Theory of Cost

Cost Concepts

Cost analysis is all about the study of the behavior of cost with respect to various production criteria like the scale of operations, prices of the factors of production, size of output, etc. It is all about the financial aspects of production. In order to understand the cost function well, in this article, we will look at various cost concepts.

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Cost Concepts

Accounting and Economic Costs

When a firm starts producing goods, it has to pay the price for the factors employed for the production. These factors include 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, etc.

Accounting Costs are these costs which are included in the cost of production. Hence, accounting costs take care of all payments and charges that the firm makes to suppliers of different productive factors.

Usually, a businessman invests some capital in his firm. If he would have invested the amount in some other firm, then he could have earned a certain interest/dividend. Further, he invests time for his business and also contributes his entrepreneurial and managerial ability to the business.

If not involved in the business, he could have offered his services to other firms for an amount of money. Accounting costs DO NOT involve these costs. They form a part of the Economic Costs. Hence, Economic costs include:

  • The normal return on the money that the businessman invests in his own business
  • The salary not paid to the entrepreneur but could have been earned if the services would have been sold elsewhere.
  • A reward for all factors owned by the businessman and used in his own business.

Therefore, the accounting costs involve cash payments that the firm makes. Economic costs, on the other hand, include the accounting costs and also take into account the amount of money the businessman could have earned with his resources if he would not have started the business.

Another name for accounting costs is Explicit Costs. Whereas, the alternate name for the costs of factors that the businessman owns is Implicit Costs. A businessman earns profits when his revenues exceed both explicit and implicit costs.

cost concepts

Outlay and Opportunity Costs

Outlay costs include the actual expenditure of funds on factors like material, rent, wages, etc. On the other hand, opportunity costs are the costs of missed opportunities. In other words, it compares the policy chosen and policy rejected.

Outlay cost concepts are actual expenditures and the books of accounts record them. Opportunity costs are about sacrificed opportunities and the books of accounts do not record them.

These costs are very useful. For example, if a cloth mill spins its own yarn, the opportunity cost of yarn to the weaving department is the price at which the yarn sells. This is used for measuring the profitability of the weaving operations.

Direct or Traceable Costs and Indirect or Non-Traceable Costs

Direct costs – costs which are easily identifiable and traceable to a particular product, operation or plant. For example, manufacturing costs are direct costs since they can be related to either a product line or territory or customer class, etc. Ensure that you know the purpose of the cost calculation before determining if a cost is direct or indirect.

Indirect costs – costs which are not easily identifiable or traceable to specific goods, services, operations, etc. These costs bear some functional relationship to production and may vary with the output. For example, costs related to electric power and the common costs incurred for the general operation of the business benefitting all products.

Fixed and Variable Costs

Fixed costs or Constant costs are not a function of the output. That is, they do not vary with the output up to a certain extent. They require a fixed expenditure of funds regardless of the output.

For example, rent, property taxes, interest on loans, etc. However, note that fixed costs can vary with the size of the plant and are usually a function of capacity. Therefore, we can conclude that fixed costs do not vary with the output volume within a capacity level.

Businesses cannot avoid fixed costs and are applicable as long as the business is operating. Alternate names for fixed costs are inescapable or uncontrollable costs.

It is important to note here, that some fixed costs continue even after the suspension of business. For example, costs associated with storing of machines that the business cannot sell in the market, etc.

Variable costs are cost concepts which are a function of the output in the production period. Variable costs vary directly with the output. Some examples of variable costs are the cost of raw materials, wages, etc. Sometimes, they vary proportionally with the output too. However, these variations depend on the utilization of fixed facilities and resources during the production process.

Solved Question on Cost Concepts

Q1. Which of the following is an example of an “explicit cost” in cost concepts?

  1. The wages a proprietor could have made by working as an employee of a large firm.
  2. The income that the firm could have earned in alternative uses by the resources.
  3. The payment of wages by the firm.
  4. The normal profit earned by a firm.

Answer: The correct answer is option C. By definition, explicit costs or accounting costs are the costs associated with the payment of the price of various factors used in production. Options a and b are the factors that the businessman holds and are hence implicit costs. Option d is not a cost at all. The payment of wages by the firm (Option c), are costs associated with labor (a factor used in production).


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3 responses to “Cost Concepts”


    I love this

  2. patience says:

    i like this indeed

  3. Akash says:

    pls provied brief theory on theory of cost for ugc net

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