Types of costs 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 decision-making, 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 the outlay 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. The difference between actual cost and opportunity cost is called economic rent or economic profit. For example, economic profit from paper-pressing machine in the above case is Rs. 70,000-Rs. 50,000 = Rs.20,000. As long as economic profit is above zero, it is rational to invest resources in paper-pressing machine.

2. Sunk Costs and Outlay Costs.

As discussed above, outlay costs mean the actual expenditure incurred for producing or acquiring a good or service. These actual expenditures are recorded in the books of account of the business unit, e.g., wage bill. These costs are also known as actual costs or absolute costs.

Types of costs

Sunk costs are the costs that are not altered by a change in quantity and cannot be recovered; e.g., depreciation. Sunk costs are a part of the outlay costs. However, most business decisions require cost estimates that are essentially incremental and not sunk in nature.

3. Explicit (or, Paid-out) Costs and Implicit (or, Imputed) Costs:

Explicit costs are those expenses which are actually paid by the firm (paid-out costs). These costs appear in the accounting records of the firm. On the other hand, implicit or imputed costs are theoretical costs in the sense that they go unrecognized by the accounting system. These costs may be defined as the earnings of those employed resources which belong to -the owner himself: For example, the interest payment on borrowed funds is an explicit cost and enters the accounting record,-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. Similarly, the amount of rent, wages, utility expenses, etc. which are paid out are the explicit costs of the firm, while wages, rent, etc. which are due to the entrepreneur for employing his own resources in the firm are all implicit costs. The explicit costs are important for calculation of profit and loss account, but for economic decision-making the firm takes into account both the explicit as well as the implicit costs.

4. Opportunity Costs and Imputed Costs:

Opportunity cost is concerned with the cost of forgone opportunities. In other words, it is the comparison between the policy that was chosen and the policy that was rejected. The concept of opportunity cost focuses attention on the net revenue that could be generated in the next best use of a scarce input. Since this net revenue must be given up, or sacrificed, to make the scarce input available for the best use, it is called opportunity cost of the input. For Example, if the firm owns land there is no cost of using the land (i.e., the rent) in the firm's account. But the firm has an opportunity cost of using this land, which is equivalent to the rent forgone by not letting the land out on rent. Imputed costs, on the other, are a sub-division of opportunity costs. These never show up in the accounting records but are definitely important for certain types of decisions. Besides the return forgone on the use of , self-owned resources, the imputed costs also include rent (never paid or received) on idle land, depreciation on fully depreciated property still in use, interest on equity capital, etc. For example, 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, discontinue or lease them. However, 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.

5. Incremental (or, Avoidable or, Escapable or, Differential) Costs and Sunk (or, Non-avoidable or, Non-escapable) Costs:
The incremental costs are the additions to costs resulting from a change in the nature and level of business activity, e.g., change in product line or output level,

Types of costs

adding or replacing a machine, changing distribution channels, etc. Since these costs can be avoided by not bringing about any change in the activity, the incremental costs are also called avoidable costs or escapable costs. Moreover, since incremental costs may also be regarded as the difference in total costs resulting from a contemplated change, they are also called differential costs. On the other hand, sunk costs are those that do not change by varying the nature or the level of business activity. 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, e.g.; depreciation. Sunk costs are irrelevant for decision-making as they do not vary with the changes contemplated for future by the management. It is the incremental costs which are important for decision-making. Although variable costs are generally incremental, but all incremental costs are not variable costs. Incremental costs may include fixed costs also, e.g.; a new proposal may involve some expenditure of a fixed nature also, besides the variable one. Further, whether a particular cost belongs to the category of sunk or incremental cost; depends upon the conditions of each business activity. A particular cost may be sunk cost in one case and incremental cost in the other case.

6. Book Costs and Out-of-pocket Costs.

Out-of-pocket costs are those expenses which are current cash payments to outsiders. All the explicit costs like payment of rent, wages, salaries, interest, transport charges, etc., fall in the category of out-of-pocket costs. On the other hand, book costs are those business costs which do not involve any cash payments but for them a provision is made in the books of account to include them in profit and loss accounts and take tax advantages, like the provisions for depreciation and for unpaid amount of the interest on the owner's capital employed in the firm. In a way book costs are the imputed costs or the payments by a firm to itself

7. Accounting Costs and Economic Costs:

Accounting costs are the actual or outlay costs. These costs point out how much expenditure has already been incurred on a particular process or on production as such. Since these costs relate to the past, these are generally sunk costs. The accounting costs are useful for managing taxation needs as well as to calculate profit or loss of the firm. On the other hand, economic costs relate to future. They are in the nature of the incremental costs-both the imputed and the explicit costs as well as the opportunity costs. Since the only casts that matter for business decisions are the future casts, it is the economic costs that are used for decision-making.

8. Private Costs and Social Costs:

Economic costs can be calculated at two levels: micro-level and macro-level. The micro-level economic costs relate to functioning of a firm' as a production unit, while the macro-level economic costs are the ones that are generated by the decisions of the firm but are paid by the society and not the firm. Far example, if the decision of a firm to expand its output leads to increase in its costs, this cost will be of the former

Types of costs

type, known as private costs. Whereas, if it also leads to certain costs to the society, (may be in the nature of greater pollution, greater congestion, etc.) these costs which are external to the firm are social costs from society's point of view. Thus, private costs are those which are actually incurred or provided for by an individual or a firm for its business activity. Social costs, on the other hand, are the total costs to the society or account of production of a good. Thus, the economic costs include both the private and social costs. However, the net social cost is the total social cost minus the private cost.

9. Direct (or, Traceable or, Assignable) Costs and Indirect (or Nontraceable or, Non-assignable or, Common) Costs.
The direct or traceable or assignable costs are the ones that have direct relationship with a unit of operation like a product, a process or a department of the firm. In other words, the costs which are directly and definitely identifiable are the direct costs. On the other hand, the indirect or no traceable or common or nonassignable costs are those whose course cannot be easily and definitely traced to a plant, a product, a process or a department. For example, in operating railway services the cost of station, track, equipment, staff, etc., cannot be assigned to either passenger or goods transportation; these are common costs. Whereas, the cost of wagons, coaches or engines can be directly assigned to the two outputs. Similarly, the costs of various departments of the Railway Board (which coordinate the various facets of railway working) cannot be divided between products or processes. In fact; whether a specific cost is direct or indirect depends upon the costing under consideration. In. the above example, since costing units are zones and divisions and the costs are classified as labour cost; repairs and maintenance cost, fuel cost, etc.,-any specific identification of cost to a process or a type of output is, therefore, not easy. Since all the direct costs are linked to a particular product / process / Department they vary with changes in them. In other words, all direct costs are variable. On the other hand, indirect costs may or may not be variable. Common costs may or may not change as a result of the proposed changes in production level, production process or marketing process. So, indirect costs are both the variable and fixed types. For example, the cost of a factory building, the track of a railway system, etc. are fixed indirect costs, while those of machines, labour services, etc. (which are common) can be put under the category of variable indirect costs. It is the variable indirect costs that are relevant for decision-making and the attempt should be made to allocate these costs to products, processes, etc., as the need be. The distinction between the direct costs and indirect costs is important. The modern firms are often multiple product ones. Any decision to expand output or to change the output-mix affects the total costs in complex ways. 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. Given this information he can minimize cost, maximize output or maximize profits. Similarly, when different processes involved in production have common cost elements (e.g., electricity for operating machines), the producer will like to identify the changes in costs with changes in output or changes in the processes. Thus, the traceability o~ costs is quite important in decisions involving additions or subtractions from the product line, product pricing, product marketing, changes in processes, changes in the

Types of costs

strength and nature of work of different departments, etc. Traceability of costs becomes further important where the multiple products that incurred common costs differ considerably in production or marketing processes.

10. Controllable Costs vs. Non-controllable Costs:

Controllable costs are those which are capable of being controlled or regulated by executive vigilance and, therefore, can be used for assessing executive efficiency. Non-controllable costs are those which cannot be subjected to administrative control and supervision. Most of the costs are controllable, except, of course, those due to obsolescence and depreciation. The level at which such control can be exercised, however, differs. For example, some costs (like, capital costs) are not controllable at factory's shop level, but inventory costs can be controlled at the shop level.

11. Replacement Costs and Original (or, 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. Historical cost of an asset states the cost of plant, equipment and materials at the price paid originally for them, 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. The differences between the historical and replacement costs result from price changes over time. Suppose a machine was acquired for Rs. 10,000 in 1988 and the same machine can be acquired for Rs. 14,000 in 1996. Here, Rs. 10,000 is the historical or original cost of the machine and Rs. 14,000 is its replacement cost. The difference of Rs. 4,000 between the two costs has resulted because of the price change of the machine during this period. In the conventional financial accounts the value of assets is shown at their historical costs. But for decision-making, firms should try to adjust historical costs to reflect price level changes.

12. Shutdown Costs and Abandonment Costs.

Shutdown costs are those which the firm incurs if it temporary stops it operations. These costs could be saved if the operations are allowed to continue. Shutdown costs include, besides the fixed costs, the cost of sheltering plant and equipment, lay-off expenses, employment and training of workers when the plant is restarted, and above all loss of the market. Abandonment costs are the costs of retiring altogether a fixed asset from use. For example, the plant installed during war time may be so improvised that it may not be required during peace time. Abandonment costs; thus, involve the problem of the disposal of assets.

Types of costs 13. Urgent Costs and Postponable Costs:

Urgent costs are those that must be incurred so that the operations of the firm continue, like the costs on material, labour, fuel, etc. Those costs whose postponement does not affect (at least for some time) the operational efficiency of the firm, are: known as postponable costs, e.g., the maintenance of building, machinery, etc. 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, buildings, etc.

14. Business Costs and Full Costs:

Business costs are relevant for the firm's profit and loss accounts and for legal and tax purposes. These costs include all the payments and contractual obligations made by the firm together with the boak.cost of depreciation an plant and equipment: On the other hand, the full costs a~e the sum of opportunity cost and normal profit. Opportunity cost is the expected earnings from the next best use of the firm's resources like capital, land, buildings and entrepreneur's effort and time. In order that the firm continues to produce, it must earn a necessary minimum return, called the normal profit.

15.Total cost, Average cost and Marginal cost: Total cost represents the money value of the total resources for production of goods and services by the firm. Average cost is the cost per unit of output, assuming that production of each unit of output incurs the same cost.That is, 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. Eg. If the total cost increase from Rs. 2000 to Rs. 2100 when production increase from 10 units to 11 units, the marginal costs of 11th unit is: Rs. 2100- Rs. 2000= Rs.100 Thus , marginal costs of nth unit(MCn) is the difference between the total costs of nth unit(TCn) and total costs of (n-1)th unit (TCn-1),i.e., MCn= (TCn-TCn-1) Total costs increases through out at different rates. Average and marginal costs first decline and then rises. Marginal costs rises earlier than average costs.

Types of costs 16. Fixed Costs and Variable Costs:

Economists often divide costs into the two main groups: fixed cost and variable costs. Fixed (or, constant) costs are that part of the total cost of the firm which does not vary with output, e.g. expenditures on depreciation, rent of land and buildings, property taxes, etc. If the period under consideration is long enough to allow the necessary adjustments in the capacity of the firm, the fixed costs no longer remain fixed. These can then be varied. To an economist the fixed costs are overhead costs and to an accountant these are indirect costs. When the output 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. Variable costs, on the other-hand, are directly dependent on the volume of output or service. Variable costs (for example, expenditure on labour, raw material, etc.) increase but not necessarily in the same proportion as the increase in 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. It is usually assumed by theorists that the variable costs continuously vary with output. 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, i.e., the cost curve would show a jump as we move from one range to another. The telephone bill, wages paid to a supervisor, etc. are some examples of such costs. These costs consist of.aTixed portion and a variable portion and is, therefore, known as semi-variable costs. For simplicity we assume that there are only two categories of costs : fixed and variable. Let us understand the nature of relationship between the various cost components with the help of Table ". (i)The fixed cost remains the same for all levels of outputs upto capacity limit of the equipment: The average fixed cost, therefore, declines proportionately with additions to output. (ii) Variable cost increases as output increases but this increase need not be equally proportionate. Its proportion first declines, becomes constant and then starts rising. Average variable cost also behaves in a similar way. (iii) Total cost is the sum of fixed and variable costs. The average total cost is, therefore, the sum of . average fixed and average variable cost. Average variable cost and average total cost curves are U-shaped.

17. 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. To illustrate, certain inputs like machinery, buildings, etc., cannot be changed by the firm whenever it so desires. It takes time to replace, add or dismantle them. Long-run, on the other hand, is defined as a period in which all inputs can be varied as desired: In other words, it is that time-span in which all adjustments and changes are possible to realise. Thus, in the short-run; some inputs are fixed (like installed capacity) while others are variable (like the level of capacity utilization). While in the long-run all inputs, including the size of the plant, are variable. ( In the short-run, by definition, some inputs are fixed while the others are variable. The latter kind of mputs give those costs that vary with the degree of

Types of costs

utilisation of variable input. The short-run costs are, therefore, of two types: fixed costs and variable costs. The fixed costs remain unchanged, while variable costs fluctuate with output. Long-run costs, in contrast, are costs that can vary with the size of plant and with other facilities. normally regarded as fixed in the short-rd-n. In fact in the long-run there are no fixed inputs and, therefore, no fixed costs, i.e., all costs are variable.

18. Incremental Cost and Marginal Cost:

Incremental cost and marginal cost are closely related. Similarity and difference between these two must be well understood. In some applications the marginal. cost is more efficient, while in others the incremental cost is more suitable. (i) Marginal cost deals with unit-by-unit changes in output, 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. Incremental cost is ,related to change in any number of units of output or even change in its quality. (ii) Marginal cost as a concept is particularly superior to incremental cost when dealing with decisions like : - selecting optimum level of inputs, when the input-output relationship reveals diminishing returns; = selecting least cost combination of inputs, where inputs reveal the tendency of diminishing marginal rate of substitution; - selecting optimurri cost combination of inputs, where the products substitute at decreasing rates; - selecting optimum maturity of productive assets, where assets gain value at decreasing rates over time; - analysis of curvilinear cost functions. In case of a linear function, marginal cost changes at a uniform rate with change in output, but in case of curvilinear function the marginal cost is different for every additional unit of output. For a profit-maximising firm (which compares margitial revenue with marginal cost) a unit-by-unit comparison of marginal cost with marginal revenue (as- output is increased) is essential. (iii) Incremental costs are superior to marginal costs in the following cases : - If discrete alternatives are to-be compared, only the incremental cost can be used, as marginal cost exists only for continuous alternatives. For example, we can compare two technical processes (though giving the same level of output) through incremental cost and not marginal cost. - Incremental cost is particularly useful in case of linear cost fiinctions, as in such functions only the end points of a range need to be compared. The choice among these concepts must be done on the basis of the problem at hand.

Types of costs

Bibliography
Mehta, P.L.Managerial Economics,Analysis problems and cases. New Delhi: Sultanchand & Sons, 1999, Sixth Edition. Dhingra, I. C.; Garg, V. K. Micro economics & Indian Economics. New Delhi: Sultanchand & Sons.