What is Cost?

All payments made by a firm in the production of a good or service are called the cost of production. These costs can be classified in different ways.

Types of costs
Fixed Cost and Variable cost
Fixed costs are expenses that do not change in proportion to the activity of a business, within the relevant period or scale of production. For example, a retailer must pay rent and utility bills irrespective of sales. Variable costs by contrast change in relation to the activity of a business such as sales or production volume. In the example of the retailer, variable costs may primarily be composed of inventory (goods purchased for sale), and the cost of goods is therefore almost entirely variable. In manufacturing, direct material costs are an example of a variable cost. An example of variable costs is the prices of the supplies needed to produce a product. A company will pay for line rental and maintenance fees each period regardless of how much power gets used. And some electrical equipment (air conditioning or lighting) may be kept running even in periods of low activity. These expenses can be regarded as fixed. But beyond this, the company will use electricity to run plant and machinery as required. The busier the company, the more the plant will be run, and so the more electricity gets used. This extra spending can therefore be regarded as variable. Along with variable costs, fixed costs make up one of the two components of total cost. In the most simple production function, total cost is equal to fixed costs plus variable costs. It is important to understand that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. If enough time passes, all costs become variable. In retail the cost of goods is almost entirely a variable cost; this is not true of manufacturing where many fixed costs, such as depreciation, are included in the cost of goods. Although taxation usually varies with profit, which in turn varies with sales volume, it is not normally considered a variable cost. Variable costs are expenses that change in proportion to the activity of a business. Along with fixed costs, variable costs make up the two components of total cost. Direct Costs, however, are costs that can be associated with a particular cost object. Not all variable costs are direct costs, however; for example, variable manufacturing overhead costs are variable costs that are not a direct costs, but indirect costs. For example, a manufacturing firm pays for raw materials. When activity is decreased, less raw material is used, and so the spending for raw materials falls. When activity is increased, more raw materials is used and spending therefore rises.

Average cost per unit

Total cost/output
It is also equal to the sum of average variable costs (total variable costs divided by Output)

Marginal cost
Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. So, the marginal costs involved in making one more wooden table are the additional materials and labour cost incurred.

Theory of Cost Types of Costs Fixed cost Fixed cost involves all the expenditure done on fixed factors of production. However, the fixed costs remain constant i.e. they do not vary with the level of output. For instance, interest, insurance premium, rent and wages of permanent employees are categorized as fixed costs. Variable cost Variable cost can be defined as the cost that does remain constant i.e. it varies with the level of output. For example, salaries of employees appointed on day to day basis and expenditure made on fuel, power and raw material. Opportunity cost It is quite true that the resources are limited; therefore the production of one commodity can only be made possible at the cost of other. The good that is given up is the opportunity cost of the commodity manufactured. Accounting cost The accounting cost outlines actual expenditure incurred during the production. Economic cost Aggregate of implicit cost, normal profits and explicit cost. Explicit cost Explicit cost embraces all the money payments done to the suppliers who provide the company with raw materials or many other equipments used in production etc. Implicit cost Implicit cost is the aggregate cost of self-owned resources. Total cost curves in short run Total Fixed Cost (TFC) Total Fixed Cost (TFC) is a straight line curve that does not change with the level of output, even in the situation when output is zero unit or one hundred units it remains same all through the course. For example, interest on bonds, insurance premium etc is considered as total fixed cost. Total Variable Cost (TVC) Total Variable cost is the cost that is directly proportional to output which implies that TVC increases when output increases and decreases when output decreases. Total Cost (TC) Total Cost (TC) is derived by adding Total fixed cost (TFC) and Total variable cost (TVC). All the changes occurring in TC are due to changes in TVC due to the fact that TFC remains constant. TC = TFC + TVC Where, TC = Total Cost TFC = Total Fixed Cost TVC = Total Variable Cost

The table below highlights the relation between TFC, TVC and TC.

Unit cost curves in short run Average Fixed Cost (AFC) There exist an inverse association between AFC and output which implies that AFC decreases with increase in output and viceversa. AFC = TFC/ Q Where, AFC = Average Fixed Cost TFC= Total Fixed Cost Q= Units of output Average Variable Cost (AVC) Average Variable cost can be easily calculated by dividing Total Variable Cost by output. AVC = TVC/Q Where, AVC = Average Variable Cost TVC = Total Variable Cost Q = Units of output Average Total cost (ATC) or Average cost (AC) Average Total cost or Average cost can be estimated by any of the two methods mentioned below:

First method; ATC = TC/Q Where, ATC = Average Total Cost TC = Total Cost Q = Units of output Second method; ATC = AFC + AVC Where, ATC = Average Total Cost AFC = Average Fixed Cost AVC = Average Variable Cost Marginal Cost (MC) MC can be defined as the increase in total cost resulting from to one unit increase in the level of output. MC = TC /Q Where, MC = Marginal Cost TC = Change in Total Cost Q = Change in Quantity

The table below highlights the relation between TC, AC and MC:

Types of Costs
By Tejvan Pettinger on January 15, 2012 in economics

A list and definition of different types of economic costs

Fixed Costs (FC). The costs which dont vary with changing output. Fixed costs might include the cost of building a factory, insurance and legal bills. Even if your output changes or you dont produce anything, your fixed costs stays 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. 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 didnt produce any cars, you may still need some workers to look after 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. Opportunity cost Opportunity cost is the next best alternative foregone. If you invest 1million in developing a cure for pancreatic cancer, the opportunity cost is that you cant use that money to invest in developing a cure for skin cancer. 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 weeks pay 350, plus also have to pay the direct cost of 200. Thus the total economic cost = 550. Accounting Costs this is the monetary outlay for producing a certain good. Accounting costs will include your variable and fixed costs you have to pay. Sunk Costs. These are costs that have been incurred and cannot be recouped. If you left the industry you cannot reclaim sunk costs. For example, if you spend money on advertising to enter an industry, you can never claim these costs back. If you buy a machine, you might be able to sell if you leave the industry. Avoidable Costs. Costs that can be avoided. If you stop producing cars, you dont have to pay for extra raw materials and electricity. Sometimes known as an escapable cost.

Market Failure

Social Costs. This is the total cost to society. It will include the private costs plus also the external cost (cost incurred by a third party). May also be referred to as True costs

External Costs. This is the cost imposed on a third party. For example, if you smoke, some people may suffer from passive smoking. That is the external cost. Private costs. The costs you pay. e.g. the private cost of a packet of cigarettes is 6.10 Social Marginal Cost. The total cost to society of producing one extra unit. Social Marginal Cost (SMC) = Private marginal cost (PMC) + External marginal Cost (XMC)

Diagram of Costs
For diagrams of costs see: Diagrams of cost curves

Average Cost Curves

ATC (Average Total Cost) = Total Cost / quantity AVC (Average Variable Cost) = Variable cost / quantity AFC (Average Fixed Cost) = Fixed cost / quantity

All Types of Costs Index? Different Types of Costs with Examples - From M to W?

(A) Actual Cost Actual cost is defined as the cost or expenditure which a firm incurs for producing or acquiring a good or service. The actual costs or expenditures are recorded in the books of accounts of a business unit. Actual costs are

also called as "Outlay Costs" or "Absolute Costs" or "Acquisition Costs". Examples: Cost of raw materials, Wage Bill etc. (B) Opportunity Cost Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other words, it is the return from the second best use of the firms resources which the firms forgoes in order to avail of the return from the best use of the resources. It can also be said as the comparison between the policy that was chosen and the policy that was rejected. The concept of opportunity cost focuses on the net revenue that could be generated in the next best use of a scare input. Opportunity cost is also called as "Alternative Cost". If a firm owns a land, there is no cost of using the land (ie., the rent) in the firms account. But the firm has an opportunity cost of using the land, which is equal to the rent forgone by not letting the land out on rent. (C) Sunk Cost Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs are generally not taken into consideration in decision - making as they do not vary with the changes in the future. Sunk costs are a part of the outlay/actual costs. Sunk costs are also called as "Non-Avoidable costs" or "Inescapable costs". Examples: All the past costs are considered as sunk costs. The best example is amortization of past expenses, like depreciation. (D) Incremental Cost Incremental costs are addition to costs resulting from a change in the nature of level of business activity. As the costs can be avoided by not bringing any variation in the activity in the activity, they are also called as "Avoidable Costs" or "Escapable Costs". More ever incremental costs resulting from a contemplated change is the Future, they are also called as "Differential Costs" Example: Change in distribution channels adding or deleting a product in the product line. (E) Explicit Cost Explicit costs are those expenses/expenditures that are actually paid by the firm. These costs are recorded in the books of accounts. Explicit costs are important for calculating the profit and loss accounts and guide in economic decision-making. Explicit costs are also called as "Paid out costs" Example: Interest payment on borrowed funds, rent payment, wages, utility expenses etc. (F) Implicit Cost Implicit costs are a part of opportunity cost. They are the theoretical costs ie., they are not recognised by the accounting system and are not recorded in the books of accounts but are very important in certain decisions. They are also called as the earnings of those employed resources which belong to the owner himself. Implicit costs are also called as "Imputed costs". Examples: Rent on idle land, depreciation on dully depreciated property still in use, interest on equity capital etc. (G) Book Cost Book costs are those business costs which don't involve any cash payments but a provision is made in the books of accounts in order to include them in the profit and loss account and take tax advantages, like provision for depreciation and for unpaid amount of the interest on the owners capital. (H) Out Of Pocket Costs Out of pocket costs are those costs are expenses which are current payments to the outsiders of the firm. All the explicit costs fall into the category of out of pocket costs. Examples: Rent Payed, wages, salaries, interest etc

(I) Accounting Costs Accounting costs are the actual or outlay costs that point out the amount of expenditure that has already been incurred on a particular process or on production as such accounting costs facilitate for managing the taxation need and profitability of the firm. Examples: All Sunk costs are accounting costs (J) Economic Costs Economic costs are related to future. They play a vital role in business decisions as the costs considered in decision making are usually future costs. They have the nature similar to that of incremental, imputed explicit and opportunity costs. (K) Direct Cost Direct costs are those which have direct relationship with a unit of operation like manufacturing a product, organizing a process or an activity etc. In other words, direct costs are those which are directly and definitely identifiable. The nature of the direct costs are related with a particular product/process, they vary with variations in them. Therefore all direct costs are variable in nature. It is also called as "Traceable Costs" Examples: In operating railway services, the costs of wagons, coaches and engines are direct costs. (L) Indirect Costs Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, a product, a process or a department. Like the direct costs indirect costs, do not vary ie., they may or may not be variable in nature. However, the nature of indirect costs depend upon the costing under consideration. Indirect costs are both the fixed and the variable type as they may or may not vary as a result of the proposed changes in the production process etc. Indirect costs are also called as Non-traceable costs. Example: The cost of factory building, the track of a railway system etc., are fixed indirect costs and the costs of machinery, labour etc.

(M) Controllable Costs

(N) Non Controllable Costs The costs which cannot be subjected to administrative control and supervision are called non controllable costs. Example: Costs due obsolesce and depreciation, capital costs etc.

(O) Historical Costs and Replacement Costs. Historical cost or original costs of an asset refers to the original price paid by the management to purchase it in the past. Whereas replacement costs refers to the cost that a firm incurs to replace or acquire the same asset now. The distinction between the historical cost and the replacement cost result from the changes of prices over time. In

conventional financial accounts, the value of an asset is shown at their historical costs but in decision-making the firm needs to adjust them to reflect price level changes. Example: If a firm acquires a machine for $20,000 in the year 1990 and the same machine costs $40,000 now. The amount $20,000 is the historical cost and the amount $40,000 is the replacement cost.

(P) Shutdown Costs The costs which a firm incurs when it temporarily stops its operations are called shutdown costs. These costs can be saved when the firm again start its operations. Shutdown costs include fixed costs, maintenance cost, layoff expenses etc.

(Q) Abandonment Costs Abandonment costs are those costs which are incurred for the complete removal of the fixed asset from use. These may occur due to obsolesce or due to improvisation of the firm. Abandonment costs thus involve problem of disposal of the asset.

(R) Urget Costs and Postponable Costs Urgent costs are those costs which have to be incurred compulsorily by the management in order to continue its operations. If urgent costs are not incurred in time the operational efficiency of the firm falls. Example: Cost of material, labour, fuel etc

Postponable costs are those which if not incurred in time do not effect the operational efficiency of the firm. Examples are maintenance costs.

(S) Business Cost and Full Cost Business costs include all the expenses incurred by the firm to carry out business activities. Costs Include all the payments and contractual obligations made by the firm together with the book cost of depreciation on plant and equipment.

Full costs include business costs, opportunity costs, and normal profits. Opportunity costs is the expected return/earnings from the next best use of the firms resources like capital, land and building, owners efforts and time. Normal profits is necessary minimum earning in addition to the opportunity costs, which a firm must receive to remain in its present occupation.

(T) Fixed Costs

Fixed costs are the costs that do not vary with the changes in output. In other words, fixed costs are those which are fixed in volume though there are variations in the output level.. If the time period in volume under consideration is long enough to make the adjustments in the capacity of the firm, the fixed costs also vary. Examples: Expenditures on depreciation costs of administrative, staff, rent, land and buildings, taxes etc.

(U) Variable Costs Variable Costs are those that are directly dependent on the output ie., they vary with the variation in the volume/level of output. Variable costs increase in output level but not necessarily in the same proportion. The proportionality between the variable costs and output depends upon the utilization of fixed facilities and resources during the production process. Example: Cost of raw materials, expenditure on labour, running cost or maintenance costs of fixed assets such as fuel, repairs, routine maintenance expenditure.

(V) Total Cost, Average Cost and Marginal Cost Total cost (TC) refers to the money value of the total resources/inputs required for the production of goods and services by the firm. In other words, it refers to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce a given level output. Total cost includes both fixed and variable costs and is given by TC = VC + FC

Average Cost (AC) , refers to the cost per unit of output assuming that production of each unit incurs the same cost. It is statistical in nature and is not an actual cost. It is obtained by dividing Total Cost(TC) by Total Output(Q) AC= TC/Q

Marginal costs(MC), refers to the additional costs that are incurred when there is an addition to the existing output level of goods ans services. In other words, it is the addition to the Total Cost(TC) on account of producing additional units.

(W) Short Run Cost and Long Run Cost Both short run and long run costs are related to fixed and variable costs and are often used in economic analysis.

Short Run Cost: These costs are which vary with the variation in the output with size of the firm as same. Short run costs are same as variable costs. Broadly, short run costs are associated with variable inputs in the utilization of fixed plant or other requirements.

Long Run Cost: These costs are which incurred on the fixed assets like land and building, plant and machinery etc., Long run costs are same as fixed costs. Usually, long run costs are associated with variations in size and kind of plant.