Concept of Cost

Cost on the Basis of Nature

Direct Cost

Direct costs are expenses that a company can easily connect to a specific “cost object,” which may be a product, department or project. It includes direct material (raw material), direct labour (wages) and direct expenses (octori, carriage , freight etc).

Indirect Cost

Indirect costs go beyond the costs associated with creating a particular product to include the price of maintaining the entire company. These overhead costs are the ones left over after direct costs have been computed, and are sometimes referred to as the “real” costs of doing business.

It includes indirect material rather than raw material, indirect labour expenses (salaries) and indirect expenses (excise duty, income tax etc.)

Cost on the Basis of Function

Prime Cost: It consist of  all the direct expenses incurred in connection of production.

Factory Cost/ Work Cost:  When prime cost is added with factory expenses (either fixed or variable) or work expenses (fuel, repairs, depreciation etc) it will give factory cost.

Office Cost/ Cost of Production:  When factory cost is added with administrative expenses like salaries, office lighting etc then it is known as Office Cost.

Total Cost: When selling and distribution expenses are added to office cost then it is known as Total Cost.

Cost on the Basis of Behaviour

Fixed costs are those costs that are fixed in volume for a certain level of output. They do not vary with output. They remain constant regardless of the level of output. Fixed costs include:

(i) Cost of managerial and administrative staff; (ii) Depreciation of machinery; (iii) Land maintenance, and the like. Fixed costs are normally short-term concepts because, in the long-run, all costs must vary.

 

Variable Costs are those that vary with variations in output. These include: (i) Cost of raw materials; (ii) Running costs of fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with output levels; and (iii) the Costs of all other inputs that may vary with the level of output.

 

Semi- Variable Cost: A semi-variable cost is a cost that contains both fixed and variable cost elements. The fixed element of the cost will be incurred repeatedly over time, while the variable element will only be incurred as a function of activity volume.

Thus, a base-level cost will be always be incurred, irrespective of volume, as well as an additional cost that is based only on volume. This concept is used to project financial performance at different activity levels.

Money Cost and Real Cost

Money Cost of production is the actual monetary expenditure made by company in the production process. Money cost thus includes all the business expenses which involve outlay of money to support business operations.

For example the monetary expenditure on purchase of raw material, payment of wages and salaries, payment of rent and other charges of business etc can be termed as Money Cost.

Real Cost of production or business operation on the other hand includes all such expenses/costs of business which may or may not involve actual monetary expenditure.

For example if owner of a business venture uses his personal land and building for running the business venture and he/she does not charge any rent for the same then such head will not be considered/included while computing the Money Cost but this head will be part of Real Cost computation.

Historical and Replacement Costs

The historical cost of an asset refers to the actual cost incurred at the time the asset was acquired.

In contrast, the replacement cost stands for the cost which must be incurred if the asset is to be purchased today. These concepts derive from the unstable nature of price behaviour as the two concepts differ due to price variations over time.

Private and Social Costs

The actual expenses of individuals/ firms which are borne or paid out by the individual or a firm can be termed as Private Cost. Thus for a business firm this may include expenses like Cost of Raw Material, Salaries and Wages, Rent, Various Overhead Expenses etc.

On the other hand Private Cost for an individual will be his or her private expenses such as expense on food, rent of house, expenses on clothing, expenses on travel, expenses on entertainment etc.

 

Social Cost on the other hand includes Private Cost and also such costs which are not borne by the firm but by the society at large. For example the cost of damage or disutility caused by the operations of a firm in an economy may not be borne by the firm in question but it impacts the society at large and thus such cost is added to the Private Cost to find the Social Cost of producing the product. Such Cost (that is cost not borne or paid out by the firm) is also known as External Cost.

Another example of external cost can be the cost of providing the basic infrastructure facilities like good roads, sewage system or network, street lights etc. Cost of such facilities is not borne by a business firm even though the firm is benefits from such facilities. Such costs (External Costs) are thus added to the Private Cost to find the Social Cost of producing a product or good.

Above can be understood by following example: If a Tannery firm (A firm processing animal skins) releases its toxic wastes in the river flowing nearby its factory premises then this act of the Tannery firm results in water pollution and environmental damage. The Cost of such damage/loss (also known as External Cost) is added to the private costs of the tannery firm to get fair idea of Social cost involved in the production of the product in question.

Social Cost of an individual will include his private cost and the cost of damage on account of his actions (that has resulted in doing harm/damage to the environment/society at large).

 Examples of such social costs include: water pollution from oil refineries, air pollution costs by mills and factories located near a city, and the like.

Explicit and Implicit Costs

Explicit Costs refer to the actual expenditures of the firm to hire, rent or purchase the input it requires in production. These include the wages to hire labour, the rental price of capital, equipment and buildings and the purchase prices of raw materials and semi finished products.

These are the recorded expenditure during the process of production. They are thus also known as accounting cost or money cost, as these are actual monetary expenditures incurred by the firm.

Explicit costs are those cost which are actually incurred and therefore are recorded in the books of accounts by the company. Example of it is rent paid, salary paid to workers, price paid for raw materials etc. Explicit costs are also called accounting costs. In other words there is outlay of cash from the company in case of explicit costs

Implicit Costs: Implicit cost arises in the case of those factors, which are possessed and supplied by the entrepreneur himself. There is no contractual obligation for payment to anyone else in order to obtain these factor units.

But, the factor units are responsible for costs, since they could be sup­plied to other producers for contractual sum, if they were not used in this business.

In the economic sense there are certain costs which are implicit in nature. This refers to the value of the inputs owned and used by the firm in its own production activity.

Implicit costs include the highest salary that the entrepreneur can earn for him, the highest return the firm could receive from investing its capital in alternatives uses or renting its land and buildings to the highest bidder rather than using them itself.

In general, following are the implicit costs, which should be included in the total cost, but go unrecorded in the account of the firm

  • Wages of labour rendered by the entrepreneur himself.
  • Interest on capital supplied by the entrepreneurs.
  • Rent of land and premises belonging to the entrepreneurs and used in the production.
  • Normal profit of entrepreneur, compensation for being the ultimate risk taker in the firm.

Accounting Cost and Economic Cost

Accounting Cost includes all such business expenses that are recorded in the book of accounts of a business firm as acceptable business expenses. Such expenses include expenses like Cost of Raw Material, Wages and Salaries, Various Direct and Indirect business Overheads, Depreciation, Taxes etc.

When such business expenses or accounting expenses are deducted from the Sales income of any firm the accounting profit is obtained. Such Accounting/Business expenses or costs are also termed as Explicit Costs.

Accounting Cost: Various allowed business expenses such as Cost of Raw Material, Salaries and Wages, Electricity Bill, Telephone Charges, Various Administrative Expenses, Selling and Distribution Expenses, Production Overhead Expenses, Other Indirect Overhead Expenses etc.

Accounting Profit = Sales Income – Accounting Cost

Economic Cost on the other hand includes all the accounting expenses as well as the Opportunity cost of a business firm. Economic Cost and Economic Profit is thus calculated as follows:

  • Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost
  • Economic Profit = Total Revenues – (Accounting Cost + Opportunity Cost)

Opportunity Cost

The opportunity cost of a factor of production is the reward (or value) that factor could have earned in the next best alternative occupation.

In fact, a cost is a forgone opportunity; the cost of engaging in an activity is the totality of all the opportunities that the activity requires you to forgo. To avoid double counting only the best alternative is considered as opportunity cost.

Accounting opportunity costs are important for financial reporting by the firm and for tax purposes. For managerial decision making purposes (with which we are primarily interested in economics) opportunity or economic costs is relevant cost concept.

 With an example of inventory valuation will clarify the distinction.

 Suppose, a firm purchased a raw material for Rs.100/- but its price subsequently rose to Rs.150/-. The accountant would continue to report the cost of the raw material at its original price of Rs.100/-.

The economist however, would value the raw material at its current or replacement value. Failure to do so might lead to the wrong managerial decision.

This would occur, if the firm decides to continue the production using the raw material, while more beneficial outcome would have been to stop output and sell the raw material booking the profit at price Rs.150/-

Incremental Cost

Incremental cost refers to the change in total cost from implementing a particular management decision, such as the introduction of a new product line, the undertaking of a new advertising campaign or the production of previously purchased components.

Sunk Costs

The costs that are not affected by the decision are irrelevant and are called sunk cost. In other words, sunk costs are not altered by the change in business activity.

Controllable Costs

Controllable costs are those which can be controlled or regulated through observation by an executive and therefore they can be used for assessing the efficiency of the executive.  Most of the costs are controllable.

Example: Inventory costs can be controlled at the shop level etc.

Non Controllable Costs

The costs which cannot be subjected to administrative control and supervision are called non controllable costs.

Example: Costs due obsolesce and depreciation, capital costs etc.

Shutdown Costs

The costs which a firm incurs when it temporarily stops its operations are called shutdown costs.  These costs can be saved when the firm again start its operations. 

Shutdown costs include fixed costs, maintenance cost, layoff expenses etc.

Abandonment Costs

Abandonment costs are those costs which are incurred for the complete removal of the fixed asset from use.  These may occur due to obsolesce or due to improvisation of the firm.  Abandonment costs thus involve problem of disposal of the asset.

Urgent Costs and Postponable Costs

Urgent costs are those costs which have to be incurred compulsorily by the management in order to continue its operations. If urgent costs are not incurred in time the operational efficiency of the firm falls.

Example: Cost of material, labour, fuel etc

Postponable costs are those which if not incurred in time do not effect the operational efficiency of the firm.  Example: maintenance costs.

Short Run and Long Run Costs

Short Run Costs: The short run costs are operating costs associated with the change in output. In the short run, the production function contains a set of fixed factor input and a set of variable inputs. Short run costs vary in relation to the variation in the variable input component only.

Long Run Costs: The long run costs are the operating costs associated with the changing scale of output and the alteration in the size of plant. In the long run production function all the factor inputs are variable. Their costs are the long run costs.

Total Fixed Costs and Total Variable Costs

Total Fixed Costs: The total obligations of the firm per time period for all fixed inputs are called total fixed costs (TFC).These are those costs that do not change when the quantity of output changes.  These include interest payment, rental expenditures, property taxes and those salaries (such as for top management) that are fixed by contract and must be paid over the life of the contract whether the firm produces or not.

Total variable costs (TVC): On the other hand, TVC are the total obligations of the firm per time period for all the variable inputs that the firm use. Variable inputs are those that the firm can change easily and on short notice. Payment for raw materials, depreciation associated with the use of the plant and equipment; most of the labour costs, excise duties are included invariable costs.

Total costs (TC) equal total fixed costs (TFC) plus total variable costs (TVC).

That is TC = TFC + TVC

Examination of the table gives us following observations regarding the total costs.

  1. TFC remain constant at all level of output it is unchanged even when the output is nil. Thus TFC is independent of output.
  2. TVC varies with the output. It is nil when there is no output. Variable costs are thus direct costs of the output
  3. TVC does not change in the same proportion. Initially it is increasing at a decreasing rate, but after a point it increases at an increasing rate. This is due of the law of variable proportion.
  4. TC varies in the same proportion as the TVC. In other words, the change in total cost is entirely, due to changes in the total variable costs. In fact the distance between TC and TVC is the TFC.
 

Important Characteristics of Cost Curves

1. The curve TFC is the curve of total fixed costs. Denoting constant characteristics of fixed cost at all level of output, TFC is a straight horizontal line, parallel to the X-axis.

2. The curve TVC represent total variable cost. It reflect the typical behaviour of total variable cost. It initially rises gradually but eventually becomes steeper, denoting a sharp rise in total variable costs.

3. The TC curve represents total cost. It is derived by vertically adding up TVC and TFC curves. The shape of the TVC and TC are identical. The only difference between two is of distance that is total fixed cost.

The firm will have four other short period categories of unit costs

(I) Average fixed Cost (AFC)

(II) Average Variable Cost (AVC)

(III) Average Total Cost (ATC) and

(IV) Marginal Cost (MC)

(I) Average fixed Cost (AFC): It is TFC divided by total output. AFC decreases as output increases.

AFC = TFC/TQ

AFC curve is a rectangular hyperbola.

II) Average Variable Cost (AVC) : It is TVC divided by total output. It is per unit cost of variable factors of production. AVC first decreases and then increase as the output increases.

AVC = TVC/TQ

AVC curve is dish shaped or U-shaped.

(III) Average Total Cost (ATC): Since ATC is the sum of AFC and AVC, it will decrease in the beginning as both component decreases initially. After a point AVC start increasing and pulls up the ATC along with it, out weighing the influence of ever decreasing AFC.

(IV) Marginal Cost (MC): Marginal Cost is the addition made to the total cost by the production of one more unit of commodity. Marginal cost is the rate of change in total costs when output is increased by one unit.

In a geometrical sense, marginal cost at any output is the slope of the total cost curve at the corresponding point. In the short run, the marginal cost is independent of fixed cost and is directly related to the variable cost.

Hence the MC curve can also be derived from TVC curve. As a matter of fact, AVC curve and MC curve are the reflection and the consequence of the law of variable proportion operating in the short run. MC also decreases initially but increases ultimately with the increase in output.

As shown in the fig above both the curves are U shaped, the explanation of which is as follows.

MC= TC n – TC n-1

MC = ∆TVC / ∆TQ

Relationship between Marginal Cost and Average Cost

There is a unique relationship between AC and MC, that is described as below:

  1. When AC is minimum, MC is equal to AC. Thus MC intersect AC at its lowest point.
  2. When AC is falling, MC is always below AC. In fact, it is the MC that pulls down AC along with its. The point to note here is that MC may be rising, but will remain below AC.
  3. When AC is rising, MC must be above AC.

Long Run Cost Curves

Long run is the period during which all inputs are variable. Thus all costs are variable in the long run (i.e. the firm faces no fixed costs). The length of time of the long run depends on the industry. In some service industries such as photocopying, the period of the long run may be only a few months or weeks.

For others, which are very capital intensive, like satellite based communication network, it may take several years. It all depends on the length of time required for the firm to be able to vary all inputs.

The Long run cost of production is the least possible cost of Production of producing any given level of output when all the inputs are variable including of course the size of the plant. A long run cost curve depicts the functional relationship between output and the long run cost of production.

Long run average cost is the long run total cost divided by the level of output. Long run average cost depicts the least possible average cost for producing all possible level of output.

In order to understand, how the long run average cost curve is derived, consider the five short run average cost curve as shown in figure.

These short run average cost curves are also called plant curves, since in the short run plant is fixed and each of the short run average cost curves corresponds to a particular plant. In the short run the firm can be operating on any short run average cost curve, given the size of the plant.

Suppose that only these five are technically possible sizes of the plants. In the long run the firm will examine that which size of the plant or on which short run average cost curve it should operate to produce a given level of output at the minimum possible cost.

In fact the long run average cost curve is locus of all tangency points with some short run average cost curves. If a firm decides to produce particular output in the long run it will pick a point on the long run average cost curve corresponding to that output and it will than build relevant plant and operate on the corresponding short-run average cost curve.

Therefore LAC is a ‘Planning Curve’ because on the basis of this curve the firm decides what plant to set up in order to produce at minimum cost the expected level of output. It is often called ‘Envelop curve’ because it envelops the SAC curves.

It can be seen from the figure that the long run average cost curve first falls and then beyond a point it rises. The U shape of LAC can be explained by the economies and diseconomies of scale. Initially when the firm increases its scale of production it reaps economies of scale.

However beyond a point, further expansion in the scale of production results diseconomies of scale.

Long Run Marginal Cost Curve (LMC)

Like the short run marginal cost curve, the long run marginal cost curve is also derived from the slope of total cost curve at the various points relating to the given output each time. The shape of LMC curve has also a flatter U shape indicating that initially as output expands in the long run, LMC tend to decline.

At a certain stage however, LMC, tends to increase. The behaviour of LMC is shows in fig

From the above fig., the relationship between LAC and LMC may be traced as follows:-

  1. When LAC is decreasing, LMC is below LAC.
  2. LMC is equal to LAC, when LAC is at its minimum point.
  3. LMC is above LAC, when LAC is rising.

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By Hassham

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