Elements of cost

Cost is defined as the amount, measured in money or cash expended or other

property transfer capital stock issued, service performed, or liability incurred in
consideration of goods or services received or to be received.

Cost may be defined as the total of all expenses incurred whether paid or
outstanding in the manufacture and sale of a product

1. Fixed Cost:
Fixed cost is that cost which remains constant at every level of production. Fixed
cost does not change with output, firms must pay these even if they shut down.
Examples include the rental costs of buildings; the costs of leasing or purchasing
capital equipment; the annual business rate charged by local authorities; the costs of
employing full-time contracted salaried staff; the costs of meeting interest payments on
loans; the depreciation of fixed capital (due solely to age) and also the costs of business
insurance.
any business with significant capacity will have high fixed costs, for example a
vehicle manufacturer that spends millions of pounds building a new factory and
installing expensive and bulky capital equipment.
Fixed costs are the overhead costs of a business.
.
2. Variable costs:
The cost which varies / changes as per the level of production is known as
variable cost. when output is zero, variable costs will be zero but as production
increases, total variable costs will rise.
Examples of variable costs include the costs of raw materials and
components, packaging and distribution costs, the wages of part-time staff or
employees paid by the hour, the costs of electricity and gas and the depreciation
of capital inputs due to wear and tear.
 Output Variable Cost

1 10

2 18

3 24

4 28

5 35

6 48

7 63

What Is the Difference Between Fixed Cost and Variable Cost?

A. Meaning
Fixed Costs: In accounting, fixed costs are expenses that remain constant for a period
of time irrespective of the level of outputs.

Variable Costs: Variable costs are expenses that change directly and proportionally to
the changes in business activity level or volume.

B. Incurred when

Fixed Costs: Even if the output is nil, fixed costs are incurred.

Variable Costs: The cost increases/decreases based on the output

C. Also known as

Fixed Costs: Fixed costs are also known as overhead costs, period costs or
supplementary costs.

Variable Costs: Variable costs are also referred to as prime costs or direct costs as it
directly affects the output levels.

D. Nature

Fixed Costs: Fixed costs are time-related i.e. they remain constant for a period of time.

Variable Costs: Variable costs are volume-related and change with the changes in
output level.

E. Examples

Fixed Costs: Depreciation, interest paid on capital, rent, salary, property taxes,
insurance premium, etc.

Variable Costs: Commission on sales, credit card fees, wages of part-time staff, etc.

3. Total Cost

Total cost is summation of both fixed cost and variable costs of the production.

Therefore,
 TC = FC + VC

Output Fixed Cost Variable Cost Total Cost

0 100 0 100

1 100 10 110

2 100 18 118

3 100 24 124

4 100 28 128

5 100 35 135

6 100 48 148

7 100 63 163

4. Marginal Cost:

Marginal cost is the additional cost incurred in the production of one more unit of
a good or service. It is derived from the variable cost of production, given that fixed
costs do not change as output changes, hence no additional fixed cost is incurred in
producing another unit of a good or service once production has already started.

MCn = TCn - TCn-1

Or

MC = 🔺TC / 🔺Q

Revenue Concepts:

There are four major markets namely, perfect competition, monopoly, monopolistic
competition, and oligopoly. Before you understand these market forms, it is important to
know the concepts of total revenue, average revenue, and marginal revenue. In this
article, we will clarify these concepts with the help of some examples and look at the
behavioral principles.

5. Total Revenue:
A firm sells 100 units of a particular commodity for Rs. 10 each. If you were to
calculate the amount realized by the firm, the answer is simple – Rs. 1,000 (100 x 10).
This is the total revenue for the firm.

Hence, the total revenue refers to the amount of money realized by a firm on the sale of
a commodity. Total revenue is expressed as follows:

TR = P x Q … where TR – Total Revenue, P – Price, and Q – Quantity of the

commodity sold.
6. Average Revenue

Average revenue is simply the revenue earned per unit of the output. In simpler
words, it is the price of one unit of the output. Average revenue is expressed as follows:

AR = TR / Q

… where AR – Average Revenue, TR – Total Revenue, and Q – Quantity of the

commodity sold.

By using the formula for total revenue, we get

AR = (P x Q) / Q

Or AR = P

For example, a firm sells 100 units of a commodity and realizes a total revenue of Rs.
1,000. Therefore, its average revenue is

AR = 1000 / 100= Rs. 10

Hence, the firm sells the commodity at a price of Rs. 10 per unit.

7. Marginal Revenue
Marginal revenue (MR) is the change in total revenue resulting from the sale of an
additional unit of a commodity.
For example, consider a firm selling 100 units of a commodity and realizing a total
revenue of Rs. 1,000. Further, it realizes a total revenue of Rs. 1,200 after selling 101
units of the same commodity. Therefore, the marginal revenue is Rs. 200.

Marginal revenue is also defined as the rate of change of total revenue resulting from
the sale of an additional unit of a commodity.

Therefore,

MR = 🔺TR / 🔺Q

… where MR – Marginal revenue, TR – Total revenue, Q – Quantity of the commodity

sold, and Δ – the rate of change.

Further, for one unit change in output, we have

MRn = TRn – TRn-1

Where,

● TRn – the total revenue when the sales are at the rate of ‘n’ units per period.
● TRn-1 – the total revenue when the sales are at the rate of (n-1) units per
period.
8. Sunk Cost:

Definition: A sunk cost, also known as a stranded cost, is an expense that has already
occurred and can’t be changed or avoided. In other words, it’s a cost that has already
been paid and can’t be refunded or reduced. It’s in the past and has no bearing on any
future decision making processes.
 Just like the name implies, sunk costs are gone and can’t be recovered.
Accountants focus on this fact when making business decisions because costs that
occurred in the past should not affect the actions in the future.

Example: ake a new market for example. When a business decides to branch out
into a new market or product line, it can spend large amounts of money on market
research, product development, and advertising. After a failed entrance attempt into the
market, many managers tend to focus on the overall past investment into a project as a
reason to keep it going. They don’t want to see all the money, time, and energy spent
trying to infiltrate a market lost by pulling out, so they continue to “invest” in the project.

This is an ineffective way of looking at the situation. Previously spent research,

development, and advertising dollars are sunk costs and are unavoidable. They have no
bearing on the current decisions that will affect the future. These costs are in the past
and should not be a reason to continue to pour money into a loosing market, segment,
or product. Instead, managers should ignore these previously spent costs and focus on
the current market. If it has potential, they should continue to invest. If it looks like it will
continue to lose money, they should stop investing and end the operations.

All large corporations have faced this dilemma at some point in their history.
Microsoft faced this situation after a failed attempt to infiltrate the portable MP3 player
market with the Zune. After a large failed product launch, Microsoft ceased Zune
production and cut its losses.

Sunk costs are expenses that a company has already incurred and avoid no
matter what course of action it takes.

9. Implicit Cost:

Definition: An implicit cost is an opportunity cost of using a firm’s internal resources

that isn’t reported as separate, distinct expense. In fact, these costs do not explicitly
state the cost of using these resources for a project.
Implicit costs are costs on which the firm waives any opportunity of earning a
profit from the use of its internal resources by third parties, such as the rent that a firm
would earn if it leased out a building that it owns instead of using it for its own
operations.
They are also costs that the firm cannot account for, such as the depreciation of
equipment or the cost of hiring an employee. For this reason, they are not recorded on
any financial statement. These costs are generally hard to quantify since there is no
physical exchange of cash or transaction directly related to them; however, some
businesses single out these as costs of potential sources of income.

Example: A manufacturing company owns a building, which is used for its own
operations instead of renting out to another firm. The company has a net profit of
Rs.25,000 per month, and the opportunity cost of rent is Rs.10,000. The actual
economic profit of the manufacturing company is Rs.25,000 – Rs.10,000 = Rs.15,000
per month.

Because the firm uses its own resources, it does not earn income on these
assets, and it cannot report any explicit costs for using the building for its own
operations. In doing so, the company waives a potential income of Rs.10,000 per
month.
If the company earned Rs.13,000 from the rent with a net income was Rs.10,000
per month, it would face a loss of Rs.10,000 – Rs.13,000 = – Rs.3,000. This means that
the asset is underutilized, and the company should rent out the building to earn an
additional profit per month instead of using it for its operations.
Implicit costs are unrecognized costs that a firm realizes when it uses its assets
and resources for one project over another.

10. Explicit Cost:

Explicit cost is valuable if you are trying to create long-term strategic goals for an
organization or simply assessing its profitability. Learning how this metric varies from
implicit costs also helps you understand and determine and establish total economic
cost. Explicit cost can be easily determined and can be invaluable for decision-making
in a business or department.

Definition: Explicit cost is a payment made to others during the course of

running a business that represents the outflows of cash in clear and obvious terms.
Explicit costs include things like wages, mortgage, rent, utilities, advertisements, raw
materials and other general, administrative and sales costs. The condition of explicit
costs is that it must be cash. If an accountant included amortization or depreciation
under explicit costs, it would be inaccurate. Here is a look at how explicit costs are
calculated:

Explicit costs = cash outflows from the company's financial statement

These costs are generally easy to identify in the general ledger, and they are in
the expenses listed on the income statement.
Importance: There are a number of reasons why the explicit cost is important,
including:

● Used to calculate profit: The net income is reflected in the income that remains
after all explicit costs have been paid. It is the only cost that you need to
calculate profit, so it is clearly indicated.
● Allows for long-term strategic planning: Because explicit cost is used to calculate
a company's profitability, it is a key metric for long-term strategic planning within
an organization.
Examples :
Here are some examples of explicit costs you could include as you calculate your
accounting profit:

Rent
Utilities
Payroll
Equipment
Supplies
Raw materials
Inventory
Mortgage
Advertising

How is explicit cost different from implicit cost?

Explicit costs refer to actual payments, such as wages and rent. Implicit costs
represent the opportunity costs that occur from allocating resources for a specific
purpose that can't be assigned a monetary value. They are not clearly identified, defined
or reported and often deal with intangibles. The time required to train a new employee is
an implicit cost, as is time spent on business activities that could be better spent in other
ways. Opportunity costs are often implicit costs, with the cost being the act of giving up
the next best alternative. For example, if an appliance company was considering
investing in a new line of refrigerators to sell but instead chose to invest the same
amount of money into an employee training program, the cost for the missed
opportunity to sell and make money off of the refrigerators is an implicit cost.

Costs will oftentimes have both explicit and implicit portions. For example, if the
printer at the printing company breaks down, the cost of the repair technician and any
parts that are needed are explicit costs, while the lost production time as a result of the
break down is an implicit cost.

11. Opportunity cost:

 Opportunity cost in economics can be defined as benefits or value missed out by
business owners, small businesses, organization, investors, or an individual because
they choose to accomplish or achieve anything else. It helps organizations in better
decision-making by showing the lost opportunity because of investing over an
alternative which can be anything like shares, stock market, real estate, land, services,
etc. Generally, the financial report does not show the opportunity cost because it is not
only about money or monetary cost. It is also associated with the lost time invested
somewhere else which is providing utility. In simple terms, it is a concept in
microeconomics that tells you about the output and potential opportunities foregone.
It shows the relation between choice and scarcity. In this article, we will learn
more about examples, formula, explicit cost, implicit cost, and concept of opportunity
cost in managerial economics.
In modern economic analysis, the factors of production are scarce as compared
to the wants.
Therefore, when society uses a certain factor in the production of a specific
commodity, then it forgoes other commodities for which it could use the same factor.
This led to the idea of an opportunity cost (OC).
Let’s say that a certain kind of steel is needed to manufacture weapons for war.
Therefore, society has to give up the number of utensils that it could produce using the
same amount of steel.
Hence, the opportunity cost of producing weapons for war is the number of
utensils forgone.
In other words, opportunity costs are the costs of the next best alternative.
Therefore, we can deduce two important aspects:

1. The opportunity costs of a product are only the best alternative forgone and not
any other alternative.
2. These costs are viewed as the next-best alternative goods that we can produce
with the same value of factors which are more or less the same
How to Calculate Opportunity Cost?
Opportunity cost = Return of Investment from the best option available – Return of
investment from the chosen option.

Examples of Opportunity Cost

Let’s understand these costs with the help of an illustration. Let’s say that a farmer has
a piece of land on which he can grow wheat or rice.
Therefore, if he chooses to grow wheat, then he cannot grow rice and vice-versa.
Hence, the opportunity cost for rice is the wheat crop that he forgoes.

12. Economic Cost and Accounting Cost

 An economist thinks of cost differently from an accountant, who is concerned
with the financial statements.
Accountants tend to take a retrospective look at a firm’s finances as they have to keep
track of assets and liabilities and evaluate past performance.

Accounting costs include actual expenses and depreciation expenses for capital
equipment, which are determined for tax purposes.
Economists, on the other hand, take a forward-looking view of the firm. They are
concerned with what costs are expected to be in the future, and how the firm would be
able to rearrange its resources to lower its costs and improve its profitability. They must,
thus, be concerned with opportunity costs.

For example, consider a firm that owns a building, and, therefore, pays no rent
for office space. Does this mean that the cost of office space is zero for the firm?
Though an accountant might treat this cost as zero, an economist would consider the
rent that the firm could have earned by leasing the office space to another company.
This foregone rent is an opportunity cost of utilizing the office space and should
be included as part of the economic cost of doing business.

Accountants and economists both include actual outlays, called explicit costs, in
their calculations. Explicit costs include wages, salaries, etc. For accountants, explicit
costs are important because they involve direct payments by a company. These costs
are relevant for the economists because the costs of wages and materials represent
money that could have been usefully spent elsewhere.

Explicit costs involve opportunity cost as well; for example, wages are the
opportunity costs for labour inputs purchased in a competitive market.

Let us look at how economic costs can differ from accounting costs in the
treatment of wages and depreciation. For example, consider an owner who manages
his own firm but chooses not to pay himself a salary, the business none the less incurs
an opportunity cost because the owner could have earned a competitive salary by
working elsewhere.

Accountants and economists also treat depreciation differently. When estimating

the future profitability of a business, an economist is concerned with the capital cost of
plant and machinery. This involves not only the explicit cost of buying and running the
machinery, but also cost associated with wear and tear.

12. recurring cost:

 Recurring costs refer to any expense that is known, anticipated, and occurs at
regular intervals. Nonrecurring costs are one-of-a-kind expenses that occur at irregular
intervals and thus are sometimes difficult to plan for or anticipate from a budgeting
perspective.

Examples of recurring costs include those for resurfacing a highway and

reshingling a roof. Annual expenses for maintenance and operation are also recurring
expenses.Examples of nonrecurring costs include the cost of installing a new machine
(including any facility modifications required), the cost of augmenting equipment based
on older technology to restore its usefulness, emergency maintenance expenses, and
the disposal or close-down costs associated with ending operations.

In engineering economic analyses recurring costs are modeled as cash flows

that occur at regular intervals.(such as every year or every 5 years.) Their magnitude
can be estimated, and they can be included in the overall analysis. Nonrecurring costs
can be handled easily in our analysis if we are able to anticipate their timing and size.
However, this is not always so easy to do.

13. Replacement Cost

Definition: Replacement cost is the amount of money required to replace an existing
asset with an equally valued or similar asset at the current market price. In other words,
it is the cost of purchasing a substitute asset for the current asset being used by a
company.
This concept is important to businesses because most assets wear out and need
to be replaced eventually. Take a car for example. After 5-10 years, the vehicle will no
longer work and will need to be retired and a new one will need to be purchased. Most
likely the replacement will cost more than the price paid for the original vehicle. Another
thing to keep in mind is that the replacement cost must include any other cost incurred
for the new asset to be fully available and operational.
When a company is evaluating the scenario of replacing an asset it is very
important to consider the profitability of the purchase at the new cost. Since the newly
purchased asset might be more expensive than the old asset, the new purchase must
be evaluated carefully to see if the net present value of the investment stays positive
considering the new price of the asset.
This concept is also important for company valuations. If a company’s asset has
a historical cost that differs widely from its current market price, the replacement cost
might increase the value of the company. For instance, if the company purchased a
building 20 years ago in an up-and-coming area, the historical cost of the building is
much less than its replacement cost. Thus, making the company more valuable than its
balance sheet lets on.
Please refer to the PPT for more information.