navy of the Revolutionary War was disbanded
in 1784, and the navy was not reestablished until 1798. During the
intervening years, the United States had minimal naval power.
Disbanding the Continental Navy was primarily a cost-savings
measure. However, there were also important non-financial arguments
for and against the navy. Some Americans who favored reestablishing
close ties with England feared that the presence of a U.S. navy on
the high seas would lead to confrontations with the British Navy.
Other Americans, including John Adams, viewed a strong navy as the
best national defense against foreign threats. Many Americans
preferred the prospect of building a navy over an army due to their
general distrust of standing armies—the result of their experience
with the British occupation in America during the latter part of
the Colonial Era. The financial factor that influenced the U.S.
response to the Barbary pirates was that any effective response
would require a significant expense relative to the government’s
available funds. The U.S. government found itself in a precarious
financial condition in the years immediately following the
Revolutionary War. The Continental Congress and individual states
borrowed over $40,000,000 to finance the war, including about
$6,000,000 from France. From 1781 to 1788, the period during which
the United States operated under the Articles of Confederation, the
federal government did not have the power to tax its citizens, levy
tariffs, or regulate commerce. The cost of operating the 4
government during this time was about $500,000 annually, not
including funding the debt. Some income was generated by the post
office and from sales of public lands, but the two principal
revenue sources available to the government were requesting support
from the states and issuing paper money. State contributions to the
federal government constituted only a small fraction of what was
needed, and issuing paper money was an inflationary measure that
had already been used extensively during the Revolutionary War. The
financial plight of the new nation was sufficiently acute that
during this period, the government borrowed from foreign sources
just to meet the interest obligations on existing foreign debt. The
ratification of the Constitution in 1788 greatly enhanced the
powers of the Federal government, and allowed the new Congress to
levy and collect duties and taxes. However, the ability of the new
government to actually enact and enforce revenue-generating
measures was untested, and evolved over time. In 1786, during the
Confederation period, and again in 1794, during Washington’s
presidency, popular opposition to taxation led to civil unrest. The
first incident, Shays’ Rebellion, arose in Massachusetts when the
State Legislature levied taxes to pay off the war debt. The second
incident, the Whiskey Rebellion, occurred in Western Pennsylvania
when the federal government imposed an excise tax on distilled
liquor. Also, although the Federal government had more potential
resources under the Constitution than under the Articles of
Confederation, it soon had more obligations. In 1790, under a plan
advanced by Secretary of the Treasury Alexander Hamilton, the
federal government assumed the remaining war debts that were owed
by the individual states. However, despite financial tribulations
at both the state and federal levels, economic conditions in the
United States during this period were generally good. A short
recession that occurred after the Revolutionary War was followed by
a period of economic growth. The strong economy led to increased
federal revenues, and that fact, combined with the success of
American leaders in keeping the nation out of the growing conflict
between England and France, enabled the government to become
current on its obligations under the national debt during
Jefferson’s administration. The Adams-Jefferson Correspondence In
1786, John Adams was the leading U.S. diplomat in London, and
Thomas Jefferson was the U.S. ambassador to France. A few years
earlier, in 1784, the Continental Congress had authorized Adams and
5 Jefferson to negotiate treaties with the Barbary States.
Consequently, the responsibility to negotiate the release of the
captured American seamen, and to establish U.S. foreign policy that
would protect U.S. shipping in the Mediterranean, fell largely to
these two men. Against this backdrop, Adams sent Jefferson a letter
that included the following analysis: Adams to Jefferson Letter
Dear Sir, "The first Question is, what will it cost us to make
Peace with all five [Barbary States]? Set it if you will at five
hundred Thousand Dollars, though I doubt not it might be done for
three or perhaps for two. The Second Question is, what Damage shall
we suffer, if we do not treat. Compute six or Eight Per Cent
Insurance upon all your Exports, and Imports. Compute the total
Loss of all the Mediterranean and Levant Trade. Compute the Loss of
half your Trade to Portugal and Spain. These computations will
amount to more than half a Million dollar a year. The third
Question is what will it cost to fight them? I answer, at least
half a Million dollar a year without protecting your Trade, and
when you leave off fighting you must pay as much Money as it would
cost you now for Peace. The Interest of half a Million Dollar is,
even at Six Per Cent, Thirty Thousand Guineas a year. For an Annual
Interest of 30,000 dollars then and perhaps for 15,000 or 10,000,
we can have Peace, when a War would sink us annually ten times as
much". In the last paragraph of the excerpt, Adams states interest
expense in terms of guineas. A guinea was worth about one dollar.
Jefferson responded to Adams a few weeks later: Dear Sir, "I ask a
fleet of 150 guns, the one half of which shall be in constant
cruise. This fleet built will cost $ 450,000. Its annual expense is
$300 a gun, including everything: this will be $45,000 a year. Were
we to charge all this to the Algerine war it would amount to little
more than we must pay if we buy peace. But as it is proper and
necessary that we should establish a small marine force (even 6
were we to buy a peace from the Algerines,) and as that force laid
up in our dockyards would cost us half as much annually as if kept
in order for service, we have a right to say that only $22,500 per
year should be charged to the Algerine war". Adams and Jefferson
exchanged numerous letters in old age, after both men had retired
from public life. One of these letters is relevant to the current
discussion, because it reveals Jefferson’s attitude towards the
Navy, and more specifically, his assessment of the economic life of
a ship: Jefferson to Adams Dear Sir, "Yet a navy is a very
expensive engine. It is admitted that in 10 or 12 years, a vessel
goes to entire decay; or, if kept in repair costs as much as would
build a new one. And that a nation who could count on 12 or 15
years of peace would gain by burning its navy and building a new
one in time".
Case Two Questions:
1. Adams calculates costs under three alternative policies: (1)
negotiate with the Barbary States; (2) wage war against the Barbary
States; and (3) do nothing. Under the first two scenarios, his cost
calculation represents projected cash outflows for the U.S.
government. The “do nothing” scenario, however, includes some
“costs” that would require no cash outlay by either the government
or its citizens. What is the relevance of this 3 rd cost
calculation, and what is the relationship of the cost of “doing
nothing” to the other two costs calculated by Adams?
2. How does Jefferson derive the amount of $22,500 per year, and
what does he mean by the statement: “we have a right to say that
only 22,500 dollars should be charged to the Algerine War”?
3. Evaluate Jefferson’s reasoning in his 1822 letter. Do you
agree with his logic? This letter does not specifically identify
the cost of building the fleet, but it does compare the
construction cost to the cost of maintaining the fleet. If the U.S.
had taken Jefferson’s advice, and burned its fleet in 1822, the
cost to build a new one might have differed from the cost of
building the original fleet. What is the relevance of each of these
costs in the decision of whether to burn the fleet?
4. Calculate the annual cost of fighting the pirates, based on
the information Jefferson provides, using the accounting technique
of asset capitalization and depreciation. First calculate the
annual depreciation expense of the fleet by capitalizing the cost
of construction, and depreciating this cost over the useful life of
the ships. (Ignore the possibility that the pirates might sink any
ships.) Then add to the depreciation expense the annual operating
costs.
5. A complete cost-benefit analysis of the alternative courses
of action for responding to the pirates requires a consideration of
non-financial factors. What non-financial factors can you identify
that you think Adams and Jefferson should consider in weighing the
pros and cons of fighting the pirates?