COST CONCEPTS
CONTENTS
11.0 Aims and Objectives
11.1 Introduction
11.2 Various Cost Concepts
11.3 Let us sum up
11.4 Lesson –end activities
11.5 References
11.0 AIMS AND OBJECTIVES
11.1 INTRODUCTION
The word 'cost' has different meanings in different situations. The accounting cost concept or the historical cost concept is not useful as such for business decision-making. The accounting records end up with the balance sheet and income statements which are meant for legal, financial and tax needs of the enterprise. The financial recordings reveal what has been happening. It is a historical recording which is not of very much help to the managerial economist in his business decision-making. The actual cost is not the relevant cost concept for business decision-making because it only reveals what has been happening. The decision-making concepts of cost aim at projecting what will happen in the alternative courses of action. Business decisions involve plans for the future and require choices among different plans. These decisions necessitate profitability calculations for which a comparison of future revenues and future expenses of each alternative plan is needed.
11.2 Various Concepts of Costs
A managerial economist must have a proper understanding of the different cost concepts which are essential for clear business thinking. The several alternative bases of classifying cost and the relevance of each for different kinds of problems are to be studied. The various relevant concepts of costs used in business decisions are given below.
Total, Average and Marginal Costs
Total cost is the total cash payment made for the input needed for production. It may be explicit or implicit is the sum total of the fixed and variable costs. Average cost is the cost per unit of output. It is obtained by dividing the total cost (TC) by the total quantity produced (Q)
Average Cost =TC/Q
Marginal cost is the additional cost incurred to produce an additional unit of output. Or it is the cost of the marginal unit produced.
Example
A company produces 1000 typewriters per annum. Total fixed cost is Rs. 1,00,000
per annum. Direct material cost per typewriter is Rs. 200 and direct labour cost Rs. 100.
Variable cost per typewriter = direct material + direct labour
= 200 + 100 = Rs. 300
Total variable cost (1000x300) = Rs.300000
Fixed Cost = Rs. 100000
Total cost = Rs.400000
TC = Rs. 400000
Average Cost =TC/Q
= Rs. 400
If output is increased by one typewriter, the cost will appear as follows:
Total variable cost (1001x300) = 300300
Fixed cost = 100000
1000
400000
Total = 400300
Here the additional cost incurred to produce the 1001th typewriter is Rs.300
(400300 - 400000). Therefore, the marginal cost per typewriter is Rs.300.
Fixed and Variable Costs
This classification is made on the basis of the degree to which they vary with the changes in volume. Fixed cost is that cost which remains constant up to a certain level of output. It is not affected by the changes in the volume of production. Then fixed cost per unit aries with output rate. When the production increases, fixed cost per unit decreases. Fixed cost includes salary paid to administrative staff, depreciation of fixed assets, rent of factory etc. These costs are fixed in the sense that they do not change in short-run. Variable cost varies directly with the variation in output. An increase in total
output results in an increase in total variable costs and decrease in total output results in a proportionate decline in the total variable costs. The variable cost per unit will be
constant. Variable costs include the costs of all inputs that vary with output like raw
materials, running costs of fixed assets such as fuel, ordinary repairs, routine maintenance
expenditure, direct labour charges etc.
The distinction of cost is important in forecasting the effect of short-run changes in
volume upon costs and profits.
Short-Run and Long-Run Costs
This cost distinction is based on the time element. Short-Run is a period during
which the physical capacity of the firm remains fixed. Any increase in output during this
period is possible only by using the existing physical capacity more intensively. Long-
Run is a period during which it is possible to change the firm's physical capacity. All the
inputs become variable in the long-term. Short-Run cost is that which varies with output
when the physical I capacity remains constant. Long-Run costs are those which vary with
output when all the inputs are variable. Short-Run costs are otherwise called variable
costs. A firm wishing to change output quickly can do it only by increasing the variable
factors. Short- Run cost concept helps the manager to take decision when a firm has to
decide whether or not to produce more or less with a given plant. Long-Run cost analysis helps to take investment decisions. Long-Run increase in output may necessitate installation of more capital equipment.
Opportunity Costs and Outlay Costs
This distinction is made on the basis of the nature of the sacrifice made. Outlay
costs are those expenses which are actually incurred by the firm. These are the actual
payments made for labour, material, plant, building, machinery, traveling, transporting
etc. These are the expense items that appear in the books of accounts. Outlay cost is an
accounting cost concept. It is also called absolute cost or actual cost. Whenever the inputs
are to be bought for cash the outlay concept is to be applied.
A businessman chooses and investment proposal from different investment
opportunities. Before taking the decision he has to compare all the opportunities and
choose the best. When he chooses the best he sacrifices the possibility of making profit
from other investment opportunities. The cost of his choice is the return that he could
have earned from other investment opportunities he has given up or sacrificed. A
businessman decides to use his own money to buy a machine for the business. The cost of
that money is the probable return on the money from the next most acceptable alternative
investment. If he invested the money at 12 percent interest, the opportunity cost of
investing in his own business would be the 12 percent interest he has forgone.
The outlay concept is applied when the inputs are to be bought from the market.
When a firm decides to make the inputs rather than buying it from the market the
opportunity cost concept is to be applied. For example, in a cloth mill, instead’ of buying
the yarn from the market they spin it themselves. The cost of this yam is really the price
at which the yarn could be sold if it were not used by them for weaving cloth.
The opportunity cost concept is made use of for long-run decisions. For example,
the cost of higher education of a student should not only be the tuition fees and book
costs but it also includes the earnings foregone by not working. This concept is very
important in capital expenditure budgeting. The cost of acquiring a petrol pump in
Trivandrum City by spending Rs. 6 lakhs is not usually the interest for that borrowed
money but it is the profit that would have been made if that Rs. 6 lakhs had been invested
in an offset printing press, which is the next best investment opportunity.
Opportunity cost concept is useful for taking short-rum decisions also. In boom
periods the scarce lathe capacity used for making a product involves the opportunity cost
of not using it to make some other product that can also produce profit. Opportunity cost
is the cost concept to use when the supply of inputs is strictly limited. Estimates of cost of
capital are essentially founded on an opportunity cost concept of investment return.
Investment decision involves opportunity costs measurable in terms of sacrificed income
from alternative investments. The opportunity cost of any action is therefore measured by
the value of the most favorable alternative course which has to be foregone if that action
is taken.
Opportunity cost arises only when there is an alternative. If there is no alternative,
opportunity cost is the estimated earnings of the next best use. Thus it represents only the
sacrificed alternative.
Hence it does not appear in financial accounts. But this concept is of very great
use in managerial decision-making.
Out-of-pocket and Book Costs
Out-of-pocket costs are those costs that involve current cash payment. Wages,
rent, interest etc., are examples of this. The out-of-pocket costs are also called explicit
costs. Book costs do not require current cash expenditure. Unpaid salary of the owner
manager, depreciation, and unpaid interest cost of owner's own fund are examples of
book costs. Book costs may be called implicit costs. But the book costs are taken into
account in determining the legal dividend payable during a period. Both book costs and
out-of-pocket costs are considered for all decisions. Book cost is the cost of self owned
factors of production. The book cost can be converted into out-of-pocket cost. If a selfowned
machinery is sold out and the service of the same is hired, the hiring charges form
the out-of-pocket cost The distinction is very helpful in taking liquidity decisions.
Incremental and Sunk costs
Incremental cost is the additional cost due to a change in the level or nature of
business activity. The change may be caused by adding a new product, adding new
machinery, replacing machinery by a better one etc. Incremental or differential cost is not
marginal cost. Marginal cost is the cost of an added (marginal) unit of output.
Sunk costs are those which are not altered by any change. They are the costs
incurred in the past. This cost is the result of past decision, and cannot be changed by
future decisions. Once an asset has been bought or an investment made, the funds locked
up represent sunk costs. As these costs do not alter when any change in activity is made
they are sunk and are irrelevant to a decision being taken now. Investments in fixed assets
are examples of sunk costs. As soon as fixed assets have been installed, their cost is sunk.
The amount of cost cannot be changed.
Incremental cost helps management to evaluate the alternatives. Incremental cost
will be different in the case of different alternatives. Sunk cost, on the other hand, will
remain the same irrespective of the alternative selected. Cost estimates of an incremental
nature only influence business decisions.
Explicit and Implicit or Imputed costs
Explicit costs are those expenses that involve cash payments. These are the actual
or business costs that appear in the books of accounts. Explicit cost is the payment made
by the employer for those factors of production hired by him from outside. These costs
include wages and salaries paid payments for raw materials, interest on borrowed capital
funds, rent on hired land, taxes paid to the government etc.
Implicit costs are the costs of the factor units that are owned by the employer
himself. It does not involve dash payment and hence does not appear in the books of
accounts. These costs did not actually incur but would have incurred in the absence of
employment of self-owned factors of production. The two normal implicit costs are
depreciation and return on capital contributed by shareholders. In small scale business
unit the entrepreneur himself acts as the manager of the business. If he were employed in
another firm he would be given salary. The salary he has thus forgone is the opportunity
cost of his services utilised in his own firm. This is an implicit cost of his business. Thus
implicit wages, implicit rent and implicit interest are the highest interest, rent and wages
which self-owned capital, building and labour respectively can earn from their next best
use. Implicit costs are not considered for finding out the loss or gains of the business, but
help a lot in business decisions.
Replacement and Historical costs
These are the two methods of valuing assets for balance sheet purpose and to find
out the cost figures from which profit can be arrived at; Historical cost is the original cost
of an asset. Historical cost valuation shows the cost of an asset as the original price paid
for the asset acquired in the past. Historical valuation is the basis for financial accounts.
Replacement cost is the price that would have to be paid currently to replace the same
asset. For example, the price of a machine at the time of purchase was Rs. 17,000 and the
present price of the machine is Rs. 20,000. The original price Rs. 17,000 is the historical
cost while Rs. 20,000 is the replacement cost. During periods of substantial change in the
price level, historical valuation gives a poor projection of the future cost intended for
managerial decision. Replacement cost is a relevant cost concept when financial
statements have to be adjusted for inflation.
Controllable and Non-controllable costs
Controllable costs are the ones which can be regulated by the executive who is in
charge of it. The concept of controllability of cost varies with levels of management. If a
cost is uncontrollable at one level of management it may be controllable at some other
level. Similarly the controllability of certain costs may be shared by two or more
executives. For example, material cost, the price of which comes under the responsibility
of the purchase executive whereas its usage comes under the responsibility of the
production executive. Direct expenses like material, labour etc. are controllable costs.
Some costs are not directly identifiable with a process or product. They are
apportioned to various processes or products in some proportion. This cost varies with the
variation in the basis of allocation and is independent of the actions of the executive of
that department. These apportioned costs are called uncontrollable costs.
Business and Full costs
A firm's business cost is the total money expenses recorded in the books of
accounts. This includes the depreciation provided on plant and equipment. It is similar to
the actual or real cost. Full cost of a firm includes not only the business costs but also
opportunity costs of the firm and normal profits. The firm's opportunity cost includes
interest on self-owned capital, the salary forgone by the entrepreneur if he were, working
in his firm. Normal profit is the minimum returns which induces the entrepreneur to
produce the same product.
Economic and Accounting Cost
Accounting costs are recorded with the intention of preparing the balance sheet
and profit and loss statements which are intended for the legal, financial and tax purposes
of the company. The accounting concept is a historical concept. It records what has
happened. The past cost data revealed by the books of accounts does not help very much
in decision-making. Decision-making needs future costs. Economic concept considers
future costs and future revenues which help future planning and choice. When the
accountant describes what has happened, the economist aims at projecting what will
happen. Accounting data ignores implicit. or imputed cost. The economist considers
decision-making costs. For this, different cost classifications relevant to different kinds of
problems are considered. The cost distinctions such as opportunity and outlay cost, shortrun
and long-run cost and replacement and historical cost are made from the economic
viewpoint.
11.3 LET US SUM UP
In this lesson initially we studied the meaning of cost, and a detailed discussion
has been made into various concepts of costs such as total cost, average cost, marginal
cost, fixed cost, variable cost; short run and long run cost, opportunity cost, out lay cost,
book costs, such cost, incremental cost, explicit and implicit cost historical cost
replacement cost, controllable abnormal controllable cost, business and full cost,
economic cost, and according cost.
11.4 LESSON – END ACTIVITIES
1. Mention the importance of opportunity cost in managerial decision making
2. Bring out the relationship between TC, MC, and AC
3. Differentiate Explicit and Implicit cost
4. Distinguish between Incremental cost and sunk cost
11.5 REFERENCES
1. Mehta, P.L. “Managerial Economics ‘Analysis, Problems & Cases’, Sultan
Chand & Sons.
2. Sundharam, K.P.M. and Sundharam E.N. “Business Economics
