Cost concepts and Other Basic Concepts

Accounting cost / 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)

Money cost / Real cost

Money Cost of production is the actual money cost made by company in the manufacture process. So the cost includes all the business expenses which nvolve amount of money to support business tasks.

For example the money expenditure on purchase of raw material, payment of labour cost, rent and other costs of business etc. can be termed as Money Cost.

Real Cost of manufacture or business operation on the other side contains all such costs of business which might 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.

Here the cost involved is the Opportunity Cost of the land and building. If the promoter of the company had not used the land and building for the business venture then the land and building could have been used elsewhere for some other venture and could have generated some income for the promoter. This income/rent which could have been earned under the next best investment option is the opportunity cost which needs to be considered while calculating the Real Cost for the firm.

Case study

A company ‘Arizona Textiles limited’ is producing cotton textiles. Various business expenses on per annum basis are as follows: Power Charges – Rs. 5, 00, 00, Cost of Yarn – Rs. 10, 00, 000, Salaries and Wages – Rs. 8, 00, 000, Various Direct and Indirect Overhead Expenses – Rs. 10, 00, 000. The company is not paying any rent for the building from where it is operating as the building is owned by the promoter of the company.

If this building had been rented out by the promoter in the market then it could have earned a rent of Rs. 2, 00,000 per annum. In the above case Money Cost is Rs. 33, 00,000, obtained after adding the following: Power Charges, Cost of Yarn, Salaries and Wages, Various Direct and Indirect Overhead Expenses.

On the other hand Real Cost is Rs. 35, 00,000, which has been obtained after adding the following: Money Cost plus the rent which the building belonging to the promoter could have earned in outside market.

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Private cost / Social cost

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 endured by the firm but by the society at large.

For example

The cost of loss or disutility caused by the tasks of a firm in an economy may not be abided 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 manufacturing the product. Such Cost is also known as External Cost. Another example of external cost can be the cost of giving the basic infrastructure facilities like good roads, sewage system or network, street lights etc.

Cost of such kind of services is not swallowed 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).

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Fix cost

Fixed Cost is the cost which does not change (that is either goes up or goes down) regardless of whether the firm is working or not. This means if the production is increasing or decreasing or constant the cost will be there. For example recent strike or Lockout in Maruti-Suzuki’s Manesar (Haryana state) plant the production process stands still.

Even when the plant is not operating the Firm still has to bear such expenditures which are indirect in nature. For Example Rent of the factory premises, Wages of administrative employees etc. In other Fixed cost is not related direct production/manufacturing expenses.

The shape of Average cost curve shows downward shpe when production is increasing and it will never become zero whatever amount of goods and services will be produced.

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Variable cost

Variable Cost on the Other hand is directly proportional to the production operations. As the size of production at any business grows, along with that grow the variable expenses.

As the name suggests, the variable expenses vary with the business operations. When the firm is not operating on account of Strike/Lockout etc, then the variable cost of the firm is Zero.

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Average cost

Average Cost is the cost that is obtained after dividing Total Cost with the number of units produced.

Total Cost = Fixed Cost + Variable Cost

Average Cost = Total Cost / Units of Good produced

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Marginal cost

Marginal Cost is the change in the Total cost when an additional unit of good is produced. In other words Marginal Cost is difference between total Cost of producing ‘N + 1’ units of good and ‘N’ units of good.

Marginal Cost = TC (n+1) – TC(n)

Following table can help in understanding the cost concepts like Total Cost (TC), Average Cost (AC), and Marginal Cost (MC) etc.

Understanding Fixed, Variable, Total, Average and Marginal Cost

Number of Units Produced	Fixed Cost	Variable Cost	Total Cos	Average Cost	Marginal Cost
1	10	5	15	15	15
2	10	10	20	10	5
3	10	17	27	9	7
4	10	30	40	10	13
5	10	45	55	11	15

In the above table, it is clearly visible that Fixed cost (which is 10) remains same irrespective of the number of units of the good being produced. On the other hand the Variable Cost is increasing as the number of units of good being produced is increasing. Thus, Variable Cost is going up from 5 to 10 and from 10 to 17 etc as the number of units of good being produced is increasing.

Again it can be seen from the above table that Total Cost is the sum total of Fixed Cost and Variable Cost. Thus Total Cost is 15 for the first unit (where 10 is Fixed Cost and 5 is Variable Cost). Again for producing 2 units, the Total Cost is 20 (where 10 is Fixed Cost and remaining 10 is the Variable Cost). Above Table also clearly indicates that the Average Cost is being obtained by dividing Total Cost with the number of units of good being produced.

Thus for the first unit of good being produced it is 15. This value has been obtained by dividing Total Cost (15) with the number of units of good produced (1). Similarly, the Average Cost of producing two units is 10, which is obtained by dividing Total Cost (20) with number of units produced (2). On the other hand Marginal Cost is the change in the total cost when an additional unit of good is being produced. Thus for the first unit of good being produced, it is 15.

This value is obtained by deducting from the Total Cost of producing ‘One’ unit of good (15) the Total Cost of producing ‘Zero’ units of good. For producing the second unit, the marginal cost is 5. This is obtained by deducting from the Total Cost of producing ‘two’ units of good (20) the Total Cost of producing ‘one’ unit of good (15).

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Opportunity cost

The resources of any firm operating in the market are limited and investment options are many. The firm therefore has to decide or select only those investment opportunities/options which provide the firm with the best return or best income on investment.

This means that if a firm can invest money/ resources only in one investment option then the firm will select that investment option which promises best return on investment to the firm.

In other words while doing so the firm gives up/rejects the next best option for investing the funds. The opportunity cost of a company is thus this income/ return which the firm could have earned on the next best investment alternative. This can also be understood by a simple example – Let us assume that an individual has two job offers in hand.

One job offer is promising him a salary of Rs. 30, 000 per month while the other job offer will ensure salary of Rs. 25, 000 per month. If the job profile and other factors related to the job offers are more or less same then it can be easily expected that the individual will select the job offer which will provide him with higher salary that is salary of Rs. 30, 000 per month.

Thus, in this case, the opportunity cost is the return involved in the next best alternative i.e; Salary of Rs. 25, 000 in the next best job offer. Concept of opportunity cost is closely related to the concept of Economic profit or Economic Rent. A firm earns or makes Economic profit only when besides covering various costs of operation, a firm is also able to earn more than its opportunity cost (or its possible earnings under the next best investment alternative).

Opportunity Cost is also termed as Implicit Cost. Economic Profit is thus earned only when following is true for the Firm:

Income of a Firm > Various Costs of Operations + Opportunity Cost OR Economic Profit = Earnings or Revenue of Firm – Economic Costs. Here Economic Cost is various expenses of the business plus the opportunity cost Some simple examples of Opportunity Cost and Economic Profit are discussed in following three brief case studies.

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Sunk cost

Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:

Capital inputs that are specific to an industry and which have little or no resale value Money spent on advertising, marketing and research and development projects which cannot be carried forward into another market or industry.

When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier to entry of new firms because they risk making huge losses if they decide to leave a market.

In contrast, markets such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets have low sunk costs so the barriers to exit are low. Asset-write-offs – e.g. the expense associated with writing-off items of plant and machinery, stocks and the good will of a brand Closure or project cancellation costs including redundancy costs, contract contingencies with suppliers and the penalty costs from ending leasing arrangements for property.

The loss of business reputation and good will – a decision to leave a market can seriously affect good will among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain.

A market downturn may be perceived as temporary and could be overcome when the economic or business cycle turns and conditions become more favorable.

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Public goods

Most economic arguments for government intervention are based on the idea that the marketplace cannot provide public goods or handle externalities. Public health and welfare programs, education, roads, research and development, national and domestic security, and a clean environment all have been labelled public goods.

Public goods have two distinct aspects—”non-excludability” and “non-rivalrous consumption.”

Non-excludability means that nonpayers cannot be excluded from the benefits of the good or service. If an entrepreneur stages a fireworks show, for example, people can watch the show from their windows or backyards.

Because the entrepreneur cannot charge a fee for consumption, the fireworks show may go unproduced, even if demand for the show is strong. The fireworks example illustrates the “free-rider” problem.

Even if the fireworks show is worth ten dollars to each person, no one will pay ten dollars to the entrepreneur. Each person will seek to “free-ride” by allowing others to pay for the show, and then watch for free from his or her backyard.

If the free-rider problem cannot be solved, valuable goods and services, ones that people want and otherwise would be willing to pay for, will remain unproduced.

The second aspect of public goods is what economists call non-rivalrous consumption. Assume the entrepreneur manages to exclude noncontributory from watching the show (perhaps one can see the show only from a private field).

A price will be charged for entrance to the field, and people who are unwilling to pay this price will be excluded.

If the field is large enough, however, exclusion is inefficient because even nonpayers could watch the show without increasing the show’s cost or diminishing anyone else’s enjoyment. That is non-rivalrous competition to watch the show. Public goods can also be provided by being tied to purchases of private goods. Shopping malls, for instance, provide shoppers with a variety of services that are traditionally considered public goods: lighting, protection services, benches, and rest-rooms,

for example

Charging directly for each of these services would be impractical. Therefore, the shopping mall finances the services through receipts from the sale of private goods in the mall. The public and private goods are “tied” together. Private condominiums and retirement communities also are examples of market institutions that tie public goods to private services.

Monthly membership dues are used to provide a variety of public services. Public goods problems can be solved by explaining individual property rights clearly for economic resources. Cleaning up a polluted lake or river for example includes a free-rider difficulty if no one retains the lake. The welfares of a clean lake are appreciated by many people, and no one can be charged for these welfares.

Once there is an owner, however, that person can charge money to fishermen, boaters, recreational users, and others who benefit from the lake. “Privately owned bodies of water are common in the British Isles, where, not surprisingly, lake owners maintain quality.” Clearly defined property rights can resolve public goods problems in other environmental areas, such as land use and species preservation.

The buffalo neared extinction and the cow did not because cows could be privately owned and husbanded for profit. Today, private property rights in elephants, whales, and other species could solve the tragedy of their near extinction. In Africa, for instance, elephant populations are growing in Zimbabwe, Malawi, Namibia, and Botswana, all of which allow commercial harvesting of elephants.

Since 1979 Zimbabwe’s elephant population rose from 30,000 to almost 70,000 today, and Botswana’s went from 20,000 to 68,000. OR the other hand, in countries that ban elephant hunting—Kenya, Tanzania, and Uganda, for example—there is little incentive to breed elephants but great incentive to poach them. In those countries elephants are disappearing.

The result is that Kenya has only 16,000 elephants today versus 140,000 when its government banned hunting. Since 1970, Tanzania’s elephant herd has shrunk from 250,000 to 61,000; Uganda’s from 20,000 to only 1,600. Property rights are a less effective solution for environmental problems involving the air, however, because rights to the air cannot be defined and enforced easily.

It is hard to imagine, for instance, how market mechanisms alone could prevent depletion of the earth’s ozone layer. In such cases economists recognize the likely necessity of a regulatory or governmental solution.

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Private goods

Private goods also have both the characteristics which public goods possess, however inversely. Private goods have well defined property rights and so they have Rivalrous and excludable consumptions. If the owner of the private property or any goods wants to and have favorable situations also to charge for the goods and services, he/she can exclude somebody who has not paid for the same and those who have paid can enjoy the same.

There is also rivalry in the use of private goods as use of other person decreasing the chances of other person using the same facility, goods and services. e.g. any particular goods from the online shopping site has limited stock and it will be limited on the bases of come early and get early even in the cheaper sale situation so as the orders are increasing chances are less for late comers to get these goods. This gives the perfect solution to the free rider problem.

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Merit goods

Merit goods are those goods which have higher opportunity cost and higher positive spillover effects and can by less consumed by people so as provided by government also by taking very less or no price and can be provided by private players taking higher prices by increasing quality. Merit goods have some similarities with the public goods but some differences also.

Education, health are merit goods because they have positive spillover effects and have higher opportunity cost also. Education has time and money both opportunity cost. The educated person can help many other person it changes the social status and even the consumption pattern as it increases the income and living standard of literate person. There are many examples of merit goods such as education, health services, training programs, public library etc.

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Production Function

Production is the result of co-operation of four factors of production viz., land, labour, capital and organization. This is evident from the fact that no single commodity can be produced without the help of any one of these four factors of production. Therefore, the producer combines all the four factors of production in a technical proportion.

The aim of the producer is to maximize his profit. For this sake, he decides to maximize the production at minimum cost by means of the best combination of factors of production. The producer secures the best combination by applying the principles of equimarginal returns and substitution.

According to the principle of equi-marginal returns, any producer can have maximum production only when the marginal returns of all the factors of production are equal to one another. For instance, when the marginal product of the land is equal to that of labour, capital and organisation, the production becomes maximum.

Meaning of Production Function

In simple words, production function refers to the functional relationship between the quantity of a good produced (output) and factors of production (inputs). “The production function is purely a technical relation which connects factor inputs and output.” Prof. Koutsoyiannis Defined production function as “the relation between a firm’s physical production (output) and the material factors of production (inputs).”

Prof. Watson In this way, production function reflects how much output we can expect if we have so much of labour and so much of capital as well as of labour etc. In other words, we can say that production function is an indicator of the physical relationship between the inputs and output of a firm. The reason behind physical relationship is that money prices do not appear in it.

However, here one thing that becomes most important to quote is that like demand function a production function is for a definite period. It shows the flow of inputs resulting into a flow of output during some time. The production function of a firm depends on the state of technology. With every development in technology the production function of the firm undergoes a change. The new production function brought about by developing technology displays same inputs and more output or the same output with lesser inputs.Sometimes a new production function of the firm may be adverse as it takes more inputs to produce the same output.

Mathematically, such a basic relationship between inputs and outputs may be expressed as:

Q = f (L, C, N)
Where Q = Quantity of output
L = Labour
C = Capital
N = Land.

L, C, N) available to the firm. In the simplest case, where there are only two inputs, labour (L) and capital (C) and one output (Q), the production function becomes. Q =f (L, C)

Definitions

The production function is a technical or engineering relation between input and output. As long as the natural laws of technology remain unchanged, the production function remains unchanged.” Prof. L.R. Klein “Production function is the relationship between inputs of productive services per unit of time and outputs of product per unit of time.”

Prof. George J. Stigler “The relationship between inputs and outputs is summarized in what is called the production function. This is a technological relation showing for a given state of technological knowledge how much can be produced with given amounts of inputs.”

Prof. Richard J. Lipsey Thus, from the above definitions, we can conclude that production function shows for a given state of technological knowledge, the relation between physical quantities of inputs and outputs achieved per period of time.

Features of Production Function

Following are the main features of production function

Substitutability

The factors of production or inputs are substitutes of one another which make it possible to vary the total output by changing the quantity of one or a few inputs, while the quantities of all other inputs are held constant. It is the substitutability of the factors of production that gives rise to the laws of variable proportions.

The substitution can not be complete substitution it can be up to certain maximum limits. For e.g. a firm may label itself fully automatic firm or factory but it can not be because there is nothing like fully automatic thing, there is always behind somebody who is reducing the need of people at maximum possible level.

Complementarity

The factors of production are also complementary to one another, that is, the two or more inputs are to be used together as nothing will be produced if the quantity of either of the inputs used in the production process is zero. The principles of returns to scale is another manifestation of complementarity of inputs as it reveals that the quantity of all inputs are to be increased simultaneously in order to attain a higher scale of total output.

Specificity

It reveals that the inputs are specific to the production of a particular product. Machines and equipment’s, specialized workers and raw materials are a few examples of the specificity of factors of production. The specificity may not be complete as factors may be used for production of other commodities too.

This reveals that in the production process none of the factors can be ignored and in some cases ignorance to even slightest extent is not possible if the factors are perfectly specific. Production involves time; hence, the way the inputs are combined is determined to a large extent by the time period under consideration.

The greater the time period, the greater the freedom the producer has to vary the quantities of various inputs used in the production process. In the production function, variation in total output by varying the quantities of all inputs is possible only in the long run whereas the variation in total output by varying the quantity of single input may be possible even in the short run.

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Stock and Flow concept

Stock and flow concept generally used by both Microeconomics and Macroeconomics but extensively in Macroeconomics. Stock means a quantity of commodity acquired at particular time while flow means some particular amount of quantity from current production going for sale in the market. In Macroeconomics there are two types of aggregates, some are stocks some are flows.

For e.g. stock of capital “K” is a stock concept because it is related to the some particular time while investment is flow concept. So we can say stock concept are timeless concepts while flow concepts have time dimension. Such as income, output, investment, consumption always specified per unit of time. Money is a stock variable while the spending of money is a flow variable.

Mostly in macroeconomics the concept of stock and flow is used such as in the theory of income, employment and output. Wealth is a stock while income is a flow, saving by any individual in a month is a flow while saving of the same individual in a day is stock.

The government debt is a stock while government deficit is a flow. Some macro variables like income, import, export, wages, and social welfare are always flow concept. One can ask about the price, is that a stock or flowi The answer is price is neither flow nor stock because it is a ratio which measures stock and flows.

Stocks and flows both affect each other but stocks only affects flows only in a long run. For e.g. investment is flow while stock of capital goods is stock. Capital goods largely affected by investment and investment itself affected by stock of capital but investment is strong driving force compare to the stock of capital.

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Normative / Positive Economics

Economics that tries to change the world, by suggesting policies for increasing economic welfare. The opposite of positive economics, which is content to try to describe the world as it is, rather than prescribe ways to make it better”. The Positive Economics is just a statement which explain what it is There is no value judgement in It., while in the case of normative economics there is value judgement which says “what ought to be”.

This suggest what should be done and what should not to be. That is why normative economics is also called proscriptive economics as it not only shows what it is but also suggest now what should be. The positive statement can be analysed for further testing while normative itself is a suggestion to do something.

For example

A person is smoking, smoking is injurious to the health so that person should not smoke. The first half of this sentence is positive statement just showing what other person is doing while the latter half of the sentence comprises value judgement that because smoking is injurious to health so a person should not smoke.

The positive statement has scope of further analysis but normative statement does not have scope of further analysis because either it is conclusion of analysis or it is forcefully applied or it is a subjective matter which differs from person to person.

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