[Excerpted from “The Great Domain of Cost-Plus:  The Waste Production Economy,” Center for a Stateless Society, 2010]

A large share of what’s conventionally counted as “output” consists of waste production.  Many areas of our national life are governed by accounting systems that count the consumption of inputs as an output.

For example, economists’ calculation of the Gross Domestic Product is a textbook illustration of the “broken window fallacy.”  That fallacy, according to Frédéric Bastiat, is the belief that a broken window is good because it creates work and revenue for the glaziers.  True, said Bastiat, it employs glaziers.  But that does not mean that the breaking of windows is a good thing; the owner of the broken window simply spends money to wind up in the same state that he would have been for free had the window not been broken at all.  “Society loses the value of objects unnecessarily destroyed….”

As the authors of Natural Capitalism point out, anything that involves an expenditure of money adds to the GDP.  Jonathan Rowe writes:

The GDP is simply a gross measure of market activity, of money changing hands. It makes no distinction whatsoever between the desirable and the undesirable, or costs and gain.  On top of that, it looks only at the portion of reality that economists choose to acknowledge—the part involved in monetary transactions.  The crucial economic functions performed in the household and volunteer sectors go entirely unreckoned.  As a result the GDP not only masks the breakdown of the social structure and the natural habitats upon which the economy—and life itself—ultimately depend; worse, it portrays such breakdown as economic gain.

Or as Scott Burns put it, “The value of a friend’s services on his own car is excluded from GNP.  But the cost of his accident, ambulance ride, and hospital stay is not.”

Everything that entails the expenditure of money adds to the GDP, even if most of the cost is waste that adds nothing to the actual production of use-value.  A pileup on the expressway that totals out a dozen cars and results in several funerals or several people spending weeks on life support means millions of dollars added to the GDP.  When you pay three times as much to buy food grown in another country with subsidized irrigation water and trucked to you on subsidized highways, as it would cost to buy food of identical quality grown by a local farmer and distributed in bulk without a brand-name markup, it adds three times as much to the GDP—even though you’re just having to work three times as long to obtain identical (or inferior) use-values.

The internal accounting mechanism of the large corporation is similar to that entailed in calculating GDP, in that it counts expenditure on inputs as the creation of wealth.    Given the pervasiveness of state cartelization, a major share of the economy is made up of oligopoly markets dominated by a handful of firms.  Because oligopoly firms tend to be “price-givers” rather than “price-takers,” and to be able to pass their costs on as a markup to the consumer via administered pricing, they are largely insulated from competitive pressure for minimizing costs. 

The dominant firms in an oligopoly market usually have similar internal cultures in most regards, and are likely to follow the same “best practices.”  Many such aspects of their business models aren’t matters for competition, because they are based on the same set of unquestioned assumptions common to the institutional culture of the entire industry.

Large corporations are also frequently isolated from pressures to minimize costs because of the superfluity of capital available for investment.  Large corporations are rarely dependent either on new stock issues or capital markets to finance new investment, choosing instead to finance expansion of capacity or upgrades of plant and equipment through retained earnings.  But as Martin Hellwig pointed out, far from serving as a constraint or imposing the need to ration investment, the value of retained earnings often exceeds the total value of opportunities for rational investment.5  Under such circumstances, the firm may well overinvest or be prodigal in the use of its funds for the sake of internal empire-building, rather than issue the surplus as dividends.

As with GDP calculations, Robin Marris wrote, the bureaucratic culture of the corporation

is likely to divert emphasis from the character of the goods and services produced to the skill with which these activities are organized….  The concept of consumer need disappears, and the only question of interest… is whether a sufficient number of consumers, irrespective of their “real need” can be persuaded to buy [a proposed new product].”

The result, as in the calculational chaos of the old Soviet Union, is not that technical progress stops or that production of a kind takes place, but that enormous sums are spent on capital outlays with no reliable way of knowing whether the expenditure was worth it.  The large corporation is riddled with the same irrationality and uneven development that plagued the USSR.

Richard Ericson remarked on the ability of communist systems to achieve great feats of engineering without regard to cost:

When the system pursues a few priority objectives, regardless of sacrifices or losses in lower priority areas, those ultimately responsible cannot know whether the success was worth achieving.

Consider also Hayek’s prediction of the uneven development, irrationality, and misallocation of resources within a planned economy:

There is no reason to expect that production would stop, or that the authorities would find difficulty in using all the available resources somehow, or even that output would be permanently lower than it had been before planning started….  [We should expect] the excess development of some lines of production at the expense of others and the use of methods which are inappropriate under the circumstances.  We should expect to find overdevelopment of some industries at a cost which was not justified by the importance of their increased output and see unchecked the ambition of the engineer to apply the latest development elsewhere, without considering whether they were economically suited to the situation.  In many cases the use of the latest methods of production, which could not have been applied without central planning, would then be a symptom of misuse of resources rather than a proof of success.

As an example he cited “the excellence, from a technological point of view, of some parts of the Russian industrial equipment, which often strikes the casual observer and which is commonly regarded as evidence of success….”

I’d be hard-pressed to find a better description of how capital is allocated under our corporatist economy.  Entire categories of goods and production methods have been developed at enormous expense, either within military industry or by state-subsidized R&D in the civilian economy, without regard to cost.  Production methods are radically distorted by such subsidies, as well.  Economic centralization and capital-intensive, blockbuster production facilities become artificial profitable, thanks to the Interstate Highway System and civil aviation.

What’s more, as we shall see shortly, the quotes above on communist central planning also describe the pervasive irrationality within the large corporation:  management featherbedding and self-dealing; “cost-cutting” measures that hollow out productive resources while leaving management’s petty empires intact; the pouring of money down the ratholes of enormous capital projects undertaken primarily for their prestige value; and the tendency to extend bureaucratic domain while cutting maintenance and support for existing obligations.  Management’s allocation of resources may create use value of a sort—but with no reliable way to assess the opportunity costs or determine whether the benefit was worth it.

The dominant corporate accounting model results, to a large extent, from the imperatives of mass production.  The mass production industrial model is based on using extremely expensive, product-specific capital equipment, which in turn requires large batch production to run the machinery at full speed and spread capital amortization costs out over as many units as possible.  This means that production is undertaken for the primary purpose of fully utilizing productive capacity and achieving economies of speed, without regard to spontaneous, preexisting demand.  The accounting system used within the typical large corporation reflects this requirement.

In Sloanist management accounting, according to William Waddell and Norman Bodek, inventory is counted as an asset “with the same liquidity as cash.”  Regardless of whether a current output is needed to fill an order, the producing department sends it to inventory and is credited for it.  Under the practice of “overhead absorption,” all overhead costs are fully incorporated into the price of goods “sold” to inventory, at which point they count as an asset on the balance sheet.

With inventory declared to be an asset with the same liquidity as cash, it did not really matter whether the next ‘cost center,’ department, plant, or division actually needed the output right away in order to consummate one of these paper sales.  The producing department put the output into inventory and took credit.

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…Expenses go down…, while inventory goes up, simply by moving a skid full of material a few operations down the stream.  In fact, expenses can go down and ROI can improve even when the plant pays an overtime premium to work on material that is not needed; or if the plant uses defective material in production and a large percentage of the output from production must be scrapped.

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…By defining the creation of inventory, including work-in-process, as a money-making endeavor, any incentive to encourage flow went out the window.  The 1950s saw the emergence of warehouses as a logical and necessary adjunct to manufacturing.  Prior to that, the manufacturing warehouse was typically a small shed out behind the plant….  By the 1960s warehouse space  often equaled, or exceeded, production space in many plants….

In other words, by the Sloanist accounting principles predominant in American industry, the expenditure of money on inputs is by definition the creation of value.  As Waddell described it at his blog,

companies can make a bunch of stuff, assign huge buckets of fixed overhead to it and move those overheads over to the balance sheet, making themselves look more profitable.

Paul Goodman’s phrase “great domain of cost-plus” sums it up perfectly.  The culture of cost-plus is traditionally associated with the public utility, and (in the brilliant work of Seymour Melman) the military contractor.  The firm is insulated from market competition, and has a guaranteed revenue source, so that it can set its prices on a cost-plus markup basis.  There is, accordingly, no incentive to minimize costs.  The higher the production cost is padded with waste and featherbedding, the higher the firm can set its prices.  This is the cost-maximizing incentive structure that resulted in the Pentagon’s notorious $600 toilet seats.  But it prevails as well, in kind if not to quite the same degree, in the large firms in civilian oligopoly markets.  The large corporation has a significant portion of its operating costs subsidized by the state, and typically operates with a superfluity of investment capital from retained earnings.  It exists in a market of restricted competition in a state-fostered cartel.  Not only is most competition in terms of brand image and minor variations in features rather than price, but even the competition in features is limited by the ability of oligopoly firms to collude in rationing technical improvements over time—with the help, of course, of government regulations in limiting the range of competition in product features and quality (remember what Paul Goodman quote about “fixed prices and slowly spooned-out improvements”?).

The very idea of “marginal productivity” is meaningless in such an environment.  “Marginal productivity” is defined as the portion which a given expenditure adds to the additional revenue stream which is realized when the product is sold.  But in an atmosphere of cost-plus markup, every expenditure on administrative overhead or wastefully allocated capital increases the final price of the good on (at least) a one-to-one basis.

And even if internal bureaucratic waste and overhead do have a detrimental effect on productivity and the nominal profit margin, management is the de facto residual claimant and management remuneration is the de facto profit for whose sake the enterprise actually exists.  The shareholder, in reality, is at best a contractual claimant with even fewer actionable rights than a bondholder;  whether management issues a dividend at all is entirely at their discretion, while they can set their own salaries virtually without limit in mutual logrolling with the Board of Directors.  So management may very well  choose, entirely rationally, to take a large slice of a small pie in preference to maximizing the size of the whole pie.

It’s interesting to consider the parallels between the management accounting system of the typical large American corporation and the old Soviet planned economy.  Both equated the using up of inputs to the creation of value.  “Selling to inventory,” under standard management accounting rules, is equivalent to the incentive systems for production under a Five-Year Plan:  there is no incentive to produce goods that will actually work or be consumed.

Another parallel between corporate management accounting and state socialism is that the transfer prices assigned to intermediate goods, and credited to the sub-processes that produce them, bear a strong resemblance to the pricing system in the Soviet planned economy.

Ludwig von Mises argued that the Soviet economy could more or less stagger along, without being utterly destroyed by the calculation problem, by assigning prices to producer goods in their economy based on price data from external markets.  Likewise, Murray Rothbard argued, the need for an external market in producer goods was a constraint on the size of a corporation; a monopoly that was vertically integrated to the point that it absorbed all producers of some intermediate good, would face calculational chaos in attempting to rationally allocate inputs of that particular intermediate good.  But Austrian scholar Peter Klein, developing Rothbard’s hints regarding potential calculation problems within the large corporation, argued that the existence of any external market at all for an intermediate good was sufficient.  But if this is so, if meaningful calculation simply requires the existence of an outside market as a reference source for establishing internal transfer prices, without prices in that external market necessarily reflecting the spot conditions of supply and demand within the firm, then the Soviet economy stood and fell on the same terms as the American corporation when it came to establishing the prices it used internally based on rough approximations from distant markets.

What’s more, there is in fact no external market for a large portion of the intermediate goods used in production by the typical large American corporation, because so many product components are unique to a particular company’s design.  If there is no external market for generic versions of some product component, then its internal transfer price must be established (through the kind of bureaucratic process it’s best not to imagine) on some sort of cost-plus basis loosely derived the external market price of the producer goods that the component is made out of (or perhaps that those producer goods are made out of).  In 1961 John Menge found that “integral, nonsubstitutable, components of the finished product,” for which no external market existed, amounted to some 65% of intermediate goods.  There is no reason to doubt that a significant share of intermediate goods today is similarly product-specific.

A good example comes from Waddell and Bodek:  the “price” assigned to each steering wheel produced on an assembly line.   It’s a product-specific component, a “good” for which there is no competitive external market hence for which no real external market price exists.  It’s assigned a “price” in a fake internal market. “Credit for that work—it looks like a payment on the manufacturing budget—is given for performing that simple task because it moves money from expenses to assets.”