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Home > Business Economics > Laws of Production > Concept of Costs
Laws of Production

Concept of Costs

It is a commonly accepted fact that physical inputs or resources are important for enhancing production. We, however, tend to miss out on the financial aspect of this rule. Some of the most important decisions pertaining to business often relate to the cost of production, instead of physical resources themselves. Hence, it is important for producers to understand cost analysis. Let’s understand the general concept of costs for that.

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Concept of Costs

In order to understand the general concept of costs, it is important to know the following types of costs:

  1. Accounting costs and Economic costs
  2. Outlay costs and Opportunity costs
  3. Direct/Traceable costs and Indirect/Untraceable costs
  4. Incremental costs and Sunk costs
  5. Private costs and Social costs
  6. Fixed costs and Variable costs

Concept of Costs

Concept of Costs in terms of Treatment

1. Accounting costs

Accounting costs are those for which the entrepreneur pays direct cash for procuring resources for production. These include costs of the price paid for raw materials and machines, wages paid to workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc. Accounting costs are treated as expenses. Chartered accountants record them in financial statements.

2. Economic costs

There are certain costs that accounting costs disregard. These include money which the entrepreneur forgoes but would have earned had he invested his time, efforts and investments in other ventures. For example, the entrepreneur would have earned an income had he sold his services to others instead of working on his own business

Similarly, potential returns on the capital he employed in his business instead of giving it to others, the output generated by his resources which he could have used for others’ benefits, etc. are other examples of economic costs.

Economic costs help the entrepreneur calculate supernormal profits, i.e. profits he would earn above the normal profits by investing in ventures other than his.

Concept of Costs in terms of the Nature of Expenses

1. Outlay costs

The actual expenses incurred by the entrepreneur in employing inputs are called outlay costs. These include costs on payment of wages, rent, electricity or fuel charges, raw materials, etc. We have to treat them are general expenses for the business.

2. Opportunity costs

Opportunity costs are incomes from the next best alternative that is foregone when the entrepreneur makes certain choices.

For example, the entrepreneur could have earned a salary had he worked for others instead of spending time on his own business. These costs calculate the missed opportunity and calculate income that we can earn by following some other policy.

Concept of Costs in terms of Traceability

1. Direct costs

Direct costs are related to a specific process or product. They are also called traceable costs as we can directly trace them to a particular activity, product or process.

They can vary with changes in the activity or product. Examples of direct costs include manufacturing costs relating to production, customer acquisition costs pertaining to sales, etc.

2. Indirect costs

Indirect costs, or untraceable costs, are those which do not directly relate to a specific activity or component of the business. For example, an increase in charges of electricity or taxes payable on income. Although we cannot trace indirect costs, they are important because they affect overall profitability.

Concept of Costs in terms of the Purpose

1. Incremental costs

These costs are incurred when the business makes a policy decision. For example, change of product line, acquisition of new customers, upgrade of machinery to increase output are incremental costs.

2. Sunk costs

Suck costs are costs which the entrepreneur has already incurred and he cannot recover them again now. These include money spent on advertising, conducting research, and acquiring machinery.

Concept of Costs in terms of Payers

1. Private costs

These costs are incurred by the business in furtherance of its own objectives. Entrepreneurs spend them for their own private and business interests. For example, costs of manufacturing, production, sale, advertising, etc.

2. Social costs

As the name suggests, it is the society that bears social costs for private interests and expenses of the business. These include social resources for which the firm does not incur expenses, like atmosphere, water resources and environmental pollution.

Concept of Costs in terms of Variability

1. Fixed costs

Fixed costs are those which do not change with the volume of output. The business incurs them regardless of their level of production. Examples of these include payment of rent, taxes, interest on a loan, etc.

2. Variable costs

These costs will vary depending upon the output that the business generates. Less production will cost fewer expenses, and vice versa, the business will pay more when its production is greater. Expenses on the purchase of raw material and payment of wages are examples of variable costs.

Solved Examples on Concept of Costs

Question: Describe the nature of the following costs and give reasons for your answers.

Answer:

1. The cost incurred in advertising: This expense can be –

  • Direct cost (traceable to sales)
  • Sunk cost (not recoverable)
  • Private cost (spent for business interests)
  • Variable cost (will vary depending on the volume of output)

2. Income earned from a job: This expense can be –

  • Economic cost (the person could earn more money by working for his business)
  • Opportunity cost (same reason as above)

3. Rent paid for factory premises: This expense can be –

  • Accounting cost (spent on procuring facilities for production)
  • Direct cost (directly affects manufacturing)
  • Outlay cost (spent on procuring access to input, i.e. factory)
  • Private cost (used for private business interests)
  • Fixed cost (does not change with variance in production levels)
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