Types of Costs

Learning Objectives:

 To categorise the different types of costs in a business scenario

 To examine the accounting cost concepts relevant to business
 To examine the analytical cost concepts relevant to business
Types of Costs

Accounting Costs Analytical costs

Opportunity Costs and Fixed and Variable

Actual Costs Costs

Business Costs and Total cost, Average

Full Costs cost and Marginal cost

Explicit Costs and Short-run costs and

Implicit Costs Lonf run costs

Out-of-pocket
pocket Costs Incremental costs and
and Book Costs Sunk costs

Historical costs and

Replacement costs

Private costs and social

costs

The Different Types of Costs:

A. Accounting Costs:

Accounting costs are also called as money costs or entrepreneur’s costs. These are the expenses
of an organization incurred during action and are entered in the books of accounts of the
organization.

In the words of Nicholson,

cholson, “Accounting cost refers to the out of packet expenses, historical
costs, depreciation, and other book keeping entries.”

Out of pocket expenses are the costs that include immediate or instant payment to outsiders.
Accounting costs are also known as actual cost or acquisition cost or absolute cost.
cost

These costs include the following:

i. Wages to labour
ii. Interest on borrowed capital

iii. Rent paid to owners of the land

iv. Cost of raw materials

v. Depreciation of capital goods

A producer should ensure that the price of the product should cover all these costs, so that
production is continued. Accounting cost comprises a number of costs.

1. Opportunity Costs and Actual Costs:

Opportunity Cost:

The concept of opportunity cost marks a significant contribution in economic analysis. Cost is
considered as the value of inputs, such as land, labor, and capital, used for the production of
goods and services. The inputs are always valuable for an organization as they are limited. If an
organization utilizes an input to produce a particular good, then the same input would not be
available to produce another good.

The cost incurred on the next best alternative that is foregone to acquire or produce a particular
good is known as opportunity cost. In other words, opportunity cost can be defined as the lost
opportunity of not being able to produce some other product. Opportunity cost is also known as
alternative cost or displacement cost or transfer cost.

Definitions of Opportunity Cost:

In the words of Leftwitch, “Opportunity cost of a particular product is the sale of value of the
foregone alternative product that resources used in its production, could have produced.”

According to Ferguson, “the alternative or opportunity cost of producing one unit of commodity
‘X’ is the amount of commodity ‘Y’ that must be sacrificed in order to use resources to produce
‘X’ rather than ‘Y’.”

Concept of Opportunity Cost:

The concept of opportunity cost occupies a very important place in modern economic analysis.
Factors of production are scarce in relation to wants. When a factor is used in the production of a
particular commodity, the society has to forgo other goods which this factor could have
produced. This gave birth to the notion of opportunity cost in economics

Two important points of Opportunity Cost:

1. The opportunity cost of anything is only the next-best alternative foregone and not any other
alternative.
2. The opportunity cost of a good should be viewed as the next-best alternative good that could
be produced with the same value of the factors which are more or less the same.

Examples of Opportunity Cost:

Let us understand the concept of opportunity cost with the help of an example. Suppose an
organization has Rs. 10, 000, 00 of which it has two alternative uses. It can-either buy a machine
for production of goods or invest it for the construction of canteen at the organization’s premises.

The annual expected income from using the machinery’ is Rs. 1, 50,000, whereas from canteen
is Rs 1, 00,000. A rational producer would opt for buying the machinery because it would yield
high income for the organization than investing for canteen. Thus, opportunity cost for buying
machinery is Rs 1, 00,000.

Actual Costs:

On the other hand, actual costs are those costs which are incurred by the organization on actual
goods to carry out the production activities. These costs are incurred on purchasing raw
materials, plant, machinery, and other physical assets. Actual costs are the payments that are
made in monetary terms and are recorded in the books of accounts.

2. Business Costs and Full Costs:

Business costs involve those costs that are incurred while carrying out business. These are also
called real costs or actual costs. According to Watson, “business costs include all the payments
and contractual obligations made by the organization together with the book cost of depreciation
on plant and equipment.”

These costs are used for calculating business profits and losses and filing returns of income tax
and other legal purposes. These costs include payment and contractual obligations made by the
organization together with the cost of depreciation on plant and equipment.

Full costs include actual costs, depreciation, implicit costs, and normal profits. Normal profits
refer to minimum earrings in addition to the opportunity cost which an organization must receive
to carry on production.

3. Explicit Costs and Implicit Costs:

Explicit costs refer to the payments incurred by an organization in exchange of acquiring various
resources, such as labour, material, plant, machinery, and technology.

In other words, explicit costs can be defined as the payments incurred by organizations for
outsiders who supply labour services, transport services, electricity, and raw materials.
According to Leftwitch, “explicit costs are those cash payments which firms make to outsiders
for their services and goods.” Explicit costs are recorded in the books of accounts of an
organization.

Apart from this, there are certain costs that are neither converted into cash outlays nor added in
the accounting system. Such costs are termed as implicit costs or imputed costs.

These costs are considered as the costs of organization’s self-owned resources. Opportunity cost
is the important example of implicit costs. Let us understand the concept of implicit costs with
the help of an example. Suppose Mr. X is carrying out his/her own business. He is also eligible
to work as a manager in some organization at the pay package of Rs. 12, 00, 000 per annum.

In such a case, he is foregoing his salary- as a manager. This loss of salary would be an implicit
cost for him from his own business. These costs are not taken into consideration, while
calculating profit and loss of a business. However, these costs enable an organization to decide
whether to select the available alternative or not.

4. Out of Pocket Costs and Book Costs:

Out of pocket costs are those cash payments or cash transfers that are made for outsiders. These
costs involve both recurring or nonrecurring expenses. All the explicit costs, such as wages, rent,
interest, transport expenditure, and salaries, are out of pocket costs.

Book costs, on the other hand refer to those costs that do not involve cash outlays, but are added
in the accounting system. These costs are included in profit and loss accounts and are useful for
getting tax benefits. For example, depreciation of machinery and unpaid interests are the book
costs of an organization.

Both, out of pocket and book costs are important for calculating the total profit and loss of an
organization. Generally, small-scale organization ignores book costs, which may lead to
overestimation of profit.

B. Analytical Costs:

Analytical costs are those costs that are taken into account for analyzing the production
activities of an organization. These costs are the deciding criteria for carrying out business
activities. For instance, if an organization is planning to expand, it needs to consider various
costs, such as incremental costs, replacement costs, and fixed costs.

In case the costs exceed the total budget of the organization, it may drop the idea of expansion.
Apart from this, analytical costs are also helpful for making organizational decisions in different
time periods.

1. Fixed Costs and Variable Costs:

Fixed costs refer to those that remain constant for a certain amount of output. The fixed costs
include costs incurred on managerial and administrative staff, depreciation of machinery, and
maintenance of lands and buildings.These costs are incurred in the short- run.

Variable costs are those costs that differ according to changes in the quantity of output. These
costs include costs incurred on raw materials, transportation, and labor. All cost are variable in
the long run.

Total costs:

Total cost (TC) = Variable cost (VC) + fixed costs (FC

2. Total Cost, Average Cost, and Marginal Cost:

Total cost refers to the total sum of the cost incurred on production of goods or services. It
involves all implicit and explicit costs as well as fixed and variable costs incurred on acquiring
resources for the production of goods or services.

Average cost is the total cost of production per unit of output. It is not considered as actual costs
and is statistical in nature.

Average cost can be calculated as follows:

Average Cost = Total Cost/ Output

Marginal Cost:

Marginal cost is the addition to the total cost for producing an additional unit of the product.

Definitions of marginal costgiven by different economists are as follows:

According to Mc Conell, “marginal cost may be defined as the additional cost of producing one
more unit of output.”
In the words of Ferguson, “marginal cost is the addition to total cost due to the addition of one
unit of output.”

Marginal cost is the increase or decrease in the total cost a business will incur by producing one
more unit of a product or serving one more customer.

If you plot marginal costs on a graph, you will usually see a U-shaped curve where costs start
high but go down as production increases, but then rise again after some point.

For example, in many of the manufacturing businesses, the marginal cost of production
decreases as the volume of output increases because of economies of scale.

Costs are lower because you can take advantage of discounts for bulk purchases of raw materials,
make full use of machinery, and engage specialized labor.

However, production will reach a point where diseconomies of scale will enter the picture and
marginal costs will begin to rise again.

Costs may rise because you have to hire more management, buy more equipment, or because you
have tapped out your local source of raw materials, causing you to spend more money to obtain
the resources.

 ATC (Average Total Cost) = Total Cost / quantity

 AVC (Average Variable Cost) = Variable cost / quantity
 MC = Marginal cost.
 AFC (Average Fixed Cost) = Fixed cost / quantity
You can use marginal costs for production decisions. If the price you charge for a product is
greater than the marginal cost, then revenue will be greater than the added cost and it makes
sense to continue production.
However, if the price charged is less than the marginal cost, then you will lose money and
production should not expand.

Formula for Marginal Cost

The formula for marginal costs can be expressed as follows:

Marginal Cost = Change in costs / Change in quantity

For the more algebraically inclin

inclined,
ed, marginal cost can be also be expressed by this equation:

Marginal cost can be calculated as follows

follows:

MC = TCn-TCn-1

n= Number of units produced

MC is the rate of change of the total cost.

It is also calculated as:

MC = ∆TC/ ∆Output

Total, average, marginal costs play an important role in analyzing the production activities of an
organization.

Calculating different types of E

Economic Costs:

Fixed Costs (FC): The costs which don’t vary with changing output output.. Fixed costs might include
the cost of building a factory, insurance and legal bills. Even if your output changes or you don’t
produce anything, your fixed costs stay the same. In the above example, fixed costs are always
£1,000.

Variable Costs (VC): Costs which depend on the output produced. For example, if you produce
more cars, you have to use more raw materials such as metal. This is a variable cost which is
increasing from 200 to 900 pounds as the quantity is increasing from 1 to 4 units

Semi-Variable Cost: Labour might be a semi-variable cost. If you produce more cars, you need
to employ more workers; this is a variable cost. However, even if you didn’t produce any cars,
you may still need some workers to look after an empty factory.

Total Costs (TC) = Fixed + Variable Costs

Marginal Costs: Marginal cost is the cost of producing an extra unit. If the total cost of 3 units is
1550, and the total cost of 4 units is 1900. The marginal cost of the 4th unit is 350.

Economic Cost: Economic cost includes both the actual direct costs (accounting costs) plus the
opportunity cost. For example, if you take time off work to a training scheme. You may lose a
week’s pay of £350, plus also have to pay the direct cost of £200. Thus, the total economic cost =
£550.

3. Short-run and Long-run Costs:

Short run refers to a period in which organization can change its output by changing only
variable factors, such as labour and capital.

In this period, the fixed factors, such as land and machinery, remain the same. The expansion is
done by hiring more labour and purchasing more raw materials.

The existing size of the plant or building cannot be increased in case of the short run.

In context of costs, short run costs are those costs that have short-term application in the
production process of an organization.

Short-run costs involve costs incurred on raw materials and payment of wages.

Short-run costs change with the change in the level of output.

In the short run the levels of usage of some input are fixed and costs associated with these fixed
inputs must be incurred regardless of the level of output produced. Other costs do vary with the
level of output produced by the firm during that time period.

The sum-total of all such costs-fixed and variable, explicit and implicit- is short-run total cost.

It is also possible to speak of semi-fixed or semi-variable cost such as wages and compensation
of foremen and electricity bill.
For the sake of simplicity, we assume that all short run costs to fall into one of two categories,
fixed or variable.

Short-Run Total Cost:

A typical short-run total cost curve (STC) is shown in Fig. 14.3.

This curve indicates the firm’s total cost of production for each level of output when the usage of
one or more of the firm’s resources remains fixed.

When output is zero, cost is positive because fixed cost has to be incurred regardless of output.
Examples of such costs are rent of land, depreciation charges, license fee, interest on loan, etc.

They are called unavoidable contractual costs. Such costs remain contractually fixed and so
cannot be avoided in the short run. The only way to avoid such costs is by going into liquidation.

The total fixed cost (TFC) curve is a horizontal straight line. Total variable is the difference
between total cost and fixed cost. The total variable cost curve (TVC) starts from the origin,
because such cost varies with the level of output and hence are avoidable. Examples are
electricity tariff, wages and compensation of casual workers, cost of raw materials etc.

In Fig. 14.3 the total cost (OC) of producing Q units of output is total fixed cost OF plus total
variable cost (FC).

Clearly, variable cost and, therefore, total cost must increase with an increase in output. We also
see that variable cost first increase at a decreasing rate (the slope of STC decreases) then increase
at an increasing rate (the slope of STC increases). This cost structure is accounted for by the law
of Variable Proportions.
Short Run Average and Marginal Cost:

One can gain a better insight into the firm’s cost structure by analyzing the behavior of short-run
average and marginal costs. We may first consider average fixed cost (AFC).

Average fixed cost is total fixed cost divided by output,

i.e., AFC = TFC /Q

Since total fixed cost does not vary with output average fixed cost is a constant amount divided
by output. Average fixed cost is relatively high at very low output levels. However, with gradual
increase in output, AFC continues to fall as output increases, approaching zero as output
becomes very large. In Fig. 14.4, we observe that the AFC curve takes the shape of a rectangular
hyperbola.

We now consider average variable cost (AVC) which is arrived at by dividing total variable cost
by output,

i.e., AVC= TVC / Q

In Fig. 14.4, AVC is a typical average variable cost curve. Average variable cost first falls,
reaches a minimum point (at output level Q2) and subsequently increases.

The next important concept is one of average total cost (ATC).

It is calculated by dividing total cost by output,

It is, therefore, the sum of average fixed cost and average variable cost.

The ATC curve, illustrated, is U-shaped in Fig. 14.4 because the AVC cost curve is U-shaped.
This is accounted for by the Law of Variable Proportions.

It first declines, reaches a minimum (at Q3 units of output) and subsequently rises. The minimum
point on ATC is reached at a larger output than at which AVC attains its minimum. This point
can easily be proved.

ATC = AFC + AVC

We know that and that average fixed cost continuously falls over the whole range of output.
Thus, ATC declines at first because both AFC and AVC are falling. Even when AVC begins to
rise after Q2, the decrease in AFC continues to drive down ATC as output increases. However,
an output of Q3 is finally reached, at which the increase in AVC overcomes the decrease in AFC,
and ATC starts rising.

Since ATC = AFC + AVC, the vertical distance between average total cost and average variable
cost measures average fixed cost. Since AFC declines over the entire range of output AVC
becomes closer and closer to ATC as output increases.

We may finally consider short-run marginal cost (SMC). Marginal cost is the change in short-
run total cost attributable to an extra unit of output: or

Short-run marginal cost refers to the change in cost that results from a change in output when the
usage of the variable factor changes. As Fig. 14.4 shows, marginal cost first declines, reaches a
minimum at Qx (note that minimum marginal cost is attained at a level of output less than that at
which AVC and ATC attain their minimum) and rises thereafter.

The marginal cost curve intersects AVC and ATC at their respective minimum points. This
result follows from the definitions of the cost curves. If marginal cost curve lies below average
variable cost curve the implication is clear: each additional unit of output adds less to total
cost than the average variable cost.

Thus, average variable cost has to fall. So long as MC is above AVC, each additional unit of
output adds more to total cost than AVC. Thus, in this case, AVC must rise.

Long Run Costs:

Long run refers to a period in which all the factors are variable.

The existing size of the plant or building can be increased in case of the long run.

Long run costs vary with variation in the size of manufacturing plant or organization.

Long-run costs include costs incurred on plant, building, and machinery.

1. Long Run Total Cost:

Long run Total Cost (LTC) refers to the minimum cost at which given level of output can be
produced. According to Leibhafasky, “the long run total cost of production is the least possible
cost of producing any given level of output when all inputs are variable.”

LTC represents the least cost of different quantities of output. LTC is always less than or equal to
short run total cost, but it is never more than short run cost.

The LTC curve is shown in Figure-10:

As shown in Figure-10, short run total costs curves; STC1, STC2, and STC3 are shown depicting
different plant sizes. The LTC curve is made by joining the minimum points of short run total
cost curves. Therefore, LTC envelopes the STC curves.
2. Long Run Average Cost:

Long run Average Cost (LAC) is equal to long run total costs divided by the level of output. The
derivation of long run average costs is done from the short run average cost curves. In the short
run, plant is fixed and each short run curve corresponds to a particular plant.

The long run average costs curve is also called planning curve or envelope curve as it helps in
making organizational plans for expanding production and achieving minimum cost.

Figure-11 shows the derivation of LAC curve:

Suppose there are three sizes of the plant and no other size of the plant can be built. In short run,
the plant sizes are fixed thus, organization increase or decrease the variable factors.

However, in the long run, the organization can select among the plants which help in
achieving minimum possible cost at a given level of output.

From Figure-11, it can be noted that till OB amount of production, it is beneficial for the
organization to operate on the plant SAC2 as it entails lower costs than SAC1. If the plant
SAC2 is used for producing OA, then cost incurred would be more. Thus, in the long run, it is
clear that the producer would produce till OB on plant SAC 2. On SAC2, the producer would
produce till OC amount of output. If an organization wants to exceed output from OC, it will be
beneficial to produce at SAC3 than SAC2.

Thus, in the long run, an organization has a choice to use the plant incurring minimum
costs at a given output. LAC depicts the lowest possible average cost for producing
different levels of output. The LAC curve is derived from joining the lowest minimum costs
of the short run average cost curves.

It first falls and then rises, thus it is U- shaped curve. The returns to scale also affect the LTC
and LAC. Returns to scale implies a change in output of an organization with a change in inputs.
In the long run, the output changes with respect to change in all inputs of production.
In case of increasing returns to scale (IRS), organizations can double the output by using
less than twice of inputs. LTC increases less than the increase in the output, thus, LAC falls. In
case of constant returns to scale (CRS), organizations can double the output by using
inputs twice.

LTC increases proportionately to the output; therefore, LAC becomes constant. On the other
hand, in case of decreasing returns to scale (DRS), organizations can double the output by
using inputs more than twice. Thus, LTC increases more than the increase in output. As a
result, LAC increases.

Figure-12 shows the effect on LAC because of returns to scale:

As shown in Figure-12, up to M, LAC slopes downward. This is because at this stage IRS is
applied. On the other hand, at M, LAC becomes constant. After M, LAC slopes upwards
implying DRS.

3. Long Run Marginal Cost:

Long run Marginal Cost (LMC) is defined as added cost of producing an additional unit of a
commodity when all inputs are variable. This cost is derived from short run marginal cost. On
the graph, the LMC is derived from the points of tangency between LAC and SAC.

LMC curve can be learned through Figure-13:

If perpendiculars are drawn from point A, B, and C, respectively; then they would intersect SMC
curves at P, Q, and R respectively. By joining P, Q, and R, the LMC curve would be drawn. It
should be noted that LMC equals to SMC, when LMC is tangent to the LAC.
In Figure-13, OB is the output at which:

SAC2 = SMC2 = LAC = LMC

We can also draw the relation between LMC and LAC as follows:

When LMC < LAC, LAC falls

When LMC = LAC, LAC is constant

When LMC > LAC, LAC rises

4. Incremental Costs and Sunk Costs:

Incremental costs are those costs that are incurred during the expansion of an organization.
These are the added costs that are involved in changing the level of production or the nature of
business activity. Expansion can be in the form of men, materials, and machinery.

Incremental costs are incurred by an organization for various purposes, such as purchasing new
machines, changing distribution channel, and launching a new product.

For instance, if an organization purchases machinery, then following incremental costs are
incurred:

i. Cost of purchase

ii. Maintenance charges

iii. Installation charges

iv. Operational charges

Sunk costs are those costs that are incurred whether there is an expansion or not.

These are the costs which are made once and cannot be altered, increased, or decreased.

These types of costs are based on the prior commitment, thus, cannot be revised or
recovered. For instance, if an organization hires a machine, it has to bear the rent and other
operational charges, which are the sunk costs of the organization.

5. Historical and Replacement Costs:

Historical costs are those costs that are incurred in the past by an organization for acquiring
assets, such as land, building, and machinery. These costs help in assessing the net worth of
the organization.
Historical costs reduce on an annual basis due to depreciated value of assets, such as machinery
and equipment. On the contrary, historical cost increases in case of land, buildings, and metals,
such as gold and silver.

Replacement cost is incurred when an asset depreciates and is replaced with the new asset. Let
us understand the concept of replacement costs with the help of an example.

For instance, the historical cost of a machine is Rs. 85, 000, which was purchased by an
organization two years ago. Now, the organization is willing to replace the existing machine with
the new one. The current price of the machine in the market is Rs. 90, 000, which is a
replacement cost.

6. Private and Social Costs:

Private costs are those costs that are incurred for carrying out different business operations.

In other words, these costs are added in the total cost of production of an organization.

In the words of miller, “private costs are those costs that are incurred by the firm or the
individual producer as a result of their own decisions.” All explicit and implicit costs fall into the
category of private costs.

On the contrary, social costs are those costs that are borne by the society and are not explicitly
paid by the organization. Such costs include pollution (air, water, and noise) and global warming,
which take place due to production activities of an organization.

According to Dictionary of Modern Economics, “social costs of a given output is defined as the
sum of money which is just adequate when paid as compensation to restore to their original
utility levels all who lose as a result of the production of the output.”