Types of

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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.
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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,
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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
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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 Non-
traceable 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 non-
assignable 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
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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.
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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.
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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
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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.
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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.