The main aim of every organization is to earn. Maximum profit, which depends on costs incurred by an organisation for different activities.
There are different types of costs that are relevant to business operations and decisions.
It is essential for organizations to have a clear idea about each costs incurred during production.
This is because the price at which an organization is willing to supply depends on the costs of production. The costs are broadly grouped into two categories, namely, accounting cost and analytical cost, which are important for business operations and decisions.
These two types of costs are shown in figure-2:
The different types of costs (as shown in Figure-2).
1. Accounting Cost:
Accounting costs are also called as money costs or entrepreneur’s costs. These are the expenses of an organization incurred during action and are entered in the books of accounts of the organization. In the words of Nicholson, “Accounting cost refers to the out of packet expenses, historical costs, depreciation, and other book keeping entries.”
Out of pocket expenses are the costs that include immediate or instant payment to outsiders. Accounting costs are also known as actual cost or acquisition cost or absolute cost.
These costs include the following:
i. Wages to labor
ii. Interest on borrowed capital
iii. Rent paid to owners of the landiv.
iv. Cost of raw materials
v. Depreciation of capital goods
A producer should ensure that the price of the product should cover all these costs, so that production is continued. Accounting cost comprises a number of costs.
Opportunity Costs and Actual Costs:
The concept of opportunity cost marks a significant contribution in economic analysis. Cost is considered as the value of inputs, such as land, labor, and capital, used for the production of goods and services. The inputs are always valuable for an organization as they are limited. If an organization utilizes an input to produce a particular good, then the same input would not be available to produce another good.
The cost incurred on the next best alternative that is foregone to acquire or produce a particular good is known as opportunity cost. In other words, opportunity cost can be defined as the lost opportunity of not being able to produce some other product. Opportunity cost is also known as alternative cost or displacement cost or transfer cost.
Some of the popular definitions of opportunity cost are as follows:
In the words of Leftwitch, “Opportunity cost of a particular product is the sale of value of the foregone alternative product that resources used in its production, could have produced.”
According to Ferguson, “the alternative or opportunity cost of producing one unit of commodity ‘X’ is the amount of commodity ‘Y’ that must be sacrificed in order to use resources to produce ‘X’ rather than ‘Y’.”
Let us understand the concept of opportunity cost with the help of an example. Suppose an organization has Rs. 10, 000, 00 of which it has two alternative uses. It can-either buy a machine for production of goods or invest it for the construction of canteen at the organization’s premises.
The annual expected income from using the machinery’ is Rs. 1, 50,000, whereas from canteen is Rs 1, 00,000. A rational producer would opt for buying the machinery because it would yield high income for the organization than investing for canteen. Thus, opportunity cost for buying machinery is Rs 1, 00,000.
On the other hand, actual costs are those costs which are incurred by the organization on actual goods to carry out the production activities. These costs are incurred on purchasing raw materials, plant, machinery, and other physical assets. Actual costs are the payments that are made in monetary terms and are recorded in the books of accounts.
Business Costs and Full Costs:
Business costs involve those costs that are incurred while carrying out business. These are also called real costs or actual costs. According to Watson, “business costs include all the payments and contractual obligations made by the organization together with the book cost of depreciation on plant and equipment.”
These costs are used for calculating business profits and losses and filing returns of income tax and other legal purposes. These costs include payment and contractual obligations made by the organization together with the cost of depreciation on plant and equipment.
On the other hand, full costs include actual costs, depreciation, implicit costs, and normal profits. Normal profits refer to minimum earrings in addition to the opportunity cost which an organization must receive to carry on production.
Explicit Costs and Implicit Costs:
Explicit costs refer to the payments incurred by an organization in exchange of acquiring various resources, such as labor, material, plant, machinery, and technology. In other words, explicit costs can be defined as the payments incurred by organizations for outsiders who supply labor services, transport services, electricity, and raw materials.
According to Leftwitch, “explicit costs are those cash payments which firms make to outsiders for their services and goods.” Explicit costs are recorded in the books of accounts of an organization. Apart from this, there are certain costs that are neither converted into cash outlays nor added in the accounting system. Such costs are termed as implicit costs or imputed costs.
These costs are considered as the costs of organization’s self-owned resources. Opportunity cost is the important example of implicit costs. Let us understand the concept of implicit costs with the help of an example. Suppose Mr. X is carrying out his/her own business. He is also eligible to work as a manager in some organization at the pay package of Rs. 12, 00, 000 per annum.
In such a case, he is foregoing his salary- as a manager. This loss of salary would be an implicit cost for him from his own business. These costs are not taken into consideration, while calculating profit and loss of a business. However, these costs enable an organization to decide whether to select the available alternative or not.
Out of Pocket Costs and Book Costs:
Out of pocket costs are those cash payments or cash transfers that are made for outsiders. These costs involve both recurring or nonrecurring expenses. All the explicit costs, such as wages, rent, interest, transport expenditure, and salaries, are out of pocket costs.
On the other hand, book costs refer to those costs that do not involve cash outlays, but are added in the accounting system. These costs are included in profit and loss accounts and are useful for getting tax benefits. For example, depreciation of machinery and unpaid interests are the book costs of an organization.
Both, out of pocket and book costs are important for calculating the total profit and loss of an organization. Generally, small-scale organization ignores book costs, which may lead to overestimation of profit.
2. Analytical Cost:
Analytical costs are those costs that are taken into account for analyzing the production activities of an organization. These costs are the deciding criteria for carrying out business activities. For instance, if an organization is planning to expand, it needs to consider various costs, such as incremental costs, replacement costs, and fixed costs.
In case the costs exceed the total budget of the organization, it may drop the idea of expansion. Apart from this, analytical costs are also helpful for making organizational decisions in different time periods.
Fixed Costs and Variable Costs:
Fixed costs refer to those that remain constant for a certain amount of output. The fixed costs include costs incurred on managerial and administrative staff, depreciation of machinery, and maintenance of lands and buildings.
These costs are incurred in the short- run. On the other hand, variable costs are those costs that differ according to changes in the quantity of output. These costs include costs incurred on raw materials, transportation, and labor.
Total Cost, Average Cost, and Marginal Cost:
Total cost refers to the total sum of the cost incurred on production of goods or services. It involves all implicit and explicit costs as well as fixed and variable costs incurred on acquiring resources for the production of goods or services. On the other hand, average cost is the total cost of production per unit of output. It is not considered as actual costs and is statistical in nature.
Average cost can be calculated as follows:
Average Cost = Total Cost/ Output
Marginal cost is the addition to the total cost for producing an additional unit of the product.
Some of the definitions of marginal costs given by different economists are as follows:
According to Mc Conell, “marginal cost may be defined as the additional cost of producing one more unit of output.”
In the words of Ferguson, “marginal cost is the addition to total cost due to the addition of one unit of output.”
Marginal cost can be calculated as follows:
MC = TCn-TCn-1
n= Number of units produced
MC is the rate of change of the total cost.
It is also calculated as:
MC = ∆TC/ ∆Output
Total, average, marginal costs play an important role in analyzing the production activities of an organization.
Short-run and Long-run Costs:
Short run refers to a period in which organization can change its output by changing only variable factors, such as labor and capital. In this period, the fixed factors, such as land and machinery, remain the same. The expansion is done by hiring more labor and purchasing more raw materials.
The existing size of the plant or building cannot be increased in case of the short run. In context of costs, short run costs are those costs that have short-term application in the production process of an organization. Short-run costs involve costs incurred on raw materials and payment of wages. Short-run costs change with the change in the level of output.
On the other hand, long run refers to a period in which all the factors are variable. The existing size of the plant or building can be increased in case of the long run. Long run costs vary with variation in the size of manufacturing plant or organization. Long-run costs include costs incurred on plant, building, and machinery.
Incremental Costs and Sunk Costs:
Incremental costs are those costs that are incurred during the expansion of an organization. These are the added costs that are involved in changing the level of production or the nature of business activity. Expansion can be in the form of men, materials, and machinery. Incremental costs are incurred by an organization for various purposes, such as purchasing new machines, changing distribution channel, and launching a new product.
For instance, if an organization purchases machinery, then following incremental costs are incurred:
i. Cost of purchase
ii. Maintenance charges
iii. Installation charges
iv. Operational charges
On the other hand, sunk costs are those costs that are incurred whether there is an expansion or not. These are the costs which are made once and cannot be altered, increased, or decreased. These types of costs are based on the prior commitment; thus, cannot be revised or recovered. For instance, if an organization hires a machine; it has to bear the rent and other operational charges, which are the sunk costs of the organization.
Historical and Replacement Costs:
Historical costs are those costs that are incurred in the past by an organization for acquiring assets, such as land, building, and machinery. These costs help in assessing the net worth of the organization. Historical costs reduce on an annual basis due to depreciated value of assets, such as machinery and equipment. On the contrary, historical cost increases in case of land, buildings, and metals, such as gold and silver.
On the other hand, replacement cost is incurred when an asset depreciates and is replaced with the new asset. Let us understand the concept of replacement costs with the help of an example.
For instance, the historical cost of a machine is Rs. 85, 000, which was purchased by an organization two years ago. Now, the organization is willing to replace the existing machine with the new one. The current price of the machine in the market is Rs. 90, 000, which is a replacement cost.
Private and Social Costs:
Private costs are those costs that are incurred for carrying out different business operations. In other words, these costs are added in the total cost of production of an organization. In the words of miller, “private costs are those costs that are incurred by the firm or the individual producer as a result of their own decisions.” All explicit and implicit costs fall into the category of private costs.
On the contrary, social costs are those costs that are borne by the society and are not explicitly paid by the organization. Such costs include pollution (air, water, and noise) and global warming, which take place due to production activities of an organization.
According to Dictionary of Modern Economics, “social costs of a given output is defined as the sum of money which is just adequate when paid as compensation to restore to their original utility levels all who lose as a result of the production of the output.”