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Types of costs 1 TYPES OF COSTS Introduction:- Production is the result of services rendered by various factors of production.

The producer or firm has to make payments for this factor services. From the point of view of the factor inputs it is called ‘factor income’ while for the firm it is ‘factor payment’, or cost of inputs. Generally, the term cost of production refers to the ‘money expenses’ incurred in the production of a commodity. But money expenses are not the only expenses incurred on the production of a commodity. But there are number of services and inputs such as entrepreneurship, land, capital etc. which are offered by an entrepreneur without changing any price or receiving any payment for them. While computing the total cost of production, allowance should be made for such expenses. It is therefore essential to have clean understanding for the different types of cost. There are several types of costs that a firm may consider relevant under various circumstances. Such costs include future costs, accounting costs, opportunity costs, implicit costs, fixed costs, variable costs, semi variable costs, private costs, social costs, common costs, etc. For the purposes of decisionmaking, it is essential to know the fundamental difference between the main cost concepts along with the conditions of their use in decision-making. 1. Actual (or, Acquisition or, Outlay) Costs and Opportunity (or, Alternative) Costs. Actual costs are the costs which the firm incurs while producing or acquiring a good or a service like the cost on raw material, labor, rent, interest, etc. The books of account generally record this information. The actual costs are also called theoutla y costs or acquisition costs or absolute costs. On the other hand; opportunity costs or alternative costs are the return_ from the second-best use of the firms resources which the firm forgoes in order to avail of - the return from the best use of the resources. Suppose that a businessman can buy either a lathe machine or a paper pressing machine with his limited resources and he can earn annually Rs.50,000 and Rs.70,000 respectively from the two alternatives. A rational businessman will certainly buy a paper-pressing machine which gives him a higher return. But in the process of earning Rs.70,000, he has forgone the opportunity to earn Rs.50,000 annually from the lathe machine. Thus, Rs.50,000 is his opportunity cost or alternative cost. Thediff erenc e between actual cost and opportunity cost is called economic

70. e. it .000-Rs. Sunk Costs and Outlay Costs. In other words. For example. On the other hand. utility expenses. the interest payment on borrowed funds is an explicit cost and enters the accounting record. which are due to the entrepreneur for employing his own resources in the firm are all implicit costs. etc. These actual expenditures are recorded in the books of account of the business unit.000. Explicit (or. The explicit costs are important for calculation of profit and loss account. These costs may be defined as the earnings of those employed resources which belong to -the owner himself: For example. These costs are also known as actual costs or absolute costs. Imputed) Costs: Explicit costs are those expenses which are actually paid by the firm (paid-out costs). wage bill. the amount of rent. which are paid out are the explicit costs of the firm.rent or economic profit. However. economic profit from paper-pressing machine in the above case is Rs. 2.. or sacrificed. These costs appear in the accounting records of the firm.-but the amount of interest which the employer could have earned (and which he forgoes when he uses his own capital in his firm) is his implicit cost. The concept of opportunity cost focuses attention on the net revenue that could be generated in the next best use of a scarce input.000 = Rs. while wages. Paid-out) Costs and Implicit (or. Opportunity Costs and Imputed Costs: Opportunity cost is concerned with the cost of forgone opportunities. As long as economic profit is above zero. implicit or imputed costs are theoretical costs in the sense that they go unrecognized by the accounting system. it is rational to invest resources in paperpressing machine. most business decisions require cost estimates that are essentially incremental and not sunk in nature.g. Types of costs 2 Sunk costs are the costs that are not altered by a change in quantity and cannot be recovered. 3. outlay costs mean the actual expenditure incurred for producing or acquiring a good or service. Similarly. it is the comparison between the policy that was chosen and the policy that was rejected. Since this net revenue must be given up.. 4. rent.g. but for economic decision-making the firm takes into account both the explicit as well as the implicit costs. etc. Sunk costs are a part of the outlay costs. to make the scarce input available for the best use. 50. wages. depreciation. e.20. As discussed above.

Non-avoidable or. On the other hand. the concept of opportunity cost is more comprehensive as it relates to all the resources (both borrowed and owned) whereas the concept of imputed cost applies only to the self-use of the self-owned resource. on the other. e. discontinue or lease them..g. It is the incremental costs which are important for decision-making. depreciation.. depreciation on fully depreciated property still in use. Incremental (or. These never show up in the accounting records but are definitely important for certain types of decisions. etc.. Since these costs can be avoided bynot bringing about any change in the activity. they are also called differential costs. imputed cost concept can be usefully employed by a firm that wishes to evaluate the relative profitability of its two warehouses in order to decide whether to continue. For Example. Types of costs 3 adding or replacing a machine.is called opportunity cost of the input. change in product line or output level.g. selfowned resources. For example. all the past costs are considered sunk costs because any change in the activity and the resulting incremental costs will have to take these preceding costs as given: One of the most important sunk costs is the amortization of past expenses. 5. e. Besides the return forgone on the use of . Moreover. Non-escapable) Costs: The incremental costs are the additions to costs resulting from a change in the nature and level of business activity. For example.e. Imputed costs. However. since incremental costs may also be regarded as the difference in total costs resulting from a contemplated change. But the firm has an opportunity cost of using this land. . Sunk costs are irrelevant for decision-making as they do not vary with the changes contemplated for future by the management. changing distribution channels. if the firm owns land there is no cost of using the land (i. interest on equity capital. which is equivalent to the rent forgone by not letting the land out on rent. the incremental cost are also called avoidable costs or escapable costs. the rent) in the firm's account. the imputed costs also include rent (never paid or received) on idle land. etc. Differential) Costs and Sunk (or. Escapable or. are a sub-division of opportunity costs. Avoidable or. sunk costs are those that do not change by varying the nature or the level of business activity.

They are in the nature of the incremental costs-both the imputed and the explicit costs as well as the opportunity costs. economic costs relate to future.g. Whereas. etc. Book Costs and Out-of-pocket Costs. whether a particular cost belongs to the category of sunk or incremental cost.if it also leads to certain costs to the society. These costs point out how much expenditure has already been incurred on a particular process or on production as such. Incremental costs may include fixed costs also. but all incremental costs are not variable costs. depends upon the conditions of each business activity. On the other hand. transport charges. like the provisions for depreciation and for unpaid amount of the interest on the owner's capital employed in the firm. Accounting Costs and Economic Costs: Accounting costs are the actual or outlay costs. wages. this cost will be of the former Types of costs 4 type. it is the economic costs that are used for decision-making. Far example. 6. salaries. Private Costs and Social Costs: Economic costs can be calculated at two levels: micro-level and macro-level.. while the macro-level economic costs are the ones that are generated by the decisions of the firm but are paid by thesoc iety and not the firm. On the other hand. Further. besides the variable one. Since the only casts that matter for business decisions are the future casts.. Out-of-pocket costs are those expenses which are current cash payments to outsiders. Since these costs relate to the past. A particular cost may be sunk cost in one case and incremental cost in the other case. book costs are those business costs which do not involve any cash payments but for them a provision is madein the books of account to include them in profit and loss accounts and take tax advantages. e.Although variable costs are generally incremental. The micro-level economic costs relate to functioning of afirm' as a production unit. interest. The accounting costs are useful for managing taxation needs as well as to calculate profit or loss of the firm. (may be in the nature of greater pollution. greater . fall in the category of out-of-pocket costs. known as private costs. In a way book costs are the imputed costs or the payments by a firm to itself 7. these are generally sunk costs. a new proposal may involve some expenditure of a fixed nature also. 8. if the decision of a firm to expand its output leads to increase in its costs. All the explicit costs like payment of rent.

(which are common) can be put under the category of variable indirect costs. are fixed indirect costs. processes. Common costs may or may not change as a result of the proposed changes in production level.) these costs which are external to the firm are social costs from society's point of view. indirect costs are both the variable and fixed types. In other words. a product. etc. Common) Costs. the track of a railway system. in operating railway services the cost of station. the costs of various departments of the Railway Board (which coordinate the various facets of railway working) cannot be divided between products or processes. coaches or engines can be directly assigned to the two outputs. Thus. Assignable) Costs and Indirect (or Nontraceable or. Thedirec t ortraceab le orassignable costs are the ones that have direct relationship with a unit of operation like a product. the cost of wagons. Direct (or. etc. Since all the direct costs are linked to a particular product / process / Department they vary with changes in them. Non-assignable or. these are common costs. etc.private costs are those which are actually incurred or provided for by an individual or a firm for its business activity. 9. theindirec t or no traceable or common or non.. Traceable or. a process or a department. equipment. labour services. In other words. etc. On the other hand.assignable costs are those whose course cannot be easily and definitely traced to a plant. However. indirect costs may or may not be variable. the above example. Thus. On the other hand. are the total costs to the society or accountof production of a good. as the need be. etc. on the other hand. It is the variable indirect costs that are relevant for decision-making and the attempt should be made to allocate these costs to products. therefore. all direct costs are variable. production process or marketing process. the cost of a factory building. fuel cost. Whereas. cannot be assigned to either passenger or goods transportation. staff. not easy.. the economic costs include both the private and social costs. repairs and maintenance cost. a process or a department of the firm.congestion. Social costs. the net social cost is the total social cost minus the private cost. So. Similarly. track. since costing units are zones and divisions and the costs are classified as labour cost. etc. For example. the costs which are directly and definitely identifiable are the direct costs.. whether a specific cost is direct or indirect depends upon the costing under consideration. . while those of machines. In. For example.-any specific identification of cost to a process or a type of output is. In fact.

equipment and materials at the price paid originally for them.The distinction between the direct costs and indirect costs is important. But any rational producer will like to get the idea of the amount of change in costs which will be brought about by changing the amount or the mix of the output.. For example. while the replacement cost states the cost that the from would have to incur if it wants to replace or acquire the same assets now. maximize output or maximize profits. Controllable Costs vs. The modern firms are often multiple product ones. electricity for operating machines). changes in the Types of costs 5 strength and nature of work of different departments. Given this information he can minimize cost. Similarly. Non-controllable Costs: Controllable costs are those which are capable of being controlled or regulated by executive vigilance and. except. Any decision to expand output or to change the output-mix affects the total costs in complex ways. Replacement Costs and Original (or. some costs (like. however. therefore. etc. product marketing. changes in processes. Thus.g. product pricing. Traceability of costs becomes further important where the multiple products that incurred common costs differ considerably in production or marketing processes. capital costs) are not controllable at factory's shop level. the producer will like to identify the changes in costs with changes in output or changes in the processes. can be used for assessing executive efficiency. Most of the costs are controllable. but inventory costs can be controlled at the shop level. of course. differs. 10. Non-controllable costs are those which cannot be subjected to administrative control and supervision. Thelevel at which such control can be exercised. when different processes involved in production have common cost elements (e. Historical cost of an asset states the cost ofplant. the traceability o~ costs is quite important in decisions involving additions or subtractions from the product line. Historical) Costs: The basis of distinction between historical and replacement costs is the way in which the assets are carried on in the balance sheet and the manner in which the amount of cost is determined. 11. those due to obsolescence and depreciation. The differences between the historical and replacement costs .

Here. etc.000 is its replacement cost. like the costs on material. fuel. the plant installed during war time may be so improvised that it may not be required during peace time.000 between the two costs has resulted because of the price change of the machine during this period.g. besides the fixed costs.result from price changes over time. buildings and entrepreneur's effort and time. Types of costs 6 13. 4. employment and training of workers when the plant is restarted. etc. Opportunity cost is the expected earnings from the next best use of the firm's resources like capital. the cost of sheltering plant and equipment. For example. involve the problem of the disposal of assets. Rs. 14. labour. Those costs whose postponement does not affect (at least for some time) the operational efficiency of the firm. are: known as postponable costs.000 in 1996. Shutdown costs include. The difference of Rs. and above all loss of the market. Urgent Costs and Postponable Costs: Urgent costs are those that must be incurred so that the operations of the firm continue. Abandonment costs are the costs of retiring altogether a fixed asset from use. This distinction of cost becomes quite obvious during the period of war or inflation when firms want to produce the maximum and postpone the maintenance of their plants. Suppose a machine was acquired for Rs. the full costs a~e the sum of opportunity cost and normal profit. Abandonment costs. 10. machinery. buildings. lay-off expenses. 10. 12. thus. But for decision-making.. the maintenance of building. In order that the . In the conventional financial accounts the value of assets is shown at their historical costs. land. etc. Business Costs and Full Costs: Business costs are relevant for the firm's profit and loss accounts and for legal and tax purposes.000 is the historical or original cost of the machine and Rs. These costs include all the payments and contractual obligations made by the firm together with the boak. 14. 14.cost of depreciation an plant and equipment: On the other hand. Shutdown Costs and Abandonment Costs. Shutdown costs are those which the firm incurs if it temporary stops it operations. e. These costs could be saved if the operations are allowed to continue. firms should try to adjust historical costs to reflect price level changes.000 in 1988 and the same machine can be acquired for Rs.

To an economist the fixed costs are overhead costs and to an accountant these are indirect costs.Rs.100 Thus . Average cost and Marginal cost: Total cost represents the money value of the total resources for production of goods and services by the firm. the marginal costs of 11th unit is: Rs. called the normal profit. marginal costs ofnth unit(MCn) is the difference between the total costs ofnth unit(TCn) and total costs of (n-1)th unit (TCn-1). the fixed costs no longer remain fixed.That is. expenditures on depreciation. Types of costs 7 16. assuming that production of each unit of output incurs the same cost. 2000= Rs. 2100 when production increase from 10 units to 11 units. e.e..i. it must earn a necessary minimum return. Fixed (or. Eg. Average cost = Total cost Number of units Marginal costs are the increnental or additional costs incurred when there is additional to the existing out puts of goods and services. MCn= (TCn-TCn-1) Total costs increases through out at different rates. Marginal costs rises earlier than average costs. When the output . rent of land and buildings. etc. Average cost is the cost per unit of output. constant) costs are that part of the total cost of the firm which does not vary with output. property taxes. If the period under consideration is long enough to allow the necessary adjustments in the capacity of the firm. If the total cost increase from Rs. Fixed Costs and Variable Costs: Economists often divide costs into the two main groups: fixed cost and variable costs.firm continues to produce. Average and marginal costs first decline and then rises. These can then be varied.Total cost. 15. 2100. 2000 to Rs.g.

is defined as a period in which all inputs can be varied as desired: In other words. Variable costs (for example. (ii) Variable cost increases as output increases but this increase need not be equally proportionate. on the other hand.e. The average total cost is. known as semi-variable costs.aTixed portion and a variable portion and is. the cost curve would show a jump as we move from one range to another. Long-run. wages paid to a supervisor. add or dismantle them. average fixed and average variable cost. becomes constant and then starts rising.. cannot be changed by the firm whenever it so desires. on the other-hand. 17. are directly dependent on the volume of output or service. For simplicity we assume that there are only two categories of costs : fixed and variable. buildings. Variable costs. Its proportion first declines. therefore. etc. are some examples of such costs. Average variable cost also behaves in a similar way. But there are cases where costs remains fixed for each of range of output but the movement of cost from one range of output to another is discontinuous. To illustrate. therefore. Average variable cost and average total cost curves are U-shaped. i. certain inputs like machinery. declines proportionately with additions to output. (iii) Total cost is the sum of fixed and variable costs. Let us understand the nature of relationship between the various cost components with the help of Table ". It is usually assumed by theorists that the variable costs continuously vary with output. The degree of proportionality between the variable cost and output depends upon the utilisation of fixed facilities and resources during the process of production. etc.goes up the fixed cost per unit of output comes down as the total fixed cost is then divided between larger number of units of output. raw material.) increase but not necessarily in the same proportion as the increase in output. The telephone bill. the sum of . expenditure on labour. etc. therefore. it is that time-span in which all . These costs consist of.. (i)The fixed cost remains the same for all levels of outputs upto capacity limit of the equipment: The average fixed cost. It takes time to replace. Short-run Costs and Long-run Costs: The short-run is defined as a period in which the supply of at least one of the inputs cannot be changed by the firm.

( In the short-run. no fixed costs. of two types: fixed costs and variable costs. whereas incremental cost is not restricted to a unit change. Marginal cost is the amount added to total cost by a unit increase in output.. The short-run costs are. are costs that can vary with the size of plant and with other facilities.selecting optimum maturity of productive assets. In fact in the long-run there are no fixed inputs and. are variable. Incremental Cost and Marginal Cost: Incremental cost and marginal cost are closely related. .selecting optimurri cost combination of inputs. Thus. cost is more efficient.adjustments and changes are possible to realise.selecting optimum level of inputs. by definition. some inputs are fixed while the others are variable. (i) Marginal cost deals with unit-by-unit changes in output. in the short-run. The fixed costs remain unchanged. . while in others the incremental cost is more suitable. in contrast.analysis of curvilinear cost functions. where the products substitute at decreasing rates. including the size of the plant. where inputs reveal the tendency of diminishing marginal rate of substitution. normally regarded as fixed in the short-rd-n. Long-run costs. In some applications the marginal. The latter kind of mputs give those costs that vary with the degree of Types of costs 8 utilisation of variable input. Similarity and difference between these two must be well understood. therefore. but in case of curvilinear function the marginal cost is different for every additional unit of output. when the input-output relationship reveals diminishing returns. while variable costs fluctuate with output. some inputs are fixed (like installed capacity) while others are variable (like the level of capacity utilization). 18. While in the long-run all inputs. where assets gain value at decreasing rates over time. therefore. (ii) Marginal cost as a concept is particularly superior to incremental cost when dealing with decisions like : . marginal cost changes at a uniform rate with change in output.e. all costs are variable. Incremental cost is . For a profit-maximising firm (which compares margitial revenue with marginal cost) . i. = selecting least cost combination of inputs.related to change in any number of units of output or even change in its quality. In case of a linear function. .

If discrete alternatives are to-be compared.output is increased) is essential.Incremental cost is particularly useful in case of linear cost fiinctions. The choice among these concepts must be done on the basis of the problem at hand. as marginal cost exists only for continuous alternatives. as in such functions only the end points of a range need to be compared. (iii) Incremental costs are superior to marginal costs in the following cases : .a unit-by-unit comparison of marginal cost with marginal revenue (as. only the incremental cost can be used. For example. . we can compare two technical processes (though giving the same level of output) through incremental cost and not marginal cost. .