ARTICLE: Understand the Concept of Various Types of Costs

In this article, you will be walking through cost and cost curves.

You will be learning about Accounting and economic costs, real costs, costs of production, social and private cost, the traditional theory and the modern theory.

Introduction

The supply and price determine the cost of a product. Understanding the concept of costs is essential for price determination.

Concept of costs

For taking any decision related to business, costs play a vital role. Production costs provide a base to fix a price of the product. Managers can make various decisions like:

  • What price should be quoted
  • Whether the order for raw materials should be placed or not
  • Whether to add a product into the product line or to abandon it.

In economics, the cost is a broader concept. For taking effective decisions, it is imperative to understand different concepts of costs.

So, Let’s get started,

  1. Accounting and Economic Costs

The total amount of expenses that a firm spends to produce a good is known as accounting cost.

Accounting costs include:

  • Wages of labor
  • Salaries of employees
  • Raw material cost
  • Expenses incurred on plant and machinery
  • Expenses incurred on capital goods
  • Rent paid if any
  • Interest paid on the borrowed amount
  • Expenses incurred on electricity, fuel, advertisement, transportation of goods and taxes.

All these types of costs are recorded in the accounting books by the accountant and also named as explicit costs.

Explicit costs refer to the payment made to the outsiders for supplying the inputs. Another kind of economic costs includes implicit costs which refer to the ascribed value of the resources of the business entrepreneur. Hence, both explicit costs (accounting costs) and implicit costs are included in the economic costs.

  1. Production Costs

While producing any commodity, various fixed and variable factors are utilised which are known as inputs. The cost incurred on employing such inputs refers to total production costs.

There are two types of production costs:

  • Total variable cost
  • Total fixed cost

Total variable cost

These are the costs which tend to change with the change in the output of the business. For producing a more massive amount of output, more labor, power, fuel and raw material are used which leads to an increase in the costs. In the case of a decrease in production, there is a decrease in variable costs also. When there is zero production, variable costs also tend to be NIL.

Total fixed cost

These are the costs which remain constant irrespective of the output produced. Interest and rent paid, depreciation of plant and machinery, salaries of employees, wages of labor are all included in total fixed costs. These costs are to be suffered by the firm even if there is no production.

  1. Real Costs

Costs incurred concerning money are regarded as expenses of production by the manufacturers. But the producers fail to understand the efforts and hard work put in by the members in manufacturing a commodity. These should be considered as the real costs.

Examples of real costs include

  • Sacrifices made by the entrepreneur to save and capitalize his money.
  • Efforts made by the labor in producing a commodity by foregoing their leisureliness.
  1. Opportunity cost

Everything cannot be manufactured altogether because the resources are limited. When a resource is used for making one commodity, it cannot be used for producing another commodity. Hence, the cost of one product is the another forgone.

According to Benham, “The opportunity cost of anything is the next best alternative that could be produced instead by the same factors or by an equivalent group of factors, costing the same amount of money.”

For example, the cost of capital for the entrepreneur is the interest that otherwise he could have gotten if he invested his money somewhere else.

  1. Social and Private Costs

Pigou used social and private costs in his book, “The Economics of Welfare” in 1932.

Talking about private costs, these are the expenses which a firm spends on producing a product or service. Both explicit and implicit costs form part of the private cost.

The activities of production can either cause value or damage to others.

For example, if a firm is producing goods like rubber and chemicals, it leads to pollution which further leads to social costs.

On the contrary, if a firm is providing education, sanitation or health facilities, it may provide benefits to the society. By adding privates and economic harm caused to others, the result refers to social costs.

The traditional theory of costs

In both short- term and long- term, the behavior of cost curves is examined, this examination is known as the traditional theory of costs.

The shape of both short- term and long- term cost curves is U-shaped, the long run curve being somewhat flattered in comparison to short-term curve.

The Modern Theory of Costs

There is a difference between the traditional and modern theory of costs. As we have studied that the shape of the cost curve is U in the traditional theory, but if we talk about the modern theory, the cost curves overlap each other and create a straight horizontal line.