What Is Absolute Advantage?

Absolute advantage is the ability of an individual, company, region, or country to produce a greater quantity of a good or service with the same quantity of inputs per unit of time, or to produce the same quantity of a good or service per unit of time using a lesser quantity of inputs, than its competitors.

Absolute advantage can be accomplished by creating the good or service at a lower absolute cost per unit using a smaller number of inputs, or by a more efficient process.

Understanding Absolute Advantage

The concept of absolute advantage was developed by 18th-century economist Adam Smith in his book The Wealth of Nations to show how countries can gain from trade by specializing in producing and exporting the goods that they can produce more efficiently than other countries. Countries with an absolute advantage can decide to specialize in producing and selling a specific good or service and use the generated funds to purchase goods and services from other countries.

Smith argued that specializing in the products that they each have an absolute advantage in and then trading the products can make all countries better off, as long as they each have at least one product for which they hold an absolute advantage over other nations.

Absolute advantage explains why it makes sense for individuals, businesses, and countries to trade with each other. Since each has advantages in producing certain goods and services, both entities can benefit from the exchange.

This mutual gain from trade forms the basis of Smith’s argument that specialization, the division of labor, and subsequent trade lead to an overall increase in prosperity from which all can benefit. This, Smith believed, was the root source of the eponymous “Wealth of Nations.”

Absolute Advantage vs. Comparative Advantage

Absolute advantage can be contrasted with comparative advantage, which is when a producer has a lower opportunity cost to produce a good or service than another producer. An opportunity cost is the potential benefits an individual, investor, or business misses out on when choosing one alternative over another.

Absolute advantage leads to unambiguous gains from specialization and trade only in cases where each producer has an absolute advantage in producing some good. If a producer lacks any absolute advantage, then Adam Smith’s argument would not necessarily apply.

However, the producer and its trading partners might still be able to realize gains from trade if they can specialize based on their respective comparative advantages instead. In his book On the Principles of Political Economy and Taxation, David Ricardo argued that even if a country has an absolute advantage over trading many kinds of goods, it can still benefit by trading with other countries if that have different comparative advantages.

Assumptions of the Theory of Absolute Advantage

Both Smith’s theory of absolute advantage, and Ricardo’s theory of comparative advantage, rely on certain assumptions and simplifications in order to explain the benefits of trade.

Barriers to Trade

Both theories assume that there are no barriers to trade. They do not account for any costs of shipping or additional tariffs that a country might raise on another’s imported goods. In the real world, though, shipping costs impact how likely both the importer and exporter are to engage in trade. Countries can also leverage tariffs to create advantages for themselves or disadvantages for competitors.

Factors of Production

Both theories also assume that the factors of production are immobile. In these models, workers and businesses do not relocate in search of better opportunities. This assumption was realistic in the 1700s.

In modern trade, however, globalization has now made it easy for companies to move their factories abroad. It has also increased the rate of immigration, which impacts a country’s available workforce. In some industries, businesses will work with governments to create immigration opportunities for workers that are essential to their business operations.

Consistency and Scale

More crucially, these theories both assume that a country’s absolute advantage is constant and scales equally. In other words, it assumes that producing a small number of goods has the same per-unit cost as a larger number and that countries are unable to change their absolute advantages.

In reality, countries often make strategic investments to create greater advantages in certain industries. Absolute advantage can also change for reasons other than investment. Natural disasters, for example, can destroy farmland, factories, and other factors of production.

Pros and Cons of Absolute Advantage

One advantage of the theory of absolute advantage is its simplicity: The theory provides an elegant explanation of the benefits of trade, showing how countries can benefit by focusing on their absolute advantages.

However, the theory of comparative advantage does not fully explain why nations benefit from trade. This explanation would later fall to Ricardo’s theory of comparative advantage: Even if one country has an absolute advantage in both types of goods, it will still be better off through trade. In other words, if one country can produce all goods more cheaply than its trading partners, it will still benefit by trading with other countries.

Also, as explained earlier, the theory also assumes that absolute advantages are static—a country cannot change its absolute advantages, and they do not become more efficient with scale. Actual experience has shown this to be untrue: Many countries have successfully created an absolute advantage by investing in strategic industries.

In fact, the theory has been used to justify exploitative economic policies in the postcolonial era. Reasoning that all countries should focus on their advantages, major bodies like the World Bank and IMF have often pressured developing countries to focus on agricultural exports, rather than industrialization. As a result, many of these countries remain at a low level of economic development.

Example of Absolute Advantage

Consider two hypothetical countries, Atlantica and Pacifica, with equivalent populations and resource endowments, with each producing two products: guns and bacon. Each year, Atlantica can produce either 12 tubs of butter or six slabs of bacon, while Pacifica can produce either six tubs of butter or 12 slabs of bacon.

Each country needs a minimum of four tubs of butter and four slabs of bacon to survive. In a state of autarky, producing solely on their own for their own needs, Atlantica can spend one-third of the year making butter and two-thirds of the year making bacon, for a total of four tubs of butter and four slabs of bacon.

Pacifica can spend one-third of the year making bacon and two-thirds making butter to produce the same: four tubs of butter and four slabs of bacon. This leaves each country at the brink of survival, with barely enough butter and bacon to go around. However, note that Atlantica has an absolute advantage in producing butter and Pacifica has an absolute advantage in producing bacon.

If each country were to specialize in their absolute advantage, Atlantica could make 12 tubs of butter and no bacon in a year, while Pacifica makes no butter and 12 slabs of bacon. By specializing, the two countries divide the tasks of their labor between them.

If they then trade six tubs of butter for six slabs of bacon, each country would then have six of each. Both countries would now be better off than before, because each would have six tubs of butter and six slabs of bacon, as opposed to four of each good which they could produce on their own.

The Bottom Line

The theory of absolute advantage represents Adam Smith’s explanation of why countries benefit from trade, by exporting goods where they have an absolute advantage and importing other goods. While the theory is an elegant and simple illustration of the benefits of trade, it did not fully explain the benefits of international trade. That would later fall to David Ricardo’s theory of comparative advantages.

What Is an Accrued Expense?

An accrued expense, also known as accrued liabilities, is an accounting term that refers to an expense that is recognized on the books before it has been paid. The expense is recorded in the accounting period in which it is incurred.

Understanding Accrued Expenses

Since accrued expenses represent a company’s obligation to make future cash payments, they are shown on a company’s balance sheet as current liabilities. An accrued expense can be an estimate and differ from the supplier’s invoice that will arrive at a later date. Following the accrual method of accounting, expenses are recognized when they are incurred, not necessarily when they are paid.

An example of an accrued expense is when a company purchases supplies from a vendor but has not yet received an invoice for the purchase. Other forms of accrued expenses include interest payments on loans, warranties on products or services received, and taxes—all of which have been incurred or obtained, but for which no invoices have been received nor payments made. Employee commissions, wages, and bonuses are accrued in the period they occur although the actual payment is made in the following period.

Accrual vs. Cash Basis Accounting

Accrual accounting differs from cash basis accounting, which records financial events and transactions only when cash is exchanged—often resulting in the overstatement and understatement of income and account balances.

Although the accrual method of accounting is labor-intensive because it requires extensive journaling, it is a more accurate measure of a company’s transactions and events for each period. This more complete picture helps users of financial statements to better understand a company’s present financial health and predict its future financial position.

Accrued Expenses vs. Prepaid Expenses

Accrued expenses are the opposite of prepaid expenses. Prepaid expenses are payments made in advance for goods and services that are expected to be provided or used in the future. While accrued expenses represent liabilities, prepaid expenses are recognized as assets on the balance sheet. This is because the company is expected to receive future economic benefit from the prepayment.

On the other hand, an accrued expense is an event that has already occurred in which cash has not been a factor. Not only has the company already received the benefit, it still needs to remit payment. Therefore, it is literally the opposite of a prepayment; an accrual is the recognition of something that has already happened in which cash is yet to be settled.

Advantages and Disadvantages of Accrued Expenses

Advantages

Accrued expenses theoretically make a company’s financial statements more accurate. While the cash method is more simple, accrued expenses strive to include activity that may not have fully been incurred but will still happen. Consider an example where a company enters into a contract to incur consulting services. If the company receives an invoice for $5,000, accounting theory states the company should technically recognize this transaction because it is contractually obligated to pay for the service.

Accrued expenses also may make it easier for companies to plan and strategize. Accrued expenses often yield more consistent financial results as companies can include recurring transactions in their financial reports that may not yet have been paid. In addition, accrued expenses may be a financial reporting requirement depending on the company and their Securities and Exchange Commission filing requirements.

Disadvantages

Because of additional work of accruing expenses, this method of accounting is more time-consuming and demanding for staff to prepare. There is a greater chance of misstatements, especially is auto-reversing journal entries are not used. In addition, a company runs of the risk of accidently accruing an expense that they may have already paid.

Last, the accrual method of accounting blurs cash flow and cash usage as it includes non-cash transactions that have not yet impacted bank accounts. For a large company, the general ledger will be flooded with transactions that report items that have had no bearing on the company’s bank statement nor impact to the current amount of cash on hand.

Special Considerations

Reversing Entries

A critical component to accrued expenses is reversing entries, journal entries that back out a transaction in a subsequent period.

Accrued expenses are not meant to be permanent; they are meant to be temporary records that take the place of a true transaction in the short-term. Every accrued expense must have a reversing entry; without the reversing entry, a company risks duplicating transactions by recording both the actual invoice when it gets paid as well as the accrued expense.

Month-End/Year-End

Accrued expenses are prevalent during the end of an accounting period. A company often attempts to book as many actual invoices it can during an accounting period before closing its accounts payable ledger. Then, supporting accounting staff analyze what transactions/invoices might not have been recorded by the AP team and book accrued expenses.

For companies that are responsible for external reporting, accrued expenses play a big part in wrapping up month-end, quarter-end, or fiscal year-end processes. A company usually does not book accrued expenses during the month; instead, accrued expenses are booked during the close period.

Example of Accrued Expense

A company pays its employees’ salaries on the first day of the following month for services received in the prior month. So, employees that worked all of November will be paid in December. If on Dec. 31, the company’s income statement recognizes only the salary payments that have been made, the accrued expenses from the employees’ services for December will be omitted.

Because the company actually incurred 12 months’ worth of salary expenses, an adjusting journal entry is recorded at the end of the accounting period for the last month’s expense. The adjusting entry will be dated Dec. 31 and will have a debit to the salary expenses account on the income statement and a credit to the salaries payable account on the balance sheet.

When the company’s accounting department receives the bill for the total amount of salaries due, the accounts payable account is credited. Accounts payable is found in the current liabilities section of the balance sheet and represents the short-term liabilities of a company. After the debt has been paid off, the accounts payable account is debited and the cash account is credited.

The Bottom Line

Companies using the accrual method of accounting recognize accrued expenses, costs that have not yet been paid for but have already been incurred. Accrued expenses make a set of financial statements more consistent by recording charges in specific periods, though it takes more resources to perform this type of accounting. While the cash method of accounting recognizes items when they are paid, the accrual method recognizes accrued expenses based on when service is performed or received. 

What Is Active Management?

The term active management means that an investor, a professional money manager, or a team of professionals is tracking the performance of an investment portfolio and making buy, hold, and sell decisions about the assets in it. The goal of any investment manager is to outperform a designated benchmark while simultaneously accomplishing one or more additional goals such as managing risk, limiting tax consequences, or adhering to environmental, social, and governance (ESG) standards for investing. Active managers may differ from other is how they accomplish some of these goals.

For example, active managers may rely on investment analysis, research, and forecasts, which can include quantitative tools, as well as their own judgment and experience in making decisions on which assets to buy and sell. Their approach may be strictly algorithmic, entirely discretionary, or somewhere in between.

By contrast, passive management, sometimes known as indexing, follows simple rules that try to track an index or other benchmark by replicating it. Those who advocate for passive management maintain that the best results are achieved by buying assets that mirror a particular market index or indexes. Their contention is that passive management removes the shortfalls of human biases and that this leads to better performance. However, studies comparing active and passive management have only served to keep the debate alive about the respective merits of either approach.

Understanding Active Management

Investors who believe in active management do not support the stronger forms of the efficient market hypothesis (EMH), which argues that it is impossible to beat the market over the long run because all public information has already been incorporated in stock prices.

Those who support these forms of the EMH insist that stock pickers who spend their days buying and selling stocks to exploit their frequent fluctuations will, over time, likely do worse than investors who buy the components of the major indexes that are used to track the performance of the wider markets over time. But this point of view narrows investing goals into a single dimension. Active managers would contend that if an investor is concerned with more than merely tracking or slightly beating a market index, an active management approach might be better suited for the task.

Active managers measure their own success by measuring how much their portfolios exceed (or fall short of) the performance of a comparable unmanaged index, industry, or market sector.

For example, the Fidelity Blue Chip Growth Fund uses the Russell 1000 Growth Index as its benchmark. Over the five years that ended June 30, 2020, the Fidelity fund returned 17.35% while the Russell 1000 Growth Index rose 15.89%. Thus, the Fidelity fund outperformed its benchmark by 1.46% for that five-year period. Active managers will also assess portfolio risk, along with their success in achieving other portfolio goals. This is an important distinction for investors in retirement years, many of whom may have to manage risk over shorter time horizons.

Strategies for Active Management

Active managers believe it is possible to profit from the stock market through any of a number of strategies that aim to identify stocks that are trading at a lower price than their value merits. Their strategies may include researching a mix of fundamental, quantitative, and technical indications to identify stock selections. They may also employ asset allocation strategies aligned with their fund’s goals.

Many investment companies and fund sponsors believe it’s possible to outperform the market and employ professional investment managers to manage the company’s mutual funds. They may see this as a way to adjust to ever-changing market conditions and unprecedented innovations in the markets.

Disadvantages of Active Management

Actively managed funds generally have higher fees and are less tax-efficient than passively managed funds. The investor is paying for the sustained efforts of investment advisers who specialize in active investment, and for the potential for higher returns than the markets as a whole.

An investor considering active management should take a hard look at the actual returns after fees of the manager.

Advantages of Active Management

A fund manager’s expertise, experience, and judgment are employed by investors in an actively managed fund. An active manager who runs an automotive industry fund might have extensive experience in the field and might invest in a select group of auto-related stocks that the manager concludes are undervalued.

Active fund managers have more flexibility. There is more freedom in the selection process than in an index fund, which must match as closely as possible the selection and weighting of the investments in the index.

Actively managed funds allow for benefits in tax management. The flexibility in buying and selling allows managers to offset losers with winners.

Managing Risk

Active fund managers can manage risks more nimbly. A global banking exchange-traded fund (ETF) may be required to hold a specific number of British banks. That fund is likely to have dropped significantly following the shock Brexit vote in 2016. An actively managed global banking fund, meanwhile, might have reduced its exposure to British banks due to heightened levels of risk.

Active managers can also mitigate risk by using various hedging strategies such as short selling and using derivatives.

Active Management Performance 

There is plenty of controversy surrounding the performance of active managers. Their success or failure depends largely on which of the contradictory statistics is quoted.

Over 10 years ending in 2021, active managers who invested in domestic small growth stocks were most likely to beat the index. A study showed that 88% of active managers in this category outperformed their benchmark index before fees were deducted.