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Cost concepts

In order to understand the cost function, we have to understand the various concepts of cost as below:

Explicit and implicit cost

  • Explicit cost also known as direct cost, which is the actual expenditure incurred by a firm to purchase or acquire the various inputs it needs during the production process. Explicit costs can be estimated and calculated exactly and they can be accounted without any difficulty. E.g. Wages, rent, etc.
  • Implicit cost is the cost which is not recognised in the books of accounts. It is also a part of the opportunity cost. It is the monetary reward for all factors owned by the entrepreneur himself. Implicit cost is also known as imputed cost. Implicit costs include:
    • The normal return on capital invested by the entrepreneur in his own business
    • The wages or salary not paid to the entrepreneur, but could have been earned if the services had been sold somewhere else
Accounting costs and economic costs:
  • Accounting costs are all the payments and charges made by the entrepreneur to the suppliers of various productive factors. Accounting costs are also explicit costs.
  • Economic costs not only take the accounting costs into consideration, but also include the amount of money which the entrepreneur could have earned if he had invested his money and sold his services and other factors in the next best alternative uses. Thus, economic costs include both, accounting costs and implicit costs.
The concept of economic costs is very important because an entrepreneur is said to be earning profits only when his revenues are able to cover both, the explicit as well as the implicit costs.

Note: Revenue refers to sales receipts.

Outlay costs and opportunity costs

  • Outlay costs are those costs which involve financial expenditure and are recorded in the books of accounts. These costs involve actual expenditure of funds. It is same as explicit cost.
  • Opportunity costs refer to the cost of the foregone opportunity. It can also be represented as the difference between the opportunity selected and the opportunity rejected. These costs are not recorded in the books of accounts. They are also known as alternative costs.
    Example: A farmer who produces wheat can produce potatoes with the same factors. Therefore, the opportunity cost of a quintal of wheat is the amount of output of potatoes given up. These cost help is decision making in scarcity of resources.

Direct costs and indirect costs

  • Direct costs are those costs which are readily identifiable and traceable to a particular product, service, operation or a plant. For example, cost of raw materials used in manufacture, wages paid to workers of administration department. These costs are also known as traceable costs.
  • Indirect costs, on the other hand, are not readily identified or visibly traceable to a particular product, service, operation or plant. These are the common costs.
    Example: factory rent and advertisement expenses. These costs are also known as non-traceable costs.

Fixed and variable costs

  • Fixed costs refer to all the money expenses incurred by the manufacturer irrespective of the output level. They are also known as unavoidable contractual costs as they have to be paid as long as the operations are going on. For example, rent of a factory building, interest on loans. Fixed costs are those costs which do not vary either with expansion or contraction of output, up to a certain level.
  • Variable costs refer to money expenses which vary directly and proportionately with the output.
    Example: Wages and cost of raw materials. It is left to the discretion of the management whether to incur these costs or not. E.g. - If the production process is stopped for some time, expense such as wages, cost of raw materials would not be incurred.

Sunk costs

Sunk costs are those that do not alter by varying the nature or level of business activity. Sunk costs are generally not taken into consideration in decision - making as they do not vary with the changes in the future. Sunk costs are a part of the outlay/actual costs. E.g. - Amortisation of past expenses such as depreciation.

Book costs

The cost that has not been incurred in actual but are recorded in the books of accounts by making the provision in the books. They are recorded to take the advantage of tax. E.g. Provision for taxation, Provision for bad debt.

Out of pocket cost

The cost incurred to meet the payment of outside parties is called ‘out of pocket cost’. They fall in the category of out of pocket costs. E.g.: Rent, wages, interest

Incremental costs

These are the cost which incurred when there is a change in the level of business activity. They are also called avoidable or differential costs. E.g. - deleting the product from the product line.

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