ICAI Notes- Unit 2: Theory of Cost | Business Economics for CA Foundation PDF Download

 Page 1


 
 
 
v 
 
3.35 
THEORY OF PRODUCTION AND COST 
 
 
LEARNING OUTCOMES 
UNIT - 2: THEORY OF COST 
 
AFTER STUDYING THIS UNIT, YOU WOULD BE ABLE TO:  
? Explain the Meaning and Different Types of Costs. 
? Define Cost Function and Explain the Difference between a Short-
Run and Long-Run Cost Function. 
? Explain the linkages between the Production Function and the Cost 
Function.  
? Explain Economies and Diseconomies of Scale and Reasons for Their 
Existence. 
 
In the previous unit, we have discussed the relationship between inputs and output in 
physical quantities. However, as we are aware, business decisions are generally based on 
cost of production i.e. the money value of inputs and output is considered. Cost analysis 
refers to the study of behaviour of cost in relation to one or more production criteria, 
namely, size of output, scale of operations, prices of factors of production and other 
relevant economic variables. In other words, cost analysis is concerned with the financial 
aspects of production relations as against physical aspects which were considered in 
production analysis. In order to have a clear understanding of the cost function, it is 
important for a businessman to understand various concepts of costs. 
2.0 COST CONCEPTS 
Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of 
production which he employs for production. He thus pays wages to workers employed, 
prices for the raw materials, fuel and power used, rent for the building he hires and interest 
on the money borrowed for doing business. All these are included in his cost of production 
and are termed as accounting costs. Accounting costs relate to those costs which involve 
cash payments by the entrepreneur of the firm. Thus, accounting costs are explicit costs and 
© The Institute of Chartered Accountants of India
Page 2


 
 
 
v 
 
3.35 
THEORY OF PRODUCTION AND COST 
 
 
LEARNING OUTCOMES 
UNIT - 2: THEORY OF COST 
 
AFTER STUDYING THIS UNIT, YOU WOULD BE ABLE TO:  
? Explain the Meaning and Different Types of Costs. 
? Define Cost Function and Explain the Difference between a Short-
Run and Long-Run Cost Function. 
? Explain the linkages between the Production Function and the Cost 
Function.  
? Explain Economies and Diseconomies of Scale and Reasons for Their 
Existence. 
 
In the previous unit, we have discussed the relationship between inputs and output in 
physical quantities. However, as we are aware, business decisions are generally based on 
cost of production i.e. the money value of inputs and output is considered. Cost analysis 
refers to the study of behaviour of cost in relation to one or more production criteria, 
namely, size of output, scale of operations, prices of factors of production and other 
relevant economic variables. In other words, cost analysis is concerned with the financial 
aspects of production relations as against physical aspects which were considered in 
production analysis. In order to have a clear understanding of the cost function, it is 
important for a businessman to understand various concepts of costs. 
2.0 COST CONCEPTS 
Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of 
production which he employs for production. He thus pays wages to workers employed, 
prices for the raw materials, fuel and power used, rent for the building he hires and interest 
on the money borrowed for doing business. All these are included in his cost of production 
and are termed as accounting costs. Accounting costs relate to those costs which involve 
cash payments by the entrepreneur of the firm. Thus, accounting costs are explicit costs and 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.36 
includes all the payments and charges made by the entrepreneur to the suppliers of various 
productive factors. Accounting costs are expenses already incurred by the firm. Accountants 
record these in the financial statements of the firm.  
However, it generally happens that an entrepreneur invests a certain amount of capital in his 
business. If the capital invested by the entrepreneur in his business had been invested 
elsewhere, it would have earned a certain amount of interest or dividend. Moreover, an 
entrepreneur may devote his time to his own work of production and contributes his 
entrepreneurial and managerial ability to do business. Had he not set up his own business, 
he would have sold his services to others for some positive amount of money. Accounting 
costs do not include these costs. These costs form part of economic cost. Thus, economic 
costs include: (1) the normal return on money capital invested by the entrepreneur himself 
in his own business; (2) the wages or salary not paid to the entrepreneur, but could have 
been earned if the services had been sold somewhere else. Likewise, the monetary rewards 
for all factors owned by the entrepreneur himself and employed by him in his own business 
are also considered a part of economic costs. Economic costs take into account these 
accounting costs; in addition, they also take into account the amount of money the 
entrepreneur could have earned if he had invested his money and sold his own services and 
other factors in the next best alternative uses. Accounting costs are also called explicit costs 
whereas the cost of factors owned by the entrepreneur himself and employed in his own 
business is called implicit costs. Thus, economic costs include both accounting costs and 
implicit costs. Therefore, economic costs are useful for businessmen while making decisions.  
The concept of economic cost is important because an entrepreneur must cover his 
economic cost if he wants to earn normal profits. Normal profit is part of implicit costs. If 
the total revenue received by an entrepreneur just covers both implicit and explicit costs, 
then he has zero economic profits. Super normal profits or positive economic profits 
(abnormal profits) are over and above these normal profits. In other words, an entrepreneur 
is said to be earning positive economic profits (abnormal profits) only when his revenues are 
greater than the sum of his explicit costs and implicit costs. 
Outlay costs and Opportunity costs: Outlay costs involve actual expenditure of funds on, 
say, wages, materials, rent, interest, etc. Opportunity cost, on the other hand, is concerned 
with the cost of the next best alternative opportunity which was foregone in order to pursue 
a certain action. It is the cost of the missed opportunity and involves a comparison between 
the policy that was chosen and the policy that was rejected. For example, the opportunity 
cost of using capital is the interest that it can earn in the next best use with equal risk. 
A distinction between outlay costs and opportunity costs can be drawn on the basis of the 
nature of the sacrifice. Outlay costs involve financial expenditure at some point of time and 
hence are recorded in the books of account. Opportunity cost is the amount or subjective 
© The Institute of Chartered Accountants of India
Page 3


 
 
 
v 
 
3.35 
THEORY OF PRODUCTION AND COST 
 
 
LEARNING OUTCOMES 
UNIT - 2: THEORY OF COST 
 
AFTER STUDYING THIS UNIT, YOU WOULD BE ABLE TO:  
? Explain the Meaning and Different Types of Costs. 
? Define Cost Function and Explain the Difference between a Short-
Run and Long-Run Cost Function. 
? Explain the linkages between the Production Function and the Cost 
Function.  
? Explain Economies and Diseconomies of Scale and Reasons for Their 
Existence. 
 
In the previous unit, we have discussed the relationship between inputs and output in 
physical quantities. However, as we are aware, business decisions are generally based on 
cost of production i.e. the money value of inputs and output is considered. Cost analysis 
refers to the study of behaviour of cost in relation to one or more production criteria, 
namely, size of output, scale of operations, prices of factors of production and other 
relevant economic variables. In other words, cost analysis is concerned with the financial 
aspects of production relations as against physical aspects which were considered in 
production analysis. In order to have a clear understanding of the cost function, it is 
important for a businessman to understand various concepts of costs. 
2.0 COST CONCEPTS 
Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of 
production which he employs for production. He thus pays wages to workers employed, 
prices for the raw materials, fuel and power used, rent for the building he hires and interest 
on the money borrowed for doing business. All these are included in his cost of production 
and are termed as accounting costs. Accounting costs relate to those costs which involve 
cash payments by the entrepreneur of the firm. Thus, accounting costs are explicit costs and 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.36 
includes all the payments and charges made by the entrepreneur to the suppliers of various 
productive factors. Accounting costs are expenses already incurred by the firm. Accountants 
record these in the financial statements of the firm.  
However, it generally happens that an entrepreneur invests a certain amount of capital in his 
business. If the capital invested by the entrepreneur in his business had been invested 
elsewhere, it would have earned a certain amount of interest or dividend. Moreover, an 
entrepreneur may devote his time to his own work of production and contributes his 
entrepreneurial and managerial ability to do business. Had he not set up his own business, 
he would have sold his services to others for some positive amount of money. Accounting 
costs do not include these costs. These costs form part of economic cost. Thus, economic 
costs include: (1) the normal return on money capital invested by the entrepreneur himself 
in his own business; (2) the wages or salary not paid to the entrepreneur, but could have 
been earned if the services had been sold somewhere else. Likewise, the monetary rewards 
for all factors owned by the entrepreneur himself and employed by him in his own business 
are also considered a part of economic costs. Economic costs take into account these 
accounting costs; in addition, they also take into account the amount of money the 
entrepreneur could have earned if he had invested his money and sold his own services and 
other factors in the next best alternative uses. Accounting costs are also called explicit costs 
whereas the cost of factors owned by the entrepreneur himself and employed in his own 
business is called implicit costs. Thus, economic costs include both accounting costs and 
implicit costs. Therefore, economic costs are useful for businessmen while making decisions.  
The concept of economic cost is important because an entrepreneur must cover his 
economic cost if he wants to earn normal profits. Normal profit is part of implicit costs. If 
the total revenue received by an entrepreneur just covers both implicit and explicit costs, 
then he has zero economic profits. Super normal profits or positive economic profits 
(abnormal profits) are over and above these normal profits. In other words, an entrepreneur 
is said to be earning positive economic profits (abnormal profits) only when his revenues are 
greater than the sum of his explicit costs and implicit costs. 
Outlay costs and Opportunity costs: Outlay costs involve actual expenditure of funds on, 
say, wages, materials, rent, interest, etc. Opportunity cost, on the other hand, is concerned 
with the cost of the next best alternative opportunity which was foregone in order to pursue 
a certain action. It is the cost of the missed opportunity and involves a comparison between 
the policy that was chosen and the policy that was rejected. For example, the opportunity 
cost of using capital is the interest that it can earn in the next best use with equal risk. 
A distinction between outlay costs and opportunity costs can be drawn on the basis of the 
nature of the sacrifice. Outlay costs involve financial expenditure at some point of time and 
hence are recorded in the books of account. Opportunity cost is the amount or subjective 
© The Institute of Chartered Accountants of India
 
 
 
v 
 
3.37 
THEORY OF PRODUCTION AND COST 
value that is foregone in choosing one activity over the next best alternative. It relates to 
sacrificed alternatives; it is, in general not recorded in the books of account. 
The opportunity cost concept is generally very useful for business managers and therefore it 
has to be considered whenever resources are scarce and a decision involving choice of one 
option over other(s) is involved. e.g., in a cloth mill which spins its own yarn, the opportunity 
cost of yarn to the weaving department is the price at which the yarn could be sold. This has 
to be considered while measuring profitability of the weaving operations. 
In long-term cost calculations also opportunity cost is a useful concept e.g., while calculating 
the cost of higher education, it is not the tuition fee and cost of books alone that are 
relevant. One should also take into account the earnings foregone, other foregone uses of 
money which is paid as tuition fees and the value of missed activities etc. as the cost of 
attending classes. 
Direct or Traceable costs and Indirect or Non-Traceable costs: Direct costs are those 
which have direct relationship with a component of operation like manufacturing a product, 
organizing a process or an activity etc. Since such costs are directly related to a product, 
process or machine, they may vary according to the changes occurring in these. Direct cos ts 
are costs that are readily identified and are traceable to a particular product, operation or 
plant. Even overhead costs can be direct as to a department; manufacturing costs can be 
direct to a product line, sales territory, customer class etc. We must know the purpose of 
cost calculation before considering whether a cost is direct or indirect. 
Indirect costs are those which are not easily and definitely identifiable in relation to a plant, 
product, process or department. Therefore, such costs are not visibly traceable to specific 
goods, services, operations, etc.; but are nevertheless charged to different jobs or products 
in standard accounting practice. The economic importance of these costs is that these, even 
though not directly traceable to a product, may bear some functional relationship to 
production and may vary with output in some definite way. Examples of such costs are 
electric power and common costs incurred for general operation of business benefiting all 
products jointly. 
Incremental costs and Sunk costs: Theoretically, incremental costs are related to the 
concept of marginal cost. Incremental cost refers to the additional cost incurred by a firm as 
result of a business decision. For example, incremental costs will have to be incurred by a 
firm when it makes a decision to change its product line, replace worn out machinery, buy a 
new production facility or acquire a new set of clients. Sunk costs refer to those costs which 
are already incurred once and for all and cannot be recovered. They are based on past 
commitments and cannot be revised or reversed if the firm wishes to do so. Examples of 
sunk costs are expenses incurred on advertising, R& D, specialised equipments and fixed 
© The Institute of Chartered Accountants of India
Page 4


 
 
 
v 
 
3.35 
THEORY OF PRODUCTION AND COST 
 
 
LEARNING OUTCOMES 
UNIT - 2: THEORY OF COST 
 
AFTER STUDYING THIS UNIT, YOU WOULD BE ABLE TO:  
? Explain the Meaning and Different Types of Costs. 
? Define Cost Function and Explain the Difference between a Short-
Run and Long-Run Cost Function. 
? Explain the linkages between the Production Function and the Cost 
Function.  
? Explain Economies and Diseconomies of Scale and Reasons for Their 
Existence. 
 
In the previous unit, we have discussed the relationship between inputs and output in 
physical quantities. However, as we are aware, business decisions are generally based on 
cost of production i.e. the money value of inputs and output is considered. Cost analysis 
refers to the study of behaviour of cost in relation to one or more production criteria, 
namely, size of output, scale of operations, prices of factors of production and other 
relevant economic variables. In other words, cost analysis is concerned with the financial 
aspects of production relations as against physical aspects which were considered in 
production analysis. In order to have a clear understanding of the cost function, it is 
important for a businessman to understand various concepts of costs. 
2.0 COST CONCEPTS 
Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of 
production which he employs for production. He thus pays wages to workers employed, 
prices for the raw materials, fuel and power used, rent for the building he hires and interest 
on the money borrowed for doing business. All these are included in his cost of production 
and are termed as accounting costs. Accounting costs relate to those costs which involve 
cash payments by the entrepreneur of the firm. Thus, accounting costs are explicit costs and 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.36 
includes all the payments and charges made by the entrepreneur to the suppliers of various 
productive factors. Accounting costs are expenses already incurred by the firm. Accountants 
record these in the financial statements of the firm.  
However, it generally happens that an entrepreneur invests a certain amount of capital in his 
business. If the capital invested by the entrepreneur in his business had been invested 
elsewhere, it would have earned a certain amount of interest or dividend. Moreover, an 
entrepreneur may devote his time to his own work of production and contributes his 
entrepreneurial and managerial ability to do business. Had he not set up his own business, 
he would have sold his services to others for some positive amount of money. Accounting 
costs do not include these costs. These costs form part of economic cost. Thus, economic 
costs include: (1) the normal return on money capital invested by the entrepreneur himself 
in his own business; (2) the wages or salary not paid to the entrepreneur, but could have 
been earned if the services had been sold somewhere else. Likewise, the monetary rewards 
for all factors owned by the entrepreneur himself and employed by him in his own business 
are also considered a part of economic costs. Economic costs take into account these 
accounting costs; in addition, they also take into account the amount of money the 
entrepreneur could have earned if he had invested his money and sold his own services and 
other factors in the next best alternative uses. Accounting costs are also called explicit costs 
whereas the cost of factors owned by the entrepreneur himself and employed in his own 
business is called implicit costs. Thus, economic costs include both accounting costs and 
implicit costs. Therefore, economic costs are useful for businessmen while making decisions.  
The concept of economic cost is important because an entrepreneur must cover his 
economic cost if he wants to earn normal profits. Normal profit is part of implicit costs. If 
the total revenue received by an entrepreneur just covers both implicit and explicit costs, 
then he has zero economic profits. Super normal profits or positive economic profits 
(abnormal profits) are over and above these normal profits. In other words, an entrepreneur 
is said to be earning positive economic profits (abnormal profits) only when his revenues are 
greater than the sum of his explicit costs and implicit costs. 
Outlay costs and Opportunity costs: Outlay costs involve actual expenditure of funds on, 
say, wages, materials, rent, interest, etc. Opportunity cost, on the other hand, is concerned 
with the cost of the next best alternative opportunity which was foregone in order to pursue 
a certain action. It is the cost of the missed opportunity and involves a comparison between 
the policy that was chosen and the policy that was rejected. For example, the opportunity 
cost of using capital is the interest that it can earn in the next best use with equal risk. 
A distinction between outlay costs and opportunity costs can be drawn on the basis of the 
nature of the sacrifice. Outlay costs involve financial expenditure at some point of time and 
hence are recorded in the books of account. Opportunity cost is the amount or subjective 
© The Institute of Chartered Accountants of India
 
 
 
v 
 
3.37 
THEORY OF PRODUCTION AND COST 
value that is foregone in choosing one activity over the next best alternative. It relates to 
sacrificed alternatives; it is, in general not recorded in the books of account. 
The opportunity cost concept is generally very useful for business managers and therefore it 
has to be considered whenever resources are scarce and a decision involving choice of one 
option over other(s) is involved. e.g., in a cloth mill which spins its own yarn, the opportunity 
cost of yarn to the weaving department is the price at which the yarn could be sold. This has 
to be considered while measuring profitability of the weaving operations. 
In long-term cost calculations also opportunity cost is a useful concept e.g., while calculating 
the cost of higher education, it is not the tuition fee and cost of books alone that are 
relevant. One should also take into account the earnings foregone, other foregone uses of 
money which is paid as tuition fees and the value of missed activities etc. as the cost of 
attending classes. 
Direct or Traceable costs and Indirect or Non-Traceable costs: Direct costs are those 
which have direct relationship with a component of operation like manufacturing a product, 
organizing a process or an activity etc. Since such costs are directly related to a product, 
process or machine, they may vary according to the changes occurring in these. Direct cos ts 
are costs that are readily identified and are traceable to a particular product, operation or 
plant. Even overhead costs can be direct as to a department; manufacturing costs can be 
direct to a product line, sales territory, customer class etc. We must know the purpose of 
cost calculation before considering whether a cost is direct or indirect. 
Indirect costs are those which are not easily and definitely identifiable in relation to a plant, 
product, process or department. Therefore, such costs are not visibly traceable to specific 
goods, services, operations, etc.; but are nevertheless charged to different jobs or products 
in standard accounting practice. The economic importance of these costs is that these, even 
though not directly traceable to a product, may bear some functional relationship to 
production and may vary with output in some definite way. Examples of such costs are 
electric power and common costs incurred for general operation of business benefiting all 
products jointly. 
Incremental costs and Sunk costs: Theoretically, incremental costs are related to the 
concept of marginal cost. Incremental cost refers to the additional cost incurred by a firm as 
result of a business decision. For example, incremental costs will have to be incurred by a 
firm when it makes a decision to change its product line, replace worn out machinery, buy a 
new production facility or acquire a new set of clients. Sunk costs refer to those costs which 
are already incurred once and for all and cannot be recovered. They are based on past 
commitments and cannot be revised or reversed if the firm wishes to do so. Examples of 
sunk costs are expenses incurred on advertising, R& D, specialised equipments and fixed 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.38 
facilities such as railway lines. Sunk costs act as an important barrier to entry of firms into 
business. 
Historical costs and Replacement costs: Historical cost refers to the cost incurred in the 
past on the acquisition of a productive asset such as machinery, building etc. Replacement 
cost is the money expenditure that has to be incurred for replacing an old asset. Instability 
in prices make these two costs differ. Other things remaining the same, an increase in price 
will make replacement costs higher than historical cost. 
Private costs and Social costs: Private costs are costs actually incurred or provided for by 
firms and are either explicit or implicit. They normally figure in business decisions as they 
form part of total cost and are internalised by the firm. Social cost, on the other hand, refers 
to the total cost borne by the society on account of a business activity and includes private 
cost and external cost. It includes the cost of resources for which the firm is not required to 
pay price such as atmosphere, rivers, roadways etc. and the cost in terms of dis-utility 
created such as air, water and environment pollution.  
Fixed and Variable costs: Fixed or constant costs are not a function of output; they do not 
vary with output upto a certain level of activity. These costs require a fixed expenditure of 
funds irrespective of the level of output, e.g., rent, property taxes, interest on loans and 
depreciation when taken as a function of time and not of output. However, these costs vary 
with the size of the plant and are a function of capacity. Therefore, fixed costs do not vary 
with the volume of output within a capacity level. 
Fixed costs cannot be avoided. These costs are fixed so long as operations are going on. 
They can be avoided only when the operations are completely closed down. These are, by 
their very nature, inescapable or uncontrollable costs. But, there are some costs which will 
continue even after the operations are suspended, as for example, for storing of old 
machines which cannot be sold in the market. These are called shut down costs. Some of the 
fixed costs such as costs of advertising, etc. are programmed fixed costs or discretionary 
expenses, because they depend upon the discretion of management whether to spend on 
these services or not. 
Variable costs are costs that are a function of output in the production period. For example, 
wages of casual labourers and cost of raw materials and cost of all other inputs that vary 
with output are variable costs. Variable costs vary directly and sometimes proportionately 
with output. Over certain ranges of production, they may vary less or more than 
proportionately depending on the utilization of fixed facilities and resources during the 
production process. 
 
© The Institute of Chartered Accountants of India
Page 5


 
 
 
v 
 
3.35 
THEORY OF PRODUCTION AND COST 
 
 
LEARNING OUTCOMES 
UNIT - 2: THEORY OF COST 
 
AFTER STUDYING THIS UNIT, YOU WOULD BE ABLE TO:  
? Explain the Meaning and Different Types of Costs. 
? Define Cost Function and Explain the Difference between a Short-
Run and Long-Run Cost Function. 
? Explain the linkages between the Production Function and the Cost 
Function.  
? Explain Economies and Diseconomies of Scale and Reasons for Their 
Existence. 
 
In the previous unit, we have discussed the relationship between inputs and output in 
physical quantities. However, as we are aware, business decisions are generally based on 
cost of production i.e. the money value of inputs and output is considered. Cost analysis 
refers to the study of behaviour of cost in relation to one or more production criteria, 
namely, size of output, scale of operations, prices of factors of production and other 
relevant economic variables. In other words, cost analysis is concerned with the financial 
aspects of production relations as against physical aspects which were considered in 
production analysis. In order to have a clear understanding of the cost function, it is 
important for a businessman to understand various concepts of costs. 
2.0 COST CONCEPTS 
Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of 
production which he employs for production. He thus pays wages to workers employed, 
prices for the raw materials, fuel and power used, rent for the building he hires and interest 
on the money borrowed for doing business. All these are included in his cost of production 
and are termed as accounting costs. Accounting costs relate to those costs which involve 
cash payments by the entrepreneur of the firm. Thus, accounting costs are explicit costs and 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.36 
includes all the payments and charges made by the entrepreneur to the suppliers of various 
productive factors. Accounting costs are expenses already incurred by the firm. Accountants 
record these in the financial statements of the firm.  
However, it generally happens that an entrepreneur invests a certain amount of capital in his 
business. If the capital invested by the entrepreneur in his business had been invested 
elsewhere, it would have earned a certain amount of interest or dividend. Moreover, an 
entrepreneur may devote his time to his own work of production and contributes his 
entrepreneurial and managerial ability to do business. Had he not set up his own business, 
he would have sold his services to others for some positive amount of money. Accounting 
costs do not include these costs. These costs form part of economic cost. Thus, economic 
costs include: (1) the normal return on money capital invested by the entrepreneur himself 
in his own business; (2) the wages or salary not paid to the entrepreneur, but could have 
been earned if the services had been sold somewhere else. Likewise, the monetary rewards 
for all factors owned by the entrepreneur himself and employed by him in his own business 
are also considered a part of economic costs. Economic costs take into account these 
accounting costs; in addition, they also take into account the amount of money the 
entrepreneur could have earned if he had invested his money and sold his own services and 
other factors in the next best alternative uses. Accounting costs are also called explicit costs 
whereas the cost of factors owned by the entrepreneur himself and employed in his own 
business is called implicit costs. Thus, economic costs include both accounting costs and 
implicit costs. Therefore, economic costs are useful for businessmen while making decisions.  
The concept of economic cost is important because an entrepreneur must cover his 
economic cost if he wants to earn normal profits. Normal profit is part of implicit costs. If 
the total revenue received by an entrepreneur just covers both implicit and explicit costs, 
then he has zero economic profits. Super normal profits or positive economic profits 
(abnormal profits) are over and above these normal profits. In other words, an entrepreneur 
is said to be earning positive economic profits (abnormal profits) only when his revenues are 
greater than the sum of his explicit costs and implicit costs. 
Outlay costs and Opportunity costs: Outlay costs involve actual expenditure of funds on, 
say, wages, materials, rent, interest, etc. Opportunity cost, on the other hand, is concerned 
with the cost of the next best alternative opportunity which was foregone in order to pursue 
a certain action. It is the cost of the missed opportunity and involves a comparison between 
the policy that was chosen and the policy that was rejected. For example, the opportunity 
cost of using capital is the interest that it can earn in the next best use with equal risk. 
A distinction between outlay costs and opportunity costs can be drawn on the basis of the 
nature of the sacrifice. Outlay costs involve financial expenditure at some point of time and 
hence are recorded in the books of account. Opportunity cost is the amount or subjective 
© The Institute of Chartered Accountants of India
 
 
 
v 
 
3.37 
THEORY OF PRODUCTION AND COST 
value that is foregone in choosing one activity over the next best alternative. It relates to 
sacrificed alternatives; it is, in general not recorded in the books of account. 
The opportunity cost concept is generally very useful for business managers and therefore it 
has to be considered whenever resources are scarce and a decision involving choice of one 
option over other(s) is involved. e.g., in a cloth mill which spins its own yarn, the opportunity 
cost of yarn to the weaving department is the price at which the yarn could be sold. This has 
to be considered while measuring profitability of the weaving operations. 
In long-term cost calculations also opportunity cost is a useful concept e.g., while calculating 
the cost of higher education, it is not the tuition fee and cost of books alone that are 
relevant. One should also take into account the earnings foregone, other foregone uses of 
money which is paid as tuition fees and the value of missed activities etc. as the cost of 
attending classes. 
Direct or Traceable costs and Indirect or Non-Traceable costs: Direct costs are those 
which have direct relationship with a component of operation like manufacturing a product, 
organizing a process or an activity etc. Since such costs are directly related to a product, 
process or machine, they may vary according to the changes occurring in these. Direct cos ts 
are costs that are readily identified and are traceable to a particular product, operation or 
plant. Even overhead costs can be direct as to a department; manufacturing costs can be 
direct to a product line, sales territory, customer class etc. We must know the purpose of 
cost calculation before considering whether a cost is direct or indirect. 
Indirect costs are those which are not easily and definitely identifiable in relation to a plant, 
product, process or department. Therefore, such costs are not visibly traceable to specific 
goods, services, operations, etc.; but are nevertheless charged to different jobs or products 
in standard accounting practice. The economic importance of these costs is that these, even 
though not directly traceable to a product, may bear some functional relationship to 
production and may vary with output in some definite way. Examples of such costs are 
electric power and common costs incurred for general operation of business benefiting all 
products jointly. 
Incremental costs and Sunk costs: Theoretically, incremental costs are related to the 
concept of marginal cost. Incremental cost refers to the additional cost incurred by a firm as 
result of a business decision. For example, incremental costs will have to be incurred by a 
firm when it makes a decision to change its product line, replace worn out machinery, buy a 
new production facility or acquire a new set of clients. Sunk costs refer to those costs which 
are already incurred once and for all and cannot be recovered. They are based on past 
commitments and cannot be revised or reversed if the firm wishes to do so. Examples of 
sunk costs are expenses incurred on advertising, R& D, specialised equipments and fixed 
© The Institute of Chartered Accountants of India
  
 
 
BUSINESS ECONOMICS  
 3.38 
facilities such as railway lines. Sunk costs act as an important barrier to entry of firms into 
business. 
Historical costs and Replacement costs: Historical cost refers to the cost incurred in the 
past on the acquisition of a productive asset such as machinery, building etc. Replacement 
cost is the money expenditure that has to be incurred for replacing an old asset. Instability 
in prices make these two costs differ. Other things remaining the same, an increase in price 
will make replacement costs higher than historical cost. 
Private costs and Social costs: Private costs are costs actually incurred or provided for by 
firms and are either explicit or implicit. They normally figure in business decisions as they 
form part of total cost and are internalised by the firm. Social cost, on the other hand, refers 
to the total cost borne by the society on account of a business activity and includes private 
cost and external cost. It includes the cost of resources for which the firm is not required to 
pay price such as atmosphere, rivers, roadways etc. and the cost in terms of dis-utility 
created such as air, water and environment pollution.  
Fixed and Variable costs: Fixed or constant costs are not a function of output; they do not 
vary with output upto a certain level of activity. These costs require a fixed expenditure of 
funds irrespective of the level of output, e.g., rent, property taxes, interest on loans and 
depreciation when taken as a function of time and not of output. However, these costs vary 
with the size of the plant and are a function of capacity. Therefore, fixed costs do not vary 
with the volume of output within a capacity level. 
Fixed costs cannot be avoided. These costs are fixed so long as operations are going on. 
They can be avoided only when the operations are completely closed down. These are, by 
their very nature, inescapable or uncontrollable costs. But, there are some costs which will 
continue even after the operations are suspended, as for example, for storing of old 
machines which cannot be sold in the market. These are called shut down costs. Some of the 
fixed costs such as costs of advertising, etc. are programmed fixed costs or discretionary 
expenses, because they depend upon the discretion of management whether to spend on 
these services or not. 
Variable costs are costs that are a function of output in the production period. For example, 
wages of casual labourers and cost of raw materials and cost of all other inputs that vary 
with output are variable costs. Variable costs vary directly and sometimes proportionately 
with output. Over certain ranges of production, they may vary less or more than 
proportionately depending on the utilization of fixed facilities and resources during the 
production process. 
 
© The Institute of Chartered Accountants of India
 
 
 
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3.39 
THEORY OF PRODUCTION AND COST 
2.1 COST FUNCTION 
Cost function refers to the mathematical relation between cost of a product and the various 
determinants of costs. In a cost function, the dependent variable is unit cost or total cost 
and the independent variables are the price of a factor, the size of the output or any other 
relevant phenomenon which has a bearing on cost, such as technology, level of capacity 
utilization, efficiency and time period under consideration. Cost function is a function which 
is obtained from production function and the market supply of inputs. It expresses the 
relationship between costs and output. Cost functions are derived from actual cost data of 
the firms and are presented through cost curves. The shape of the cost curves depends 
upon the cost function. Cost functions are of two kinds: They are short-run cost functions 
and long-run cost functions. 
2.2 SHORT RUN TOTAL COSTS 
Total, fixed and variable costs: There are some factors which can be easily adjusted with 
changes in the level of output. A firm can readily employ more workers if it has to increase 
output. Similarly, it can purchase more raw materials if it has to expand production. Such 
factors which can be easily varied with a change in the level of output are called variable 
factors. On the other hand, there are some factors such as building, capital equipment, or 
top management team which cannot be so easily varied. It requires comparatively longer 
time to make changes in them. It takes time to install new machinery. Similarly, it takes time 
to build a new factory. Such factors which cannot be readily varied and require a longer 
period to adjust are called fixed factors. 
Corresponding to the distinction between variable and fixed factors, we distinguish between 
short run and long run periods of time. Short run is a period of time in which output can be 
increased or decreased by changing only the amount of variable factors such as, labour, raw 
materials, etc. In the short run, quantities of fixed factors cannot be varied in accordance 
with changes in output. If the firm wants to increase output in the short run, it can do so 
only by increasing the variable factors, i.e., by using more labour and/or by buying more raw 
materials. Thus, short run is a period of time in which only variable factors can be varied, 
while the quantities of fixed factors remain unaltered. On the other hand, long run is a 
period of time in which the quantities of all factors may be varied. In other words, all factors 
become variable in the long run. 
Thus, we find that fixed costs are those costs which are independent of output, i.e., they do 
not change with changes in output. These costs are a “fixed amount” which is incurred by a 
firm in the short run, whether the output is small or large. Even if the firm closes down for 
© The Institute of Chartered Accountants of India