Need of Cost Concepts from Economics View point with the broader perspective

“Cost is a fundamental notion in economics.” It refers to the sum of money paid to get products and services. To put it another way, cost is a financial assessment of the resources, materials, hazards, time, and utilities consumed to acquire goods and services.

Cost principles and interrelationships: Optimal input utilization and production. A farmer’s decision is heavily influenced by high production costs. Most producers consider the cost of creating more units of product, whether explicitly or implicitly.

Need for Cost Concepts: Before we understand the cost concepts, one question that often comes to mind is, “Why do we need to understand cost concepts?” As we all know,  business decisions are generally based on the cost of production, i.e., the money value of inputs and outputs is considered. Cost analysis refers to the study of the behavior of costs in relation to one or more production criteria, namely, size of output, scale of operations, prices of factors of production, and other relevant economic variables. In other words, cost analysis is concerned with the financial aspects of production relations as opposed to physical aspects, which were considered in production analysis. In order to have a clear understanding of the cost function, it is important for a businessman to understand various concepts of cost.

Accounting Costs and Economic Costs: An entrepreneur has to pay a price for various factors of production that he employs for production. He has to pay:

All these costs are included in the cost of production and are termed “accounting costs.” Thus, accounting costs include those costs that involve cash payments by the firm’s  entrepreneurs. Accounting costs are explicit costs and include all payments and charges made by the entrepreneur to the suppliers of the various productive factors. Accounting costs are recorded in the financial statements of the firm by the accountant.

Economic Costs:  However, it is common for an entrepreneur to invest a certain amount of money in his business. The capital invested by the entrepreneur in his business would have generated a certain amount of interest or dividend if it had been invested elsewhere. Furthermore, an entrepreneur can devote his time to his own production work while also contributing his company management and entrepreneurial skills. He would have offered his services to others for a positive amount of money if he hadn’t started his own firm. These costs are not included in accounting costs. These expenses are included in the economy. cost. It is very important for us to understand which costs need to be included in economic costs. Thus, economic costs include:

•  The normal return on money capital invested by the entrepreneur himself in his own business; 
•  The wages or salary that are not paid to the entrepreneur but could have been earned if the services had been sold somewhere else. 
•  The monetary rewards for all factors owned by the entrepreneur himself and employed by him in his own business are also considered a part of economic costs.

Economics VS. Accounting Costs:  Economic costs take into account these accounting costs; in addition, they also take into account the amount of money the entrepreneur could have earned if he had invested his money and sold his own services and other factors in the next best alternative uses.whereas the cost of factors owned by the entrepreneur himself and employed in his own business is called implicit costs. Thus, economic costs include both accounting costs and implicit costs. Therefore, economic costs are useful for businessmen while making decisions. Implicit costs include normal profit. If an entrepreneur’s entire revenue just covers both implicit and explicit costs, he has zero economic profits. Over and above, these normal profits are super normal profits or positive economic profits (abnormal profits). In other words, an entrepreneur can only be regarded as making positive economic profits (abnormal profits) if his revenues exceed his explicit and implicit costs. The concept of economic cost is significant because if an entrepreneur wants to earn normal profits, he must cover his economic costs.

Outlay Costs and Opportunity Costs:

Outlay Costs: Outlay costs involve actual expenditure of funds on, say, wages, materials, rent, interest, etc. Any costs incurred to acquire an asset or execute a strategy, as well as costs paid to suppliers for goods or services, are considered outlay costs.

Start-up, production, and asset acquisition costs are all outlay expenditures for new projects for corporations.

Opportunity Costs: The cost of the next best alternative option that was foregone in order to pursue a specific action is referred to as the opportunity cost. It is the cost of a missed opportunity and involves a comparison of the policy selected and the policy rejected. The interest that capital can earn in the next best use with equivalent risk is an example of the opportunity cost.

Outlay Costs vs. Opportunity Costs: On the basis of the nature of the sacrifice, a distinction can be made between outlay costs and opportunity costs. Outlay costs are financial expenditures that are recorded in the books of account at some point in time. The amount of subjective value foregone by selecting one activity over the next best alternative is known as opportunity cost. It has to do with sacrificed options and isn’t usually documented in the books of account.

Benefits of opportunity costs:  The opportunity cost concept is generally very useful for business managers, and therefore it has to be considered whenever resources are scarce and a decision involving the choice of one option over another is involved. For example, in a cloth mill which spins its own yarn, the opportunity cost of yarn to the weaving department is the price at which the yarn could be sold. This has to be considered while measuring the  profitability of the weaving operations.

In long-term cost calculations, opportunity cost is a useful concept as well. For example, when assessing the cost of higher education, it is not just the tuition fee and the cost of books that are relevant. As part of the cost of attending classes, one should include the foregone, other foregone uses of money spent as tuition fees, and the value of missed activities. 

Direct or traceable costs and indirect or non-traceable costs 

Direct or traceable costs are those costs that have a direct relationship with a component of an operation, such as manufacturing a product, organizing a process or an activity, and so on. Because such costs are directly related to a product, process, or machine, they may fluctuate in response to changes occurring in those factors. Direct costs are expenses that may be easily identified and linked to a certain product, operation, or plant. Even though overhead costs can be allocated directly to a specific department, manufacturing costs can be allocated to a specific product line, sales territory, or customer class.

Indirect or non-traceable costs are those costs which are not easily and definitely identifiable in relation to a plant, product, process, or department. As a result, such costs are not visibly traceable to specific goods, services, operations, etc. but are instead charged to various jobs or products under standard accounting practice. The economic significance of these costs stems from the fact that, while not immediately traceable to a product, they may have some functional relationship to production and may vary in some definitive  way with the output. Electricity and common costs incurred for general business operations benefiting all products jointly are examples of such costs.

Incremental costs and Sunk costs: 

Incremental Costs: Theoretically, incremental costs are related to the concept of marginal cost. An incremental cost refers to the additional cost incurred by a firm as a result of a business decision. For example, incremental costs will have to be incurred by a firm when it makes a decision to change its product line, replace worn out machinery, buy a new production facility, or acquire a new set of clients.

Incremental costs are related to the concept of marginal cost in economic theory. The additional expense incurred by a firm  as a result of a business decision is known as the  incremental cost. When a company decides to update its product line, replace worn-out machinery, buy a new production facility, or acquire  a new set of clients, for example, incremental costs will have to be incurred by the firm.

Sunk costs: Sunk costs are expenses that have been incurred once and for all and cannot be retrieved. They are based on past commitments and can’t be revised or reversed even if the firm wants to. Sunk costs include advertising, research and development, specialized equipment, and fixed facilities such as railway lines. Sunk costs are a significant barrier to the entry of firms into business.

Historical costs and replacement costs

Historical costs: The cost of acquiring a productive asset in the past, such as machinery or a building, is referred to as a historical cost.

 Replacement Costs: The replacement cost is the amount of money that must be spent to replace an old asset.

Difference between Historical Costs and Replacement Costs: These two costs differ due to price instability. If all other factors stay constant, an increase in price will result in replacement costs higher than historical costs.

Private costs and social costs: 

Private costs are costs that are either explicitly or implicitly incurred or supplied by firms. They are usually included in business decisions because they are included in the total cost and are internalized by the firm.

“Social costs” refer to the total cost borne by society as a result of business activity, which includes both private and external costs. It covers the cost of resources for which the firm is not required to pay a price, such as the atmosphere, rivers, and roadways, as well as the cost of dis-utility caused by pollution of the air, water, and environment.

fixed and variable costs.

Fixed costs are not a function of output. They remain constant up to a certain level of activity. These costs, such as rent, property taxes, interest on loans, and depreciation when measured in terms of time rather than production, necessitate a constant outlay of capital regardless of output. These costs, on the other hand, vary depending on the plant’s size and capacity. As a result, fixed costs are unaffected by the volume of output within a certain capacity level. They are unavoidable as long as operations are going on. These costs remain fixed. Only when the operations are entirely shut down can they be avoided. These are costs that are unavoidable or uncontrollable by their very nature. However, some expenditures will persist even after operations are suspended, such as the cost of warehousing outdated devices that cannot be sold on the market. These are called “shutdown costs.” Some fixed costs, such as advertising costs, are programmable fixed costs or discretionary expenses because they depend upon the discretion of management to decide  whether to spend on these services or not.

Variable costs are costs that are a function of output in the production period. Casual laborer wages, raw material costs, and all other input costs that vary with output are examples of variable costs. Variable costs vary directly and sometimes proportionately with output. Depending on the use of fixed facilities and resources during the production process, they may vary less or more than proportionately over particular ranges of production.

Thanks for Reading, Always Welcome.