TYPES OF COSTS
There are many different types of costs that a firm may consider relevant for decision-making under varying situations. The manner in which costs are classified or defined is largely dependent on the purpose for which the cost data are being outlined.
Explicit and Implicit Costs: The opportunity cost (or cost of the foregone alternative) of a resource is a cost in the most basic form. While this particular definition of cost is the preferred baseline for economists in describing cost, not all costs in decision-making situations are completely obvious; one of the skills of a good manager is the ability to uncover hidden costs. For a long time, there has been a considerable disagreement among the economists and accountants on how costs should be treated. The reason for the difference of the opinion is that the two groups want to use the cost data for dissimilar purposes. Traditionally, the accountants have been primarily connected with collection of historical cost data for use in reporting a form’s financial behavior and position and in calculating its taxes. The main function of accountants have been reporting, stewardship and control. They report of what has happened, present information that will protect the interests of various shareholders in the firm, and provide standards against which performance can be judged. All these have indirect relationship to decision-making. Business economists, on the other hand, have been primarily concerned with using cost data in decision-making. These purposes call for different types of cost data and classification.
Traditional accounting data is not directly suitable for decision-making. While accountants still rely primarily on historical cost in determining the profit or loss of a firm, economists prefer to use the opportunity cost baseline concept for this purpose.
The opportunity cost of a resource can be defined as the value of the resource in its next best use, that is, if it were not being used for the present purpose. The opportunity cost is the benefit of using a resource for the next most attractive alternative. For example, the opportunity cost of a student’s doing a full time MBA could be the income that he would have earned if he had employed his labor resource on a job, rather that spending them in studying economics, accounting, and so on. The time cost, in money terms, can be referred to as implicit cost of doing a MBA.
The out-of pocket costs on tuition and teaching materials are the explicit costs that a student incurs while pursuing MBA. Thus the total cost of doing a MBA to a student is implicit costs (opportunity cost) plus the explicit (out-of pocket) costs.
Accountants typically use those costs that are recorded in their books as representing an actual transfer of money. These are explicit or nominal costs and after to not represent full economic costs that should be considered in a given decision. In addition to explicit costs the business economist uses implicit or imputed cost in evaluation a decision.
Furthermore, in measuring the cost of resource in use, the accountant is only concerned with its acquisition cost. But, for decision-making purposes, we necessarily talk about future costs and revenues, and therefore, past costs have very little relevance. Also, the traditional accounting procedure for valuing assets on the balance sheets is acquisition cost minus depreciation. This faulty as the true current market value of an asset may differ from its book value.
Direct and Indirect Costs: There are some costs, which can be directly attributed to production of a given product. The use of raw material, labor input, and machine time involved in the production of each unit can be determined. On the other hand, there are certain costs like stationery and other office and administrative expenses electricity charges, depreciation of plant and buildings, and other such expenses that cannot easily and accurately be separated and attributed to individual units of production, except on arbitrary basis. When referring to the separate costs of first category accountants call them the direct, or prime costs per unit. The accountants refer to the joint costs of the second category as indirect or overhead costs.
Direct and indirect costs are not exactly synonymous to what economists refer to as variable costs and fixed costs. The criterion used by the economical to divide cost into either fixed or variable is whether or not the cost varies with the level of output, whereas the accountant divides the cost on the basis of whether or not the cost is separable with respect to the production of individual output units. The accounting statement often divides the overhead expenses into ‘variable overhead’ and ‘fixed overhead’ categories. If the variable overhead expenses per unit are added to the direct cost per unit, we arrive at what economists call as average variable cost.
Private Costs versus Social Costs: A further distinction that is useful to make especially in the public sector, is between private and social costs. Private costs are those that accrue directly to the individuals or firms engaged in relevant activity. External costs, on the other hand, are passed on to persons not involved in the activity in any direct way (i.e. they are passed on to society at large). Consider the case of a manufacturer located on the bank of a river that dumps the waste into water rather than disposing if of in some other manner. While the private cost of dumping to the firm is zero, it is definitely positive to the society. It affects adversely the people located down stream and incurs higher costs in terms of treating the water chemically for their use, or to travel long distances to fetch potable water. If these external costs were included in the production costs of producing firm, a true picture of real or social costs of the output would be obtained. Ignoring external costs may lead to an inefficient and undesirable allocation of resources in society.
Relevant Costs and Irrelevant Costs: The relevant costs for decision-making purposes are those costs, which are incurred as a result of the decision under consideration. The relevant costs are also referred to as the incremental costs. Costs that have incurred already and costs that will be incurred in the future regardless of the present decision are irrelevant costs as far as the current decision problem is concerned.
There are basically three categories of relevant or incremental costs. These are the present-period explicit costs, the opportunity costs implicitly involved in the decision, and the future cost implications that flow from the decision. for example, direct labor and material costs, and changes in the variable overhead costs are the natural consequences of a decision to increase the output level. Also, if there is any expenditure on capital; equipment incurred as a result of such a decision, is should be included in full, not withstanding that the equipment may have a useful life remaining that the equipment may have a useful life remaining after the present decision has been carried out. Thus, the incremental costs of a decision to increase the output level will include all present-period explicit costs, which will be incurred as a consequence of this decision. It will exclude any present-period explicit cost that will be incurred regardless of the present decision.
The opportunity cost of a resource under use, as discussed earlier, becomes a relevant cost while arriving at the economic profit of the firm. Many decisions are having implications for future costs, both explicit and implicit. If a firm expects to incur some costs in the future as a consequence of the present analysis, such future costs should be included in the present value terms if known for certain.
Economic Costs and Profits: Our earlier discussion of economic costs suggests that economists and accountants use the term ‘profits’ differently. Accounting profits are the firm’s total revenue less its economic costs. But economists define profits differently. Economic profits are the firm’s total revenue less its explicit costs (explicit and implicit, the latter including a normal profit required to retain resources in a given line of production). Therefore, when an economist says that a firm is just covering its costs, it is meant that all explicit and implicit costs are being met, and that, the entrepreneur is receiving a return just large enough to retain his or her talents in the present line of production. If a firm’s total receipts exceed all its economic costs, the residual accruing to the entrepreneur is called an economic or pure profit.
| Total Revenue Minus | Economic Cost = Economic Profit
Accounting Cost = Accounting Profit |
An economic profit is not a cost, because by definition it is a return in excess of the normal profit required to retain the entrepreneur in a particular line of production.
Separate and Common Costs: Costs can also be classified on the basis of their trace ability. The costs that can be easily attributed to a product, a division, or a process are called separate costs, and the rest are called non-separate or common costs. The distinction between separate and common costs is of particular significance in a multi-product firm for setting up economic prices for different products.
Fixed and variable Costs: Fixed costs are those costs, which in total do not vary with changes in output. Fixed costs are associated with the very existence of a firm’s plant and therefore must be paid even if the firm’s level of output is zero. Such costs as interest on borrowed capital, rental payments, a portion of depreciation charges on equipment and buildings, and the salaries of top level management and key personnel are generally fixed costs.
On the other hand, variable costs are those costs, which increase with the level of output. They include payment of raw materials, charges on fuel and electricity, wages and salaries of temporary staff, depreciation charges associated with wear and tear of assets, and sales commission, etc.
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