The cost concepts which are relevant to business operations and decisions can be studied on the basis of their purpose, under two overlapping categories:
(i) Concepts used for accounting purposes, and
(ii) Concepts used in economic analysis of the business activities. Let us discuss here some important concepts of the two categories.
A. Some Accounting Cost Concepts:
1. Opportunity Cost and Actual Cost:
Opportunity cost refers to the loss of earnings due to opportunities foregone due to scarcity of resources. If resources were unlimited, there would be no need to forego any income-yielding opportunity and, therefore, there would be no opportunity cost. Resources are scarce but have alternative uses with different returns. Incomes maximizing resource owners put their scarce resources to their most productive use and forego the income expected from the second best use of the resources.
Therefore, the opportunity cost may be defined as the expected returns from the second best use of the resources foregone due to the scarcity of resources. The opportunity cost it is also called Alternative cost. For example, suppose that a person has a sum of Rs. 1, 00,000 for which he has only two alternative uses. He can buy either a printing machine or, alternatively, a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and from the lathe, Rs. 15,000.
If he is a profit maximizing investor, he would invest his money in printing machine and forego the expected income from the lathe. The opportunity cost of his income from printing machine is the expected income from the lathe, i.e., Rs. 15,000.
The opportunity cost arises because of the foregone opportunities. Thus, the opportunity cost of using resources in printing business, the best alternative is the expected return from the lathe, the second best alternative. In assessing the alternative cost, both explicit and implicit costs are taken into account.
Associated with the concept of opportunity cost is the concept of economic rent or economic profit. For example, economic rent of the printing machine is the excess of its earning over the income expected from the lathe (i.e., Rs. 20,000 – Rs. 15,000 = Rs. 5,000).
The implication of this concept for business man is that investing in printing machine is preferable so long as its economic rent is greater than zero. Also, if firms know the economic rent of the various alternative uses of their resources, it will be helpful in the choice of the best investment avenue.
On the other hand, actual costs are those which are actually incurred by the firm in payment for labour, material, plant, building, machinery, equipment, travelling and transport, advertisement, etc. The total money expenses, recorded in the books of accounts are, for all practical purposes, the actual costs. Actual cost comes under the accounting concept.
2. Business Costs and Full Costs:
Business costs include all the expenses which are incurred to carry our business. The concept of business costs is similar to the actual or real costs. Business costs “include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment”.
These cost concepts are used for calculating business profits and losses and for filling returns for income-tax and also for other legal purposes.
Full costs, on the contrary, include business costs, opportunity cost and normal profit. The opportunity cost includes the expected earnings from the second best use of the resources, or the market rate of interest on the total money capital, and also the value of entrepreneur’s own services which are not charged for in the current business.
Normal profit is a necessary minimum earning in addition to the opportunity cost, which a firm must get to remain in its present occupation.
3. Explicit and Implicit or Imputed Costs:
Explicit costs refer to those which fall under actual or business costs entered in the books of accounts. The payments for wages and salaries, materials, license fee, insurance premium, depreciation charges are the examples of explicit costs. These costs involve cash payments and are recorded in normal accounting practices.
In contrast with these costs, there are not certain other costs which do not take the form of cash outlays, nor do they appear in the accounting system. Such costs are known as implicit or imputed costs. Implicit costs may be defined as the earning expected from the second best alternative use of resources. For instance, suppose an entrepreneur does not utilize his services in his own business and works as a manager in some other firm on a salary basis.
If he starts his own business, he foregoes his salary as manager. This loss of salary is the opportunity costs of income from his own business. This is an implicit cost of his own business; implicit, because the entrepreneur suffers the loss, but does not charge it as the explicit cost of his own business. Thus, implicit wages, rent and interest are the highest wages, rents and interest which owner’s labour, building and capital can respectively earn from their second best use.
Implicit costs are not taken into account while calculating the loss or gains of the business, but they form an important consideration in whether or not a factor would remain in its present occupation. The explicit and implicit costs together make the economic cost.
4. Out-of-Pocket and Book Costs:
Out-of-pocket costs means costs that involve current cash payments to outsiders while book costs such as depreciation do not require current cash payments. In concept, this distinction is quite different from traceability and also from variability with output. Not all out-of- pocket costs are variable, e.g., salaries paid to the administrative staff.
Neither are they all direct, e.g., the electric power bill. Book costs are in some cases variable and in some cases readily traceable, and hence become a part of direct costs. The distinction primarily shows how cost affects the cash position. Book costs can be converted into out-of-pocket costs by selling the assets and having them on hire. Rent would then replace depreciation and interest.
While undertaking expansion, book costs do not come into the picture until the assets are purchased. Yet the question to be answered is: What will be the gross earnings of the investment during its life time and do they justify the outlay? Transfer of old equipment to new areas will bring book costs into the picture.
B. Some Analytical Cost Concepts:
5. Fixed and Variable Costs:
Fixed costs are those costs which are fixed in volume for a certain given output. Fixed cost does not vary with variation in the output between zero and certain level of output. The costs that do not vary for a certain level of output are known as fixed cost.
The fixed costs include:
(i) Cost of managerial and administrative staff.
(ii) Depreciation of machinery, building and other Axed assets, and
(iii) Maintenance of land, etc. The concept of fixed cost is associated with short-run.
Variable costs are those which vary with the variation in the total output. They are a function of output. Variable costs include cost of raw materials, running cost on fixed capital, such as fuel, repairs, routine maintenance expenditure, direct labour charges associated with the level of output, and the costs of all other inputs that vary with output.
6. Total, Average and Marginal Costs:
Total cost represents the value of the total resource requirement for the production of goods and services. It refers to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level of output. It includes both fixed and variable costs. The total cost for a given output is given by the cost function.
Average cost (AC) is of statistical nature, it is not actual cost. It is obtained by dividing the total cost (TC) by the total output (Q), i.e.
AC = TC / Q = average cost
Marginal cost is the addition to the total cost on account of producing an additional unit of the product. Or, marginal cost is the cost of marginal unit produced. Given the cost function, it may be defined as
MC = TC/ Q
These cost concepts are discussed in detail in the following section. Total, average and marginal cost concepts are used in economic analysis of firm’s production activities.
7. Short-Run and Long-Run Costs:
Short-run and long-run cost concepts are related to variable and fixed costs respectively, and often marked in economic analysis interchangeably. Short-run costs are the costs which vary with the variation in output, the size of the firm remaining the same. In other words, short-run costs are the same as variable costs. Long-run costs, on the other hand, are the costs which are incurred on the fixed assets like plant, building, machinery, etc. Such costs have long-run implication in the sense that these are not used up in the single batch of production.
Long-run costs are, by implication, the same as fixed costs. In the long-run, however, even the fixed costs become variable costs as the size of the firm or scale of production increases. Broadly speaking, ‘the short-run costs are those associated with variables in the utilization of fixed plant or other facilities whereas long-run costs are associated with the changes in the size and kind of plant.’
8. Incremental Costs and Sunk Costs:
Incremental costs are closely related to the concept of marginal cost but with a relatively wider connotation. While marginal cost refers to the cost of the marginal unit of output, incremental cost refers to the total additional cost associated with the marginal batch of output.
The concept of incremental cost is based on the fact that in the real world, it is not practicable for lack of perfect divisibility of inputs to employ factors for each unit of output separately. Besides, in the long run, firms expand their production; hire more men, materials, machinery and equipments.
The expenditures of this nature are incremental costs and not the marginal cost (as defined earlier). Incremental costs arise also owing to the change in product lines, addition or introduction of a new product, replacement of worn out plant and machinery, replacement of old technique of production with a new one, etc.
The Sunk costs are those which cannot be altered, increased or decreased, by varying the rate of output. For example, once it is decided to make incremental investment expenditure and the funds are allocated and spent, all the preceding costs are considered to be the sunk costs since they accord to the prior commitment and cannot be revised or reversed or recovered when there is change in market conditions or change in business decisions.
9. Historical and Replacement Costs:
Historical costs are those costs of an asset acquired in the past whereas replacement cost refers to the outlay which has to be made for replacing an old asset. These concepts own their significance to unstable nature of price behaviour.
Stable prices over time, other things given, keep historical and replacement costs on par with each other. Instability in asset prices makes the two costs differ from each other.
Historical cost of assets is used for accounting purposes, in the assessment of net worth of the firm. The replacement cost figures in the business decision regarding the renovation of the firm.
10. Private and Social Costs:
There are not certain other costs which arise due to functioning of the firm but are not normally marked in the business decisions nor does are such cost explicitly borne by the firms. The costs of this category are borne by the society.
Thus, the total cost generated by a firm’s working may be divided into two categories:
(i) Those paid out or provided for by the firms, and
(ii) Those not paid or borne by the firms- it includes use of resource freely available plus the disutility created in the process of production.
The costs of the former category are known as private costs and of the latter category are known as external or social costs. The example of social cost are: Mathura Oil Refinery discharging its wastage in the Yamuna river causes water pollution; Mills and factories located in a city cause air pollution by emitting smoke.
Similarly, plying cars, buses, trucks, etc., cause both air and noise pollution. Such pollutions cause tremendous health hazards which involve health cost to the society as a whole. Such costs are termed external costs from the firm’s point of view and social cost from society’s point of view.
The relevance of the social costs lies in understanding the overall impact of firm’s working on the society as a whole and in working out the social cost of private gains. A further distinction between private costs and social costs is therefore in order.
Private costs are those which are actually incurred or provided for by an individual or a firm on the purchase of goods and services from the market. For a firm, all the actual costs both explicit and implicit are private costs. Private costs are internalized costs that are incorporated in the firm’s total cost of production.
Social costs on the other hand, refer to the total cost to the society on account of production of a commodity. Social costs include both private cost and the external cost.
Social costs include:
(a) The cost of resources for which the firm is not compelled to pay a price, i.e., atmosphere, rivers, lakes, and also for the use of public utility services like roadways, drainage system, etc., and
(b) The cost in the form of ‘disutility’ created through air, water and noise pollutions, etc. The costs of category.
(b) Generally assumed to equal the total private and public expenditures are incurred to safeguard the individual and public interest against the various kinds of health hazards created by the production system.
The private and public expenditure, however, serve only as an indicator of ‘public disutility’, they do not give the exact measure of the public disutility or the social costs.
C. Other Costs Concepts:
11. Urgent and Postponable Cost:
Urgent costs are those costs which must be incurred in order to continue operations of the firm. For example, the costs of materials and labour which must be incurred if production is to take place.
Postponable costs refer to those costs which can be postponed at least for some time e.g., maintenance relating to building and machinery. Railways usually make use of this distinction. They know that the maintenance of rolling stock and permanent way can be postponed for some time.
Therefore their maintenance expenditure is incurred mainly in periods of slack activity when the rolling stock is comparatively idle. During World War II most maintenance was virtually postponed due to the rush of work in railways as also in other factories. Such postponement of maintenance expenditure tends to create employment during periods of slack activity and thus serves as an anti-cyclical measure.
12. Escapable and Unavoidable Costs:
Escapable costs refer to costs which can be reduced due to a contraction in the activities of a business enterprise. It is the net effect on costs that is important, not just the costs directly avoidable by the contraction. And the difficult problem is estimating these indirect effects rather than directly savable costs.
1. Closing apparently unprofitable branch house-storage costs of other branches and transportation charges would increase.
2. Reducing credit sales-costs estimated may be less than the benefits otherwise available.
Escapable costs are different from controllable and discretionary costs. The latter are like chopping off the additional fat and are not directly associated with a special curtailment decision.
13. Controllable and Non-Controllable Costs:
The concept of responsibility accounting leads directly to the classification of cost as controllable or uncontrollable. The controllability of a cost depends upon the levels of responsibility under consideration. A controllable cost may refer to one which is reasonably subject to regulation by the executive with whose responsibility that cost is being identified. Thus a cost which is uncontrollable at one level of responsibility may be regarded as controllable at some other, usually higher level.
The control- liability of certain cost may be shared by two or more executives. For example, materials cost where price paid is the responsibility of the purchasing department and the usage is the responsibility of the production supervisor. This distinction is primarily useful for expense and efficiency control.
Direct material and direct labour costs are usually controllable. Regarding so for, overhead costs, some costs are controllable and others are not. Indirect labour, supplies and electricity are usually controllable. An allocated cost is not controllable. It varies with the formula adopted for allocation and is independent of the actions of the supervisor.
14. Direct and Indirect Costs (Traceable and Common Costs):
A direct or traceable cost is that which can be identified easily and indisputably with a unit of operation (costing unit/cost centre). Common or indirect costs are those that are not traceable to any plant, department or operation, or to any individual final product. To take an example, the salary of a divisional manager, when division is a costing unit, will be a Direct Cost.
The monthly salary of the general manager, when one of the divisions is a costing unit, would be an Indirect Cost. The salary of the manager of the other division is neither a direct nor an indirect cost. Thus, whether a specific cost is direct or indirect depends upon the costing unit under consideration. The concepts of direct and indirect costs are meaning-less without identification of the relevant costing unit.