Cost concepts

Definition
The Amount of expenditure, notional or actual, attributable to a thing or product.

Cost of Production
Business Decisions are generally taken on the basis of the money value of the inputs and outputs. Input multiplied by the respective prices is the cost of production. It is otherwise called as money value of the inputs.

Cost Function
Cost is the function of output c=f(X) C=f(X, T, ,K) WHERE C=TOTAL COST X=output T=technology K=price of factors = FIXED FACTORS(S)

Determinants Of Cost
(1) Rate of output (i.e., utilization of fixed plant) (2) Size of plant (3) Prices of input factors (materials and labor) (4) Technology

(5) Stability of output

(6) Efficiency (of management as well as labor)

Elements of cost
MATERIAL
LABOUR OTHER EXPENSES

Accounting and Economic Cost

The cost concepts are categorized on the basis of purpose and nature. Cost Concepts used in accounting purposes Cost concepts used in economic analysis of business activities

Accounting Cost Concepts

Opportunity Cost and Actual Cost
Business Cost and Full Cost Explicit Cost and Implicit cost.

Out of pocket and Book cost.

Economic Cost Concepts

Fixed and Variable Cost
Total , Average and Marginal Costs

Short Run and Long Run costs

Incremental Costs and Sunk Cost.

Historical and Replacement Cost.

Actual Cost
The actual expenditure incurred for producing a commodity. These cost are recorded in the books of accounts. It is otherwise called as outlay cost or absolute cost. Eg: Wages paid Cost of materials purchased Interest paid.

Opportunity Cost
The cost of the best alternative foregone. It is revenue earned or income which could have been earned by employing a commodity in some other alternative use.

 Eg: One hectare of land, lets assume one can grow either paddy, wheat or sugarcane. If one decides to grow paddy as against either sugarcane or wheat. the benefit foregone by not producing sugarcane is the opportunity cost of growing paddy.

Business cost
All expense which are incurred to carry out a business is business cost. It includes all payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment. These cost concepts are used for calculating business profits and losses for filling returns of income tax .

Full Cost
The concept of full cost includes business cost, opportunity cost and normal profit.

Explicit Cost
Explicit cost are those which fall under the actual or business cost which are entered in the books of accounts. Eg: Payment of wages and salaries
Materials License fee Insurance Premium Depreciation.

Implicit Cost
Implicit cost are those which do not take the form of the cash outlays, or they do not appear in the accounting system. Eg: Opportunity cost.

Out of Pocket cost

The items Which involves cash payments or cash transfers both recurring and non recurring. Eg: Explicit cost

Book cost
Certain actual business cost which do not involve cash payments, but the provisions are made in the books of accounts are book cost. Eg: Interest unpaid
Depreciation allowances.

Economic Cost

Fixed cost
In a short period there are factors that are fixed and some variable. The fixed factors are Machinery and plant , Factory building. The cost incurred for the fixed factors are called as fixed cost. Fixed cost do change in the long run.

Fixed Cost Curve

Variable Cost
Variable cost vary with every change in Output. Variable Cost increase as the volume of the Production Increases. Variable Cost include cost of raw materials , wages of labor, Fuel , Electricity.etc.

Variable Cost Curve

Cost VC

Output

Total Cost
Total Expenditure incurred on the production of goods and service. It includes both Fixed and Variable cost.

Total Cost
TC = TFC + TVC
Cost TC

TVC

TFC

Output

Average Cost
Average Fixed Costs (AFC)
The total fixed costs divided by output.

Average Variable Costs (AVC)

The total variable costs divided by output.

Average Total Costs (ATC)

The total costs divided by output. The summation of average fixed costs and average variable costs, i.e., ATC=AFC+AVC.

Average Fixed cost

AVC = TFC / No. of units (Fixed cost per Unit)

Average Variable Cost

AVC = TVC / No.of Units (Variable cost per unit)

Cost

AVC

Output

AC and MC

$ MC

ATC AVC

AFC

Marginal Costs
Marginal Cost is the addition to the total cost , when the production of good is increased by one unit. The cost involved in producing one unit is Marginal cost. It is otherwise called as Incremental Cost or Differential Cost.

 The change in total costs divided by the change in output. TC/Y The change in total variable costs divided by the change in output. TVC/Y

Marginal Cost & AC

Cost

MC

AC

Output

Incremental, Marginal and Sunk Costs

Incremental Cost
Incremental cost is the change in cost tied to a managerial decision. Fixed cost and variable cost changes

Marginal cost
Additional cost of producing one additional unit of output Only the variable cost changes

Shut down & Abandonment Costs

Shutdown cost Expenses of temporary closure Abandonment cost Expenses of permanent closure

Sunk Cost
Is an expenditure that cannot be
recovered Sunk costs are irrelevant to present decisions.

Avoidable and Unavoidable cost

Cost that can be avoided by eliminating a product or department is avoidable and that which cannot be, is unavoidable. Ex. Rent of factory is unavoidable if a product is discontinued

Historical, Current and Replacement Cost

Historical Versus Current Costs
Historical cost is the actual cash outlay. Current cost is the present cost of previously acquired items.

Replacement Cost
Cost of replacing productive capacity using current technology.

Short-run and Long-run Costs

How Is the Operating Period Defined?
At least one input is fixed in the short run. All inputs are variable in the long run.

Fixed and Variable Costs

Fixed cost is a short-run concept. All costs are variable in the long run.

Cost Concepts
Total Fixed Costs (TFC)
The summation of all fixed and sunk costs to production.

Total Variable Costs (TVC)

The summation of all variable costs to production.

Total Costs (TC)

The summation of total fixed and total variable costs. TC=TFC+TVC

Marginal Cost

Cost

MC

Output

Typical Average & Marginal Cost Curves

AFC is always declining at a decreasing rate. ATC and AVC decline at first, reach a minimum, then increase at higher levels of output. The difference between ATC and AVC is equal to AFC. MC is generally increasing. MC crosses ATC and AVC at their minimum point.
If MC is below the average value: Average value will be decreasing. If MC is above the average value: Average value will be increasing.

Long-Run cost curves

Nothing is fixed everything is variable.

The long run average cost curve is called as the envelope curve

Long-Run Average Cost Curve