What is Cost? - Definitions, Types and Theory

What is Cost? 

Cost is an input concept in Economics. Cost refers to the amount of payment made to acquire any goods and services. In a simpler way, the concept of cost is a financial valuation of resources, materials, undergone risks, time and utilities consumed to purchase goods and services. From an economist's point of view, the cost of manufacturing any goods and services is often said to be the concept of opportunity cost.

By way of sharp competition nowadays, companies urge to make maximum profits. The company's decision to maximize earnings relies on the behavior of its costs and revenues. Besides the concept of opportunity cost, there are several other concepts of cost namely fixed costs, explicit costs, social costs, implicit costs, social costs, and replacement costs. 

Learning Objective:

Knowledge acquire in this page shall enable you to know:

The definition of Cost 

Types of Cost.

Theory of Cost in Economics.

Comparing Short Run and Long Run Cost.

Definition of Cost

In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore.

In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost.

In this case, money is the input that is gone in order to acquire the thing. This acquisition cost may be the sum of the cost of production as incurred by the original producer, and further costs of transaction as incurred by the acquirer over and above the price paid to the producer. Usually, the price also includes a mark-up for profit over the cost of production.

More generalized in the field of economics, cost is a metric that is totaling up as a result of a process or as a differential for the result of a decision.  Hence cost is the metric used in the standard modeling paradigm applied to economic processes.

An aspect of cost important in economic analysis is marginal cost, or the addition to the total cost resulting from the production of an additional unit of output. A firm desiring to maximize its profits will, in theory, determine its level of output by continuing production until the cost of the last additional unit produced (marginal cost) just equals the addition to revenue (marginal revenue) obtained from it. Another consideration involves the cost of intentionally of externalizes that is, the costs that are imposed either intentionally or unintentionally on others. thus the cost of generating electricity by burning high-sulfur bituminous coal can be measured not only by the cost of the coal and its transport to the power plant (among other economic considerations) but also by its cost in terms of air pollution.

Types of Cost

The idea behind the concept of opportunity cost is that the cost of one item is the lost opportunity to do something else. For example, by being married to a person, one could lose the opportunity to marry some other person or by investing more capital on video games, one might lose the opportunity in watching movies. The concept of cost can be effortlessly comprehended by classifying the costs. The process of grouping costs is based on similarities or common characteristics. A well-defined classification of costs is certainly essential to mention the costs of cost centers.

1.   Direct Costs

2.   Indirect Costs

3.   Fixed Costs

4.   Variable Costs

5.   Operating Costs

6.   Opportunity Costs

7.   Sunk Costs

8.   Controllable Costs

9.   The Bottom Line

1. Direct costs: They are the direct cost associated with the production of a product. Direct costs would include labor or materials. Are among the most common. They may also include distribution costs and other expenses, depending on the method of accounting. The most obvious example of a direct cost would be a car manufacturing company. The two direct costs would be the total of the wages paid to the employees used to build the car and the cost of the individual parts themselves.

You can see how such costs are direct. The training of the employees, supervision, utilities, and other costs are not factored in. Direct costs are the same as Cost of Goods Sold, a very relevant metric for general accounting purposes. Cost of Goods Sold is sometimes referred to as the Cost of Sales.

2. Indirect costs: Are a little more difficult to trace. Indirect costs often cannot be traced back to an individual department. The workers in a car manufacturing plant might all use the internet, water, and lighting to create a vehicle. But these costs are indirect and are used all over the plant. Other indirect costs can include IT and office maintenance staff. They are indirect but still highly relevant to the business and the end product.

3. Fixed costs: Do not vary with the number of goods or services a company produces over the short term. For example, suppose a company leases a machine for production for two years. The company has to pay $2,000 per month to cover the cost of the lease, no matter how many products that machine is used to make. The lease payment is considered a fixed cost as it remains unchanged.

4. Variable Costs: In direct contrast to a fixed cost, a variable cost can change depending on business performance. The more products you produce, the more you will pay for packaging and distribution. But remember that a variable cost is not a direct cost. Even if you pay more for components and if you pay more for hours worked, this still goes under direct costs in most instances.

5. Operating Costs: These are sometimes referred to as operating expenses. These can be either fixed or variable. Operating costs are costs that are associated with daily business activity but are distinct from indirect costs. Rent and utilities are typical examples of operating costs. They are essential for business operations but are not involved in the manufacturing process directly or indirectly.

6. Opportunity Costs: This is usually only relevant when deciding between two or three potential business opportunities. The opportunity cost is the cost associated when you go with one investment, and potentially lose out on other investments. What has to be understood is that there is always a potentially superior investment, and you need to shoot for ‘good’ as opposed to perfect. If you are deciding to rent vs buy a new piece of equipment, and then you could compute the opportunity cost with all of the variables.

7. Sunk Costs: Are costs that will not be recovered by the business. They cannot be gotten back regardless of what happens. They are excluded from future business decisions. If you have invested money in a business that has gone bankrupt, it is a sunk cost already (even though you may recuperate some of the revenue through the court system).

 

8. Controllable Costs: Are ones where a manager (or board) decides what will happen at a particular cost. Bonuses, charitable donations, advertising, office supplies, employee events, are all examples of controllable costs. But their value is not so easy to calculate. While they are a cost, you cannot simply reduce them down to zero and expect to run a successful business.

9. The Bottom Line: Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and therefore improve the value of the firm.

The perception of Costs in terms of Treatment

1. Economic Cost: There are certain costs that accounting costs disregard. These include money which the entrepreneur forgoes but would have earned had he invested his time, efforts and investments in other ventures. For example, the entrepreneur would have earned an income had he sold his services to others instead of working on his own business

2. Accounting costs: Are those for which the entrepreneur pays direct cash for procuring resources for production. These include costs of the price paid for raw materials and machines, wages paid to workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc. Accounting costs are treated as expenses. Chartered accountants record them in financial statements.

Similarly, potential returns on the capital he employed in his business instead of giving it to others, the output generated by his resources which he could have used for others’ benefits, etc. are other examples of economic costs.b Economic costs help the entrepreneur calculate super normal profits, i.e. profits he would earn above the normal profits by investing in ventures other than his.

 

Theory of Cost in Economics

The modern theory of cost in Economics also specifies about economies of scale where an increased production decreases the cost per unit of production. The returns to scale first increases, then stabilizers for some time and then decreases. Let's take a look at the different types of economies.

Technical: Technical economies include investment in machinery and more efficient capital equipment to increase production efficiency.

Effective Management: When an organization increases operation, they need a better division of labor into various sub-departments for efficient management.

Commercial: A large amount of components and raw materials is needed with increased production. Hence raw material costs decrease. The advertisement cost for a unit of production also falls, which such increments.

Finance: With a raised Finance, any company becomes popular. Their banking securities increase and Finance is raised at a much lower cost. 

Risk Management: As the firm becomes more diverse, risk-taking factors also increase.

Comparing Short Run and Long Run Costs

As per the theory of cost analysis, during the short run period, a company tries to increase its output by changing only the variable factors such as raw materials or labor. The fixed variables remain untouched. The long-run period is where the company can change any factor to obtain desirable outputs as per their interests. Ultimately all these factors result in cost.