Concept of Cost

EconomicsArticles / Tutorial Titles

Introduction

In our day-to-day lives, we often come across the concept of cost. We know that there is nothing free in the market. Yet to define cost in real terms we have to go through a complex process of understanding. This is so because there are many types of costs and knowing them is often an ardent task for the people who incur them.

What is Cost?

Cost is the required expenditure need to create and sell goods and services. Sometimes, the cost is also defined as the expenditure required to own assets. Cost is charged to expense when it is sold or consumed. This charge to expense may get significantly deferred in the case of an asset.

Outlay Costs and Opportunity Costs

Outlay cost refers to an actual expenditure of funds on various factors that may include wages, rent, building, etc. Opportunity cost, on the other hand, refers to the cost of lost opportunity.

In simpler terms, outlay costs are related to policy accepted while opportunity costs are related to policy rejected.

Outlay costs are real expenditures made by an entity and books of accounts necessarily record them. On the contrary, opportunity costs are sacrificed expenditures and hence, books of accounts do not record them.

Example of Outlay Cost

An example of outlay cost is the money spent on buying goods and services.

Example of Opportunity Cost

An example of opportunity cost would be the cost of planting anything else than wheat for a farmer who plants wheat instead of something else.

Accounting Costs and Economic Costs

Accounting costs include −

  • The normal return on the money a businessman earns in his own business instead of investing in other businesses and earning interest.

  • The salary of an entrepreneur has not been paid but could have been earned if the services could be sold somewhere else.

  • A reward is obtained for all factors owned by a businessman that is used in his own business.

Therefore, accounting costs include all types of cash payments made by a firm.

Economic costs, on the other hand, include costs that could have been made by outsourcing the services instead of owning one’s own business.

Direct or Traceable costs and Indirect or Untraceable costs

Direct costs are costs that can be attached to a known source of expenditure, such as a particular product, plant, or operation. Manufacturing costs are direct costs because they can be connected to either a product line or a specific customer class. Similarly, wages are also a direct or traceable cost because they are related to the operation of the business.

Indirect costs or untraceable costs are costs that cannot be attached to a specific good, service, or operation. Indirect costs have some indirect relationship with production and it may vary with output. The common cost incurred during the operation of a firm is an indirect cost. It is hard to trace indirect costs and hence businesses must be alert not to incur too much of them. However, although indirect costs are not traceable, the owners of businesses do understand that costs have been incurred indirectly, so they can control them.

Incremental Costs and Sunk costs

Incremental costs are costs that are dependent on a decision-making process that has been initiated by the management in the present. Incremental costs that do not have any link with a current decision can be ignored because the incremental costs won’t be altered due to the decision. However, if incremental costs will incur due to a present decision, they must be taken into account.

Historic costs or sunk costs are costs that have been incurred in the past and do not have any relationship with the decision-making process. Therefore, they are often ignored by the management. Sunk costs are historical costs that cannot be changed whatever the current condition of the business. Therefore, they are costs that are out of reach of the management of a firm.

Private Costs and Social Costs

Private costs are costs that occur due to the day-to-day operations of a business. So, private costs are the result of the operation of the firm itself. The private costs are, therefore, borne by the organizations themselves. Private costs are actual costs incurred due to a firm’s operations. Both implicit costs, such as depreciation, insurance, and interest, and explicit costs, such as wage, rent, and raw materials are private costs.

Private costs incurred by firms yield benefits or rewards in the long run. For example for a goods firm, its costs incurred in production and transportation yields the reward of revenues.

The social cost of a firm is the cost in terms of the effect of an initiative taken by a firm. Often, companies discharge the wastes into rivers due to which water pollution takes place. This has an impact or cost to society. The social cost may be either negative or positive. For example, companies taking up social welfare plans offer a positive social cost while factories that pollute the air exert a negative cost to society.

Fixed and Variable Costs

Fixed costs are costs that do not change with changing amount of production. These costs remain unaltered even if production is increased or decreased. These costs are specifically independent of the business costs of the company in all situations.

For example, costs of tax, rent, depreciation, etc., remain fixed during the operations of the business and they are considered fixed costs.

Variable costs, on the other hand, are costs that vary with the amount of production and sale. With an increase in production, these costs may go up while production is decreased, they may come down.

Variable costs include costs of labor, utility, raw materials, and commissions.

Conclusion

Cost is a topic of major importance in economics because it is an indispensable tool of the economy. All goods and services in an economy have a cost of their own and without the concept of cost, it would be impossible for us to exchange goods and services. The concept of cost is therefore a central idea in economics that help us steer economic progress.

It is also important to note that cost also attached value to items and so, we can determine the worth of a good or service from the cost of the item. Although cost is mainly dependent upon demand and supply, its variations are important to note to learn about the value of an object.

The idea of the concept of cost is probably as old as economics itself and so, it is easily understood that cost is an indispensable concept in the subject of economics. Without cost, no market or economic system may exist. Therefore, knowing the concept of cost is not only important but also undeniable for the ultimate knowledge of economic studies.

FAQs

Qns 1. What are examples of direct and indirect costs?

Ans. Direct costs include direct labor, commissions, direct materials, piece-rate wages, and manufacturing supplies.

Examples of indirect costs are quality control costs, production supervision salaries, insurance, and depreciation.

Qns 2. What is meant by opportunity cost?

Ans. Opportunity cost is the cost of opportunity lost due to selecting an alternative opportunity and leaving the next best opportunity for this.

For example, if an individual buys a certain brand’s car instead of the previously chosen one, the price of the previously chosen car would be the opportunity cost.

raja
Updated on 13-Oct-2022 11:19:47

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