Cost and Cost Classification

Concept of Cost and Cost Classifications

Cost generally refers to the price that must be paid for an item. In production, cost denotes the price that must be paid for the use of factors of production.

As business decision are generally taken on the basis of money value of the inputs and outputs, the cost for the production can be defined as inputs multiplied by their respective prices and added together give the money value of the inputs, i.e. the cost of production.

The kinds f cost concept to be used in a particular situation depends on the business operations and the business decisions to be made. Defining and distinguishing the cost concepts are necessary to emphasis that:

1. Cost estimates produced by conventional financial accounting are not appropriate for all managerial uses.

2. Different business problem call different kinds of costs. Some important classifications of cost concept are as following: 1. Actual cost and opportunity cost

Actual costs means the actual expenditure incurred for acquiring or producing a good or service. These costs are recorded in the books of account. They consists actual wages paid, cost of material purchased, interest paid etc.

The opportunity cost of a product is the opportunity lost of not being able to produce some other product. That is the commodity which is sacrificed is the opportunity cost of the commodity produced. It can also be defined as the excepted return from the second best use of the resources which are foregone due to the scarcity of the resources.

2. Explicit costs and implicit costs

The cash payment which a firm makes to those outsiders who supply labour services, raw materials transport services, electricity etc. are the explicit costs. These costs are entered in the books of account.

In contrast to explicit costs, the costs of self owned resources which are employed by the firm are implicit costs. For example rent of own land and building owned by the firm, interest on owner’s capital etc. These costs are not entered in the books of account.

Opportunity cost is the best example of implicit cost. For example, suppose an entrepreneur does not utilize his services in his own business and works as a manager in some other firm on a salary basis. If he set up his own business, he foregoes his salary as a manager. The lost of salary is the opportunity cost of income from his own business.

3. Incremental costs and sunk costs

At the time the firm undertakes expansion. It might set up a new factory or introduce a new product. Cost which increase because of expansion of a firm are called incremental costs, and the costs which have to be borne whether there is expansion or not are called sunk costs.

For example, if a firm wants to purchase a machine it has to bear cost of purchase, installation charges, maintenance charges and operational charges. Now instead of purchasing the machine, the firm decided to hire the machine (not expansion), it does not have to bear the first three costs. These are the costs which increase only through expansion and are incremental cost. However, by hiring the machine the firm cannot avoid operational charges. This cost has to be borne by the firm whether there is expansion or not; this is sunk cost.

4. Avoidable costs and unavoidable costs

Costs which can be avoided due to contraction of the firm are called avoidable costs and the costs which cannot be avoided because of contraction are unavoidable costs. For example, a firm decided to close its showroom. By closing the showroom it can avoid the rent of the showroom, wages to workers in the showroom, electricity charges etc. these are avoidable costs. However, it has to continue to employ the salesmen who move from place to place; the salaries of these salesmen cannot be avoided because of contraction of the firm; these become unavoidable costs.

5. Historical costs and replacement costs

Historical cost means the cost of a plant at a price originally paid for it. Replacement cost means the price that would have to be paid currently for acquiring the same plant. For example, if the price of the machine at the time of purchase, say, in 1990 was Rs. 10000 and if the present price is Rs. 400000, the original cost of Rs. 10000 is the historic cost while Rs. 40000 is the replacement cost.

6. Common costs and traceable costs

Some costs are common to all the products of multiple product firm. These are common costs. However, there are some costs which are traceable to a particular product of a multiple product firm; these are called traceable costs.

For example, consider a press, publishing a newspaper and a monthly magazine. Some costs like cost of printer, salaries of publisher etc are common to both of these products; these are common costs. However, the raw material used or a cutter used for the newspaper or the magazine can be specific to a particular product; these are traceable costs.

Those costs which must be incurred in order to continue operations of the firm are urgent costs. For example cost of material and labours.

Costs, which can be postponed at least for some time, are known as postponable costs. For example maintenance relating to building and machinery.

8. Short-run costs and long-run costs

Short-run costs are the costs which vary with the variation in output when fixed plant and capital equipment remain the same.

Long-run costs are the costs which vary with the output when all factors inputs including plant and equipment vary.

9. Fixed costs and variable costs

The costs that do not vary for a certain level of changes in output are defined as fixed costs. The fixed costs include costs of managerial and administrative staff, depreciation of machinery, building, and other fixed assets, maintenance of land etc. The costs that vary with the changes in output are known as variable costs. This include cost of raw material, wages, running cost of fixed capital such as fuel, routine maintenance expenditure, repair etc.

10. Total cost, average cost, and marginal cost

Total cost (TC) is the sum of total fixed cost and total variable cost, i.e.TC=TFC+TVC. The total cost directly varies with the output and can be expressed as TC= f(q), where q is the quantity of output.

Average cost (AC) is the cost per unit of output, and is obtained by dividing total cost (TC) by total output q as:

AC=TC/q

Marginal cost is the addition made to the total cost when one additional unit is produces. It is calculated as:

MC =TC -TC where n is the number of unit produced

Marginal cost is the change in total cost due to the change in output. Hence, it is also calculated as:

MC= TC/ q

Accounting costs are the costs of production of a firm. These are expenses of production and are paid by the producer. These are the explicit costs and they enter the account book of the firm. These costs include:

1. Wages to labour

2. Interest on borrowed capital 3. Rent and royalty paid by the firm 4. Cost of raw materials

5. Replacement and repairing charges of machinery 6. Depreciation of capital goods

7. Normal profit of manufacturer (amount sufficient to induce him to continue business)

Accordingly cost can be classified as:

1. Production costs, including material costs, wage cost, and interest cost 2. Selling costs, including cost of advertising

3. Other costs, including insurance charges, taxes etc

Producer must make sure that the price of the product must cover these costs and normal profit, or else, he cannot afford to continue production.

For more detailed analysis of cost, the following accounting classifications are done: 1. Direct material cost

2. Direct labour cost

3. Direct expenses or charges 4. Indirect cost or overhead cost

Direct material and direct labour costs refers to such material and labour charges which can conveniently be identified with a particular job, process or product. e.g. cost of cloth used to make a shirt.

In addition there may be some expenses incurred only for a particular job, process or product. Such expenditure is direct to the job. In other words, it has to be added to the cost o particular job. Such as hire of machinery specially required for a job, royalty paid on the basis of production etc.

Indirect costs include all other cost not specially charged to a particular job or process. These costs represent expenditure incurred for common benefit of all work and which cannot be conveniently allocated for a particular job, process or product.

Economic Costs

Economic costs mean those payments which must be received by resource owners in order to ensure that they will continue to supply them in the process of production.

This definition is based on the fact that resources are scarce and they have alternative uses. To use them in one process is to deny their use in other process.

Accounting cost is the cost that involves cash payments. But economic cost consist not only all accounting costs but also the opportunity cost, i.e. the money on capital, services and other factors the entrepreneur could have earned if he had invested on next best alternative.

In another words, explicit costs, implicit costs and normal profits together form the economic cost.

Example of real life situation

Mr. Gangualy, owner of Student-friend Stationary, is doing business since the last fifteen years. He is very satisfied man from his business. He thinks that the costs he had made in his business is very adequate and he is able to make enough profit from his business. One morning when he was reading newspaper, he came to know about economic cost. As he was not familiar with this cost, he can’t get the article of the newspaper. Then he decided to know about the economic cost and wanted to determine the economic cost of his own business. So he consulted with an economist. The economist asked him to show his financial statement. Mr. Ganguli showed him the following Profit and Loss Account of Student-friend Stationary.

Profit and Loss Account of Student-friend Stationary

For the year ended 31

December 2008

Dr.

Cr.

Particulars Amount Particulars Amount

To salary and wages 20000 By gross profit 100000

To fire insurance premium 4000 By discount received 4000

To repair and maintenance 1000 By commission received 3500

To water and electricity 15000 By miscellaneous incomes 2500

To postage and telegram 2000

To telephone expenses 2500 To depreciation on furniture 5000 To audit fees 3000 To bank charges 500 To discount allowed 3500 To carriage outwards 1500 To freight outwards 2000 To commission to salesman 2500 To travelling expenses 2000 To advertising 4500 To bad depts. 1500 To packing expenses 1000 To loss by theft 500 To net profit 38000 Total 110000 110000

After seeing this profit and loss account, the economist suggested different opportunity costs that are not mentioned in this account. Those opportunity costs are the cost of land and building that he had used of its own. The monthly rent of land and building is Rs.1000, so the yearly cost rent he could get is Rs. 12000. Mr. Gangulay has invested Rs. 50000 own capital for opening the business, instead of that if he had deposited the same money in bank then he could have earn interest at 7% per annum i.e. (50000 x 7%) Rs. 3500. Similarly if Mr. Ganguli had worked somewhere else he could have earned Rs. 3000 per month, thus can have Rs. 36000 annual income. Now after adding these costs to the accounting costs, economic costs of Student-friend stationary can be achieved.

The Accounting costs from the above Profit and Loss accounts are:

salary and wages 20000

fire insurance premium 4000 repair and maintenance 1000 water and electricity 15000 postage and telegram 2000 telephone expenses 2500 depreciation on furniture 5000 audit fees 3000 bank charges 500 discount allowed 3500 carriage outwards 1500 freight outwards 2000 commission to salesman 2500 travelling expenses 2000 advertising 4500 bad depts. 1500 packing expenses 1000 loss by theft 500

total accounting cost 72000

Now the opportunity costs are:

Rent on land and building 12000 Interest on capital 3500 Salary of Mr. Ganguli 36000 Total opportunity cost 51500

Thus the economic cost of Mr. Ganguali’s Student-friend stationary is: Econimic cost = Accounting Costs + Opportunity costs

= 72000 + 51500 = 123500

Conclusion

Thus we can say that economic cost is always greater than accounting costs as economic cost also include the opportunity costs which are not mentioned in the book of account. As we see in the above real life situation that Profit and Loss account does not include the opportunity costs. In economic term, cost means economic cost which include both the accounting costs and the opportunity costs.

State whether true or false

1. The commodity that is scarified is the opportunity cost of the commodity produced.

2. Implicit costs are entered in the books of account. 3. Incremental cost increases with the expansion of firm.

4. Economic cost consist all accounting costs but not opportunity costs. 5. Accounting cost is the cost that involves cash payment.

Fill in the blanks

1. The cost that varies with the changes in the output are known as ___________. 2. __________ costs are the costs which vary with the variation in the output

when all input factors vary.

3. Opportunity cost is the best example of ________________.

4. Cost which increases because of expansion of a firm is called ___________. 5. Marginal cost is the change in ____________ due to the change in output.

Answer

True and false

1) True 2) False 3) True 4) False 5) True Fill in the blanks

1) Variable cost 2) Long-run 3) Implicit cost 4) Incremental cost 5) Total cost

References

Books

1) H. Crag Petersen & W. Cris Lewis; Managerial Economics Third edition. Prentice Hall of India Pvt. Lt.

2) R.L. Varshney & K.L. Maheshwari; Managerial Economics Seventeenth edition and enlarged edition, 2002. Sutan Chand &Sons Education publishers, New Delhi.

3) Prof. Praddep Datar, Managerial Economics, SDLC Pune.

4) K.K. Dewett & A. Chand, Modern Economic Theory Twenty-first revised edition, Shyamlal Charitable Trust, Ram Nagar, New Delhi.

5) D.N. Dwivedi, Managerial Economics Sixth revised edition, Vikash Publishing House Pvt. Ltd.

6) Board of Studies I.C.A.I, Fundamentals of Accounting

Websites

1) http://en.wikipedia.org 2) http://dictionary.bnet.com