Profit is the ultimate aim of any business and the long-run prosperity of a firm depends

upon its ability to earn sustained profits. Profits are the difference between selling
price and cost of production. In general the selling price is not within the control of a firm
but many costs are under its control. The firm should therefore aim at controlling and
minimizing cost. Since every business decision involves cost consideration, it is
necessary to understand the meaning of various concepts for clear business thinking
and application of right kind of costs.

A managerial economist must have a clear understanding of the different cost concepts
for clear business thinking and proper application. The several alternative bases of
classifying cost and the relevance of each for different kinds of problems are to be
studied. The various relevant concepts of cost are:

1. Opportunity costs and Outlay costs: Out lay cost also known as actual costs
are those expends which are actually incurred by the firm these are the payments made
for labour, material, plant, building, machinery traveling, transporting etc. These are all
those expense item appearing in the books of account, hence based on accounting cost
concept. On the other hand opportunity cost implies the earnings foregone on the next
best alternative, has the present option is undertaken. This cost is often measured by
assessing the alternative, which has to be scarified if the particular line is followed. The
opportunity cost concept is made use for long-run decisions. This concept is very
important in capital expenditure budgeting. This concept is very important in capital
expenditure budgeting. The concept is also useful for taking short-run decisions.
Opportunity cost is the cost concept to use when the supply of inputs is strictly limited
and when there is an alternative. If there is no alternative, opportunity cost is zero. The
opportunity cost of any action is therefore measured by the value of the most favorable
alternative course, which had to be foregoing if that action is taken.
2. Explicit and Implicit costs: Explicit costs are those expenses that involve cash
payments. These are the actual or business costs that appear in the books of accounts.
These costs include payment of wages and salaries, payment for raw-materials, interest
on borrowed capital funds, rent on hired land, Taxes paid etc. Implicit costs are the
costs of the factor units that are owned by the employer himself. These costs are not
actually incurred but would have been incurred in the absence of employment of self –
owned factors. The two normal implicit costs are depreciation, interest on capital etc. A
decision maker must consider implicit costs too to find out appropriate profitability of
alternatives.
3. Historical and Replacement costs: Historical cost is the original cost of an
asset. Historical cost valuation shows the cost of an asset as the original price paid for
the asset acquired in the past. Historical valuation is the basis for financial accounts. A
replacement cost is the price that would have to be paid currently to replace the same
asset. During periods of substantial change in the price level, historical valuation gives a
poor projection of the future cost intended for managerial decision. A replacement cost
is a relevant cost concept when financial statements have to be adjusted for inflation.
4. Short-run and Long-run costs: Short-run is a period during which the physical
capacity of the firm remains fixed. Any increase in output during this period is possible
only by using the existing physical capacity more extensively. So short run cost is that
which varies with output when the plant and capital equipment in constant. Long run
 costs are those, which vary with output when all inputs are variable including plant and
capital equipment. Long-run cost analysis helps to take investment decisions.
5. Out-of pocket and Books costs: Out-of pocket costs also known as explicit
costs are those costs that involve current cash payment. Book costs also called implicit
costs do not require current cash payments. Depreciation, unpaid interest, salary of the
owner is examples of book costs. But the book costs are taken into account
in determining the level dividend payable during a period. Both book costs and out-of-
pocket costs are considered for all decisions. Book cost is the cost of self-owned factors
of production.
6. Fixed and Variable costs: Fixed cost is that cost which remains constant for a
certain level to output. It is not affected by the changes in the volume of production. But
fixed cost per unit decrease, when the production is increased. Fixed cost includes
salaries, rent, administrative expenses, depreciation’s etc. Variable is that which varies
directly with the variation is output. An increase in total output results in an increase in
total variable costs and decrease in total output results in a proportionate decline in the
total variables costs. The variable cost per unit will be constant. Ex: Raw materials,
labor, direct expenses, etc.
7. Post and Future costs: Post costs also called historical costs are the actual
cost incurred and recorded in the book of account these costs are useful only for
valuation and not for decision making. Future costs are costs that are expected to be
incurred in the futures. They are not actual costs. They are the costs forecasted or
estimated with rational methods. Future cost estimate is useful for decision making
because decision are meant for future.
8. Traceable and Common costs: Traceable costs otherwise called direct cost, is
one, which can be identified with a products process or product. Raw material, labor
involved in production is examples of traceable cost. Common costs are the ones that
common are attributed to a particular process or product. They are incurred collectively
for different processes or different types of products. It cannot be directly identified with
any particular process or type of product.
9. Avoidable and Unavoidable costs: Avoidable costs are the costs, which can be
reduced if the business activities of a concern are curtailed. For example, if some
workers can be retrenched with a drop in a product – line, or volume or production the
wages of the retrenched workers are escapable costs. The unavoidable costs are
otherwise called sunk costs. There will not be any reduction in this cost even if reduction
in business activity is made. For example cost of the ideal machine capacity is
unavoidable cost.
10. Controllable and Uncontrollable costs: Controllable costs are ones, which can
be regulated by the executive who is in change of it. The concept of controllability of
cost varies with levels of management. Direct expenses like material, labour etc. are
controllable costs. Some costs are not directly identifiable with a process of product.
They are appointed to various processes or products in some proportion. This cost
varies with the variation in the basis of allocation and is independent of the actions of
the executive of that department. These apportioned costs are called uncontrollable
costs.
11. Incremental and Sunk costs: Incremental cost also known as different cost is
the additional cost due to a change in the level or nature of business activity. The
change may be caused by adding a new product, adding new machinery, replacing a
machine by a better one etc. Sunk costs are those which are not altered by any change
– They are the costs incurred in the past. This cost is the result of past decision, and
cannot be changed by future decisions. Investments in fixed assets are examples of
sunk costs.
12. Total, Average and Marginal costs: Total cost is the total cash payment made
for the input needed for production. It may be explicit or implicit. It is the sum total of the
fixed and variable costs. Average cost is the cost per unit of output. If is obtained by
dividing the total cost (TC) by the total quantity produced (Q). Marginal cost is the
additional cost incurred to produce and additional unit of output or it is the cost of the
marginal unit produced.
13. Accounting and Economics costs: Accounting costs are the costs recorded for
the purpose of preparing the balance sheet and profit and ton statements to meet the
legal, financial and tax purpose of the company. The accounting concept is a historical
concept and records what has happened in the post. Economics concept considers
future costs and future revenues, which help future planning, and choice, while the
accountant describes what has happened, the economics aims at projecting what will
happen.
Type # 1. Money Cost:
Money cost is that type of cost which is expressed or calculated in monetary terms. It is
the cost concept based on an accountant’s point of view. It is the cost in which the
expenses are included, namely, price of raw materials, wages of labour, interest on
capital, rent on land, salaries of managers and the normal profit of entrepreneur. Money
cost is called accounting cost of production. Money cost consists of three elements in it.

They are:
(i) Explicit Costs:
These costs consist of all the payments made on the basis of contract to various factors
of production employed by a firm, namely, factor prices, prices of raw materials, rent,
wages, interest, salaries, depreciation of plant and machinery and selling cost incurred
during a given period of time. The record of such costs is maintained by the accountant.

(ii) Implicit Costs:

These costs are invisible costs of production. The payment made to the owned factors
of production is included in these costs. Interest on owned capital, wages to owned
labour, salary to owned managers, owned building, furniture and other infrastructures of
the owner of the firm are part and parcel of implicit costs. The calculation of implicit cost
is not an easy task.

(iii) Normal Profit:

It is also a part of money cost. It is the minimum remuneration which a firm should get in
order to remain in an industry. It is over and above the explicit and implicit cost of an
individual firm. It is motivational factors for a firm to keep the production continue.

A business manager should take into consideration all these three parts of money cost
because they affect his business decisions. Explicit costs can easily be calculated as
their record is maintained by the accountant in a business firm while the calculation of
implicit cost is difficult.

Hence, money cost can be calculated by the following formula:

Money Cost = Explicit Cost + Implicit Cost + Normal Profit

Type # 2. Real Cost:

This type of cost is calculated by a sociologist. He is concerned with pains, sacrifices
and efforts made by the society in the production of a commodity. According to
Professor Alfred Marshall, all the physical and mental labour in the production activity
directly and indirectly involved, the pains and sacrifices made by the owner of capital in
accumulation of capital are included in real cost.
Water pollution, air pollution, noise pollution, industrial diseases, pressure on transport
facilities, emergence of dirty colonies, prostitution and gambling are the vices which are
caused by the growth and development of industries in any country.

All these are causing social cost. Shri Sunder Lal Bahugna and Megha Patkar have also
opposed the Narmada Project because of high social cost in the form of ecological
imbalance, displacement and rehabilitation of the affected people and adverse impact
on socio-cultural life in the area.

The real or social cost can be calculated from the following formula:
Real Cost = Pains + Sacrifices + Efforts + Inconveniences + Ill Effects

Real cost is also called social cost. It is based on the sacrifices and pains taken by the
society on the production of a commodity.

The concept of real cost or social cost has been criticised on the following
grounds:

(i) The cost is based on sacrifices and pains of the society which is related with the
persons concerned and psychology of the people. It is not measureable on account of
subjectivity and psychology of the people.

(ii) It is not a practical concept of cost. The remuneration of an unskilled labour should
be high because of more pains and sacrifices made by him but an actor gets high
remuneration.

Type # 3. Opportunity Cost:

According to an economist point of view there is also a concept of cost known as
opportunity cost. Modern economists have propounded this concept. It is also called
alternative cost, transfer income and transfer cost. It is economic cost of production of a
commodity. Economics deals with unlimited wants and limited or scarce means which
have alternative uses.

Hence, every economic decision involves a choice between alternative uses. According
to opportunity cost production of each commodity involves the cost in the form of
sacrifice in the sense that a commodity is not produced because of alternative uses and
scarce means in the economy. For example, X commodity is produced and production
of commodity Y forgone.

Hence, the cost of production of X is the commodity Y foregone. The alternative forgone
is the opportunity cost of alternative chosen. Professor Benham has rightly pointed out
that the opportunity cost of any commodity is the second best alternate by which
another production of a commodity from the same means was possible.
The diagram shows sugarcane on OX-axis and rice on OY- axis. If a farmer decides to
grow OS of sugarcane he has to forgo RP units of rice. Hence opportunity cost of
growing OS of sugarcane is RP of rice which the farmer might have grown instead.

Opportunity cost is also called transfer earnings or transfer price. It is the minimum
payment to be paid to a factor of production to keep it in the present use otherwise it
has gone in another alternative.

Professor A.C. Pigou has given an example of a maid servant that she has been paid
for her services and the remuneration is a part and parcel of national income. But as
soon as she is married by his master she is not paid any remuneration and her services
are not included while calculating the national income. Thus, the opportunity earning of
a housewife is zero and the opportunity cost is the cost of next best alternative.

Uses and Importance of Opportunity Cost:

The concept of opportunity cost has importance and uses in the study of
economic analysis as given below:
(i) Allocation of Inputs in Competitive Uses:
Production inputs are scarce and they have alternative uses. When the factors of
production are demanded for various uses then they will go to those alternatives where
they will get high rate of remuneration and leave these where they are getting low rate
of remuneration. Such transfer of resources goes on till the demand price of all inputs in
all the uses is equalised.

(ii) Determination of Rent:

According to modern theory of rent, surplus r the opportunity cost is called rent and it is
calculated by the formula given below-

Rent = Actual Earning – Opportunity Cost

Limitations to Opportunity Cost:

Opportunity cost has been criticised by the opponents of the concept.

It has the following limitations:

(i) The concept does not apply on specific factors of production. A specific factor is that
which has no alternative use. It means its opportunity cost is zero.

(ii) The concept is based on the assumption that factors of production have perfect
mobility. But in actual practice we see that the mobility of factors or production is also
affected by non-economic factors, namely, environment, language, caste, religion, etc.

(iii) The concept is also based on the assumption of perfect competition. This
assumption is imaginary and unrealistic one.
(iv) The concept of opportunity cost is based on the assumption that all the units of a
factor of production are homogeneous which is also not correct. For example, labour
can be classified into skilled, unskilled and semiskilled.

Type # 4. Direct Cost and Indirect Cost:

Direct cost is concerned with the production of a commodity. It is incurred directly on the
factors of production. Any expenditure incurred on raw material, wages, fuel, etc. Such
cost can easily be identified and it is directly concerned with the process of production.
For example, in the production of commodity X the direct cost can be calculated by
taking into consideration the salaries of all the employees, cost of raw material, energy
charges, etc.

Indirect costs are those costs which are not concerned directly with the production of a
commodity. Such costs consist selling cost, office overheads, rent of the building,
depreciation of the machines, etc. The allocation of these costs should be done
judiciously on all the departments, processes or goods. Thus indirect cost can be
calculated by deducting production cost of goods and services from the total cost.

Indirect Cost = Total Cost — Direct Cost

On the basis of the analysis of direct and indirect costs a business manager can take
the decision regarding the contraction and expansion of any production activity, working
of any department or process.

Type # 5. Incremental Costs and Sunk Costs:

When a business firm changes its business activities or nature of its business, then the
incremental costs are incurred by the firms. It is the cost due to change in the total cost
due to change in the level of business activity.

For example, a business firm purchases new machinery in place of old machinery or a
new product is included in the process or production and all such changes increases the
total cost of production of that firm then it is called incremental costs. The difference
between the changed total cost and initial total cost (before such change) is incremental
cost.

It is calculated on the basis of the following formula:

Incremental Cost = Changed Total Cost – Initial Total Cost

Sunk costs are those costs which are not affected by the changes in the level of
business activity or nature of business of a business firm. These costs remain
unchanged. Depreciation is an example of such costs. Such costs are also known as
bad debt costs. When investment is made in a sick unit it is a bad debt because the
investment made by the business manager may be recovered or may not be recovered.
When such business firm is auctioned and whatever receivables they are included in
the sunk cost.

Both incremental and sunk costs are important when the various alternatives are
evaluated by the business manager while taking the business decisions. The
incremental costs differ from one alternate to another while sunk costs do not change.

Type # 6. Replacement Costs and Historical Costs:

When an old machine is replaced with a new machine the cost incurred in such
replacement is called replacement cost. It is also called substitution cost. It is important
for such business firm where projects are replaced and production process is changed.

Historical cost is that type of cost which is based on the purchase price of machinery
initially. This cost is based on the point of view of an accountant because an accountant
will show machine in his balance sheet at the original cost rather than the present cost
prevailing in the market or market cost of the machine.

Replacement cost plays an important role in business decision-making because it

affects the total cost of a business firm.

Type # 7. Fixed Costs and Variable Costs:

Fixed costs are those costs which are fixed whether production is being carried on or
there is no production at all. These costs are short run costs wherein they remain fixed
from zero production to the maximum possible production of a business firm. These
costs are borne by the firm. These costs are called supplementary costs, general costs,
indirect costs and overhead costs. Rent of building, land tax, insurance premium,
depreciation, salaries to managers, interest on permanent or fixed capital, etc., are
examples of such costs.

Variable costs are those costs which are directly related to production of a firm. They
vary with the production. When production is not carried on such costs will not arise.
Cost of raw materials, direct wages, expenses on fuel, etc., are the examples of such
costs. These costs depend upon the volume of output.

Type # 8. Short Run Costs and Long Run Costs:

Short run costs are those costs which are concerned with the short run production of a
firm. They are of two types, namely, fixed costs and variable costs.

Long run costs are those costs which are concerned with the long run process of
production. In the long run all the factors of production are variable and even the scale
of production can be changed. All the costs during long run are variable costs.