Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its ability to earn sustained profits. Profits are the difference between selling price and cost of production. In general the selling price is not within the control of a firm but many costs are under its control. The firm should therefore aim at controlling and minimizing cost. Since every business decision involves cost consideration, it is necessary to understand the meaning of various concepts for clear business thinking and application of right kind of costs.
A managerial economist must have a clear understanding of the different cost concepts for clear business thinking and proper application. The several alternative bases of classifying cost and the relevance of each for different kinds of problems are to be studied. The various relevant concepts of cost are:
- Opportunity costs and Outlay costs: Out lay cost also known as actual costs are those expends which are actually incurred by the firm these are the payments made for labour, material, plant, building, machinery traveling, transporting etc. These are all those expense item appearing in the books of account, hence based on accounting cost concept. On the other hand opportunity cost implies the earnings foregone on the next best alternative, has the present option is undertaken. This cost is often measured by assessing the alternative, which has to be scarified if the particular line is followed. The opportunity cost concept is made use for long-run decisions. This concept is very important in capital expenditure budgeting. This concept is very important in capital expenditure budgeting. The concept is also useful for taking short-run decisions. Opportunity cost is the cost concept to use when the supply of inputs is strictly limited and when there is an alternative. If there is no alternative, opportunity cost is zero. The opportunity cost of any action is therefore measured by the value of the most favorable alternative course, which had to be foregoing if that action is taken.
- Explicit and Implicit costs: Explicit costs are those expenses that involve cash payments. These are the actual or business costs that appear in the books of accounts. These costs include payment of wages and salaries, payment for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc. Implicit costs are the costs of the factor units that are owned by the employer himself. These costs are not actually incurred but would have been incurred in the absence of employment of self — owned factors. The two normal implicit costs are depreciation, interest on capital etc. A decision maker must consider implicit costs too to find out appropriate profitability of alternatives.
- Historical and Replacement costs: Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset as the original price paid for the asset acquired in the past. Historical valuation is the basis for financial accounts. A replacement cost is the price that would have to be paid currently to replace the same asset. During periods of substantial change in the price level, historical valuation gives a poor projection of the future cost intended for managerial decision. A replacement cost is a relevant cost concept when financial statements have to be adjusted for inflation.
- Short-run and Long-run costs: Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in output during this period is possible only by using the existing physical capacity more extensively. So short run cost is that which varies with output when the plant and capital equipment in constant. Long run costs are those, which vary with output when all inputs are variable including plant and capital equipment. Long-run cost analysis helps to take investment decisions.
- Out-of pocket and Books costs: Out-of pocket costs also known as explicit costs are those costs that involve current cash payment. Book costs also called implicit costs do not require current cash payments. Depreciation, unpaid interest, salary of the owner is examples of book costs. But the book costs are taken into account in determining the level dividend payable during a period. Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of self-owned factors of production.
- Fixed and Variable costs: Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the changes in the volume of production. But fixed cost per unit decrease, when the production is increased. Fixed cost includes salaries, rent, administrative expenses, depreciation’s etc. Variable is that which varies directly with the variation is output. An increase in total output results in an increase in total variable costs and decrease in total output results in a proportionate decline in the total variables costs. The variable cost per unit will be constant. Ex: Raw materials, labor, direct expenses, etc.
- Post and Future costs: Post costs also called historical costs are the actual cost incurred and recorded in the book of account these costs are useful only for valuation and not for decision making. Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They are the costs forecasted or estimated with rational methods. Future cost estimate is useful for decision making because decision are meant for future.
- Traceable and Common costs: Traceable costs otherwise called direct cost, is one, which can be identified with a products process or product. Raw material, labor involved in production is examples of traceable cost. Common costs are the ones that common are attributed to a particular process or product. They are incurred collectively for different processes or different types of products. It cannot be directly identified with any particular process or type of product.
- Avoidable and Unavoidable costs: Avoidable costs are the costs, which can be reduced if the business activities of a concern are curtailed. For example, if some workers can be retrenched with a drop in a product — line, or volume or production the wages of the retrenched workers are escapable costs. The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this cost even if reduction in business activity is made. For example cost of the ideal machine capacity is unavoidable cost.
- Controllable and Uncontrollable costs: Controllable costs are ones, which can be regulated by the executive who is in change of it. The concept of controllability of cost varies with levels of management. Direct expenses like material, labour etc. are controllable costs. Some costs are not directly identifiable with a process of product. They are appointed to various processes or products in some proportion. This cost varies with the variation in the basis of allocation and is independent of the actions of the executive of that department. These apportioned costs are called uncontrollable costs.
- Incremental and Sunk costs: Incremental cost also known as different cost is the additional cost due to a change in the level or nature of business activity. The change may be caused by adding a new product, adding new machinery, replacing a machine by a better one etc. Sunk costs are those which are not altered by any change — They are the costs incurred in the past. This cost is the result of past decision, and cannot be changed by future decisions. Investments in fixed assets are examples of sunk costs.
- Total, Average and Marginal costs: Total cost is the total cash payment made for the input needed for production. It may be explicit or implicit. It is the sum total of the fixed and variable costs. Average cost is the cost per unit of output. If is obtained by dividing the total cost (TC) by the total quantity produced (Q). Marginal cost is the additional cost incurred to produce and additional unit of output or it is the cost of the marginal unit produced.
- Accounting and Economics costs: Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit and ton statements to meet the legal, financial and tax purpose of the company. The accounting concept is a historical concept and records what has happened in the post. Economics concept considers future costs and future revenues, which help future planning, and choice, while the accountant describes what has happened, the economics aims at projecting what will happen.