by Cost analysis is all about the study of the behavior of cost with respect to various production criteria like the scale of operations, prices of the factors of production, size of output, etc. It is all about the financial aspects of production.
Accounting and Economic Costs
When a firm starts producing goods, it has to pay the price for the factors employed for the production. These factors include wages to workers employed, prices for the raw materials, fuel and power used, rent for the building he hires, and interest on the money borrowed for doing business, etc.
Accounting Costs are these costs which are included in the cost of production. Hence, accounting costs take care of all payments and charges that the firm makes to suppliers of different productive factors.
Usually, a businessman invests some capital in his firm. If he would have invested the amount in some other firm, then he could have earned a certain interest/dividend. Further, he invests time for his business and also contributes his entrepreneurial and managerial ability to the business.
If not involved in the business, he could have offered his services to other firms for an amount of money. Accounting costs do not involve these costs. They form a part of the Economic Costs. Hence, Economic costs include:
- The normal return on the money that the businessman invests in his own business
- The salary not paid to the entrepreneur but could have been earned if the services would have been sold elsewhere.
- A reward for all factors owned by the businessman and used in his own business.
Therefore, the accounting costs involve cash payments that the firm makes. Economic costs, on the other hand, include the accounting costs and also take into account the amount of money the businessman could have earned with his resources if he would not have started the business.
Another name for accounting costs is Explicit Costs. Whereas, the alternate name for the costs of factors that the businessman owns is Implicit Costs. A businessman earns profits when his revenues exceed both explicit and implicit costs.
Implicit and explicit cost
Implicit cost
An implicit cost is any cost that has already occurred but not necessarily shown or reported as a separate expense. It represents an opportunity cost that arises when a company uses internal resources toward a project without any explicit compensation for the utilization of resources. This means when a company allocates its resources, it always forgoes the ability to earn money off the use of the resources elsewhere, so there’s no exchange of cash. Put simply, an implicit cost comes from the use of an asset, rather than renting or buying it.
Implicit costs are also referred to as imputed, implied, or notional costs. These costs aren’t easy to quantify. That’s because businesses don’t necessarily record implicit costs for accounting purposes as money does not change hands.
These costs represent a loss of potential income, but not of profits. A company may choose to include these costs as the cost of doing business since they represent possible sources of income.
Explicit Cost
Explicit costs are normal business costs that appear in the general ledger and directly affect a company’s profitability. Explicit costs have clearly defined dollar amounts, which flow through to the income statement. Examples of explicit costs include wages, lease payments, utilities, raw materials, and other direct costs.
Explicit costs—also known as accounting costs—are easy to identify and link to a company’s business activities to which the expenses are attributed. They are recorded in a company’s general ledger and flow through to the expenses listed on the income statement. The net income (NI) of a business reflects the residual income that remains after all explicit costs have been paid. Explicit costs are the only accounting costs that are necessary to calculate a profit, as they have a clear impact on a company’s bottom line. The explicit-cost metric is especially helpful for companies’ long-term strategic planning.
Fixed and Variable Costs
Fixed costs or Constant costs are not a function of the output. That is, they do not vary with the output up to a certain extent. They require a fixed expenditure of funds regardless of the output.
For example, rent, property taxes, interest on loans, etc. However, note that fixed costs can vary with the size of the plant and are usually a function of capacity. Therefore, we can conclude that fixed costs do not vary with the output volume within a capacity level.
Businesses cannot avoid fixed costs and are applicable as long as the business is operating. Alternate names for fixed costs are inescapable or uncontrollable costs.
It is important to note here, that some fixed costs continue even after the suspension of business. For example, costs associated with storing of machines that the business cannot sell in the market, etc.
Variable costs are cost concepts which are a function of the output in the production period. Variable costs vary directly with the output. Some examples of variable costs are the cost of raw materials, wages, etc. Sometimes, they vary proportionally with the output too. However, these variations depend on the utilization of fixed facilities and resources during the production process.
Total Cost
In economics, the total cost (TC) is the total economic cost of production. It consists of variable costs and fixed costs. Total cost is the total opportunity cost of each factor of production as part of its fixed or variable costs.
Marginal Cost
In economics, marginal cost is the change in the total cost when the quantity produced changes by one unit. It is the cost of producing one more unit of a good. Marginal cost includes all of the costs that vary with the level of production. For example, if a company needs to build a new factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount of marginal cost varies according to the volume of the good being produced. Economic factors that impact the marginal cost include information asymmetries, positive and negative externalities, transaction costs, and price discrimination. Marginal cost is not related to fixed costs. An example of calculating marginal cost is: the production of one pair of shoes is $30. The total cost for making two pairs of shoes is $40. The marginal cost of producing the second pair of shoes is $10.
Average Cost
The average cost is the total cost divided by the number of goods produced. It is also equal to the sum of average variable costs and average fixed costs. Average cost can be influenced by the time period for production (increasing production may be expensive or impossible in the short run). Average costs are the driving factor of supply and demand within a market. Economists analyze both short run and long run average cost. Short run average costs vary in relation to the quantity of goods being produced. Long run average cost includes the variation of quantities used for all inputs necessary for production.
Relationship between Average and Marginal Cost
Average cost and marginal cost impact one another as production fluctuate:
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