CONCEPTS OF COST When commodities and services are produced, various expenses have to be incurred, e.g.

, purchase of raw materials, payment to labour, landlord, capitalist, etc. The sum total of the expenses incurred plus the normal profit expected by the producer is called the cost of production. The various concepts of cost are discussed below: 1. Nominal Cost and Real Cost: Nominal cost is the money cost of production. The real costs of production are the pain and sacrifices of labour involved in the process of production. 2. Explicit and Implicit costs: Explicit costs are the accounting costs or contractual cash payments which the firm makes to other factor owners for purchasing or hiring the various factors. Implicit costs are the costs of self-owned factors which are employed by the entrepreneur in his own business. These implicit costs are the opportunity costs of the self-owned and self-employed factors of the entrepreneur, that is, the money incomes which these self-owned factors would have earned in their next best alternative uses. 3. Accounting Costs and Economic Cost: Accounting costs are the actual or explicit costs which are paid by the entrepreneurs to the owners of hired factors and services. On the other hand, economic costs not only include the explicit costs but also the implicit costs of the self-owned factors or resources which are used by the entrepreneur in his own business. 4. Opportunity Cost: The opportunity cost (or transfer earnings) of any good is the expected return from the next best alternative good that is forgone or sacrificed. For example, if a farmer who is producing wheat can also produce potatoes with the same factors. Then, the opportunity cost of a quintal of wheat is the amount of output of potatoes given up. 5. Business Cost and Full Cost: Business costs include all the expenses which are incurred in carrying out a business. The concept of business cost is similar to the accounting or actual cost. The concept of Full cost includes two other costs: the opportunity cost and normal profit. Normal profit is a necessary minimum earning which a firm must get to remain in its present occupation. 6. Private costs and Social Costs: Private costs are the economic costs which are actually incurred or provided for by an individual or a firm. It includes both explicit and implicit costs. Social cost, on the other hand, implies the cost which a society bears as a result of production of a commodity. Social cost includes both private cost and the external cost. External cost includes (a) the cost of free goods or resources for which the firm is not required to pay for its used, e.g., atmosphere, rivers, lakes etc. (b) the cost in the form of disutility caused by air, water, and noise pollution, etc. 7. Total, Average and Marginal Costs: Total cost refers to the total outlays of money expenditure, both explicit and implicit on the resources used to produced a given output. Average cost is the cost per unit of output which is obtained by dividing the total cost (TC) by the total output (Q), i.e., TC/Q = average cost. Marginal cost is the addition made to the total cost as a result of producing one additional unit of the product. Marginal cost is defined as ?TC/?Q. 8. Fixed Costs and Variable Costs: Fixed costs are the expenditure incurred on the factors such as capital, equipment, plant, factory building which remain fixed in the short run and cannot be changed. Therefore, fixed costs are independent of output in the short run i.e., they do not vary with output in the short run. Even if no output is produced in the short run, these costs will have to be incurred. Variable costs are costs incurred by the firms on the employment of variable factors such as labour, raw materials, etc., whose amount can be easily increased or decreased in the short run. Variable costs vary with the level of output in the short run. If the firm decided not to produce any output, variable costs will not be incurred. 9. Short-run and Long-run Cost: Short-run costs are the costs which vary with the change in output, the size of the firm remaining the same. Short-run costs are the same as variable costs. On the other hand, long-run costs are incurred on the fixed assets, like plant, building, machinery, land etc. Long-run cost are the same as fixed-costs. However, in the long-run even the fixed costs become variable costs as the size of the firm or scale or production is increased. Relation Between Marginal Cost(MC) and Average Cost(AC): The relationship between MC and AC may be explained as follows: 1. When MC falls, AC also falls but at lower rate than that of MC. So long as MC curve lies below the AC curve, the AC curve is falling. 2. When MC rises, AC also rises but at lower rate than that of MC. That is, when MC curve lies above AC curve, the AC curve is rising. 3. MC intersects AC at its minimum. That is, MC = AC at its minimum.

Consequences of Cost Concept The impact of using Cost Concept is as follows:1. The assets are valued at cost or book value or at the cost derived amounts 2. Items which have no cost are ignored, that is, if the business entity does not pay anything for an asset, it would appear in the books of account. The goodwill would appear in the accounts only when the enterprise has purchased the intangible asset for a price. 3. Unrealized gains, i.e., gains on unsold assets are to be ignored 4. The real value of the capital employed is not available in the Balance Sheet Justification of Cost Concept The justification for the cost concept lies in the following arguments:1. The acquisition cost is highly objective because it is derived from an independent transaction between two parties i.e. the business entity and the vendor 2. The details of the original transaction can be easily verified from the documents that are exchanged at the time of purchase such as purchase invoice, title of ownership, property deed, and check books and so on. 3. When the assets are to be recorded at market value, difficulties may arise regarding which value of which market to be taken into account. 4. The going concern assumes that the business entity will continue its activities indefinitely and thus eliminate the necessity of using current values or liquidation values of asset valuation. Limitations of Cost Concept The limitations or drawbacks of this principle are as follows:1. The items which do not have any cost are ignored. Thus the knowledge and technical skill built inside the enterprise, a favorable location, brand name and reputation of the business as time goes would find no place in the assets of the business entity. 2. The money-measurement assumption which assumes that purchasing power of rupee is stable is a major limitation of the cost concept. 3. The actual information needed by the management, investors, creditors etc. may be current values of assets therefore values based upon historical cost may not be useful for their purposes. CLASSIFICATION OF COST DISTINCTIONS Sr. No. 1 2 3 4 5 6 7 8 9 10 Dichotomy Opportunity costs Past cost vs. vs Outlay costs Basis of Distinction Nature of the sacrifices Degree of anticipation Time perspective Degrees of variation with output rate Traceability to unit of operation Immediacy of expenditure Relation to added activity Relation to retrenchment Controllability Timing of valuation

Future costs

Short run costs vs. Long-run cost Variable costs vs. Fixed costs

Traceable costs vs. Common costs Out-of-pocket costs vs. Book costs

Incremental costs vs. Sunk costs Escapable costs vs. Unavoidable costs

Controllable costs vs. Non-controllable costs Replacement costs vs. Historical costs