What is Cost Concepts?

  • Post last modified:10 February 2022
  • Reading time:19 mins read

Cost Concepts

Cost is measurement in monetary terms of the amount of resources used for the purpose of production of goods or rendering services. It can be expressed in terms of money it means the amount of expenses incurred on or attributable to some specific thing or activity.

The term cost is used in this very form. In reference to production/manufacturing of goods and services cost refers to sum total of the value of resources used like raw material and labour and expenses incurred in producing or manufacturing of given quantity.

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 involve amount of money to support business tasks.

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

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.

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.

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.

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.

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.

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)

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.

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.

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.

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.

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.

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 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.

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.

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 41 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.

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.

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.

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).

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.

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.

Features of Production Function

Following are the main features of production function

Substitutability

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 43 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

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.

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.

Stock and Flow concept

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 t. 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 flow. The answer is price is neither flow nor stock because it is a ratio which measures stock and flows.

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.

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.


What is cost concepts?

Cost is ‘measurement in monetary terms of the amount of resources used for the purpose of production of goods or rendering services. It can be expressed in terms of money; it means the amount of expenses incurred on or attributable to some specific thing or activity.

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