At the end of this Unit, you should be able to:
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.
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 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 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 costs 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 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.