Cost and Revenue Concepts

 

Cost Concepts

 

Various Concepts of Costs

A managerial economist must have a proper understanding of the different cost concepts which are essential for clear business thinking. The several alternative bases of classifying cost and the relevance of each for different kinds of problems are to be studied. The various relevant concepts of costs used in business decisions are given below.

 

Total, Average and Marginal Costs

Total cost is the total cash payment made for the input needed for production. It may be explicit or implicit is the sum total of the fixed and variable costs. Average cost is the cost per unit of output. It is obtained by dividing the total cost (TC) by the total quantity produced (Q)

Average Cost  = TC / Q

Marginal cost is the additional cost incurred to produce an additional unit of output. Or it is the cost of the marginal unit produced.

 

Example

A company produces 1000 typewriters per annum. Total fixed cost is Rs. 1,00,000 per annum. Direct material cost per typewriter is Rs. 200 and direct labour cost Rs. 100. Variable cost per typewriter = direct material + direct labour

= 200 + 100 = Rs. 300

Total variable cost (1000×300) = Rs.300000

 

Fixed Cost = Rs. 100000

Total cost = Rs.400000

TC = Rs. 400000

Average Cost = TC / Q  =   400000 / 1000  =  Rs. 400

 

If output is increased by one typewriter, the cost will appear as follows:

Total variable cost (1001×300) = 300300

Fixed cost                                   =100000

Total                                           = 400300

 

Here the additional cost incurred to produce the 1001th typewriter is Rs.300 (400300 – 400000). Therefore, the marginal cost per typewriter is Rs.300.

Fixed and Variable Costs

This classification is made on the basis of the degree to which they vary with the changes in volume. Fixed cost is that cost which remains constant up to a certain level of output. It is not affected by the changes in the volume of production. Then fixed cost per unit aries with output rate. When the production increases, fixed cost per unit decreases.

Fixed cost includes salary paid to administrative staff, depreciation of fixed assets, rent of factory etc. These costs are fixed in the sense that they do not change in short-run. Variable cost varies directly with the variation in output. An increase in total output results in an increase in total variable costs and decrease in total output results in a proportionate decline in the total variable costs. The variable cost per unit will be constant.

Variable costs include the costs of all inputs that vary with output like raw materials, running costs of fixed assets such as fuel, ordinary repairs, routine maintenance expenditure, direct labour charges etc.

The distinction of cost is important in forecasting the effect of short-run changes in volume upon costs and profits.

 

Short-Run and Long-Run Costs

This cost distinction is based on the time element. Short-Run is a period during which the physical capacity of the firm remains fixed. Any increase in output during this period is possible only by using the existing physical capacity more intensively. Long- Run is a period during which it is possible to change the firm’s physical capacity.

All the inputs become variable in the long-term. Short-Run cost is that which varies with output when the physical I capacity remains constant. Long-Run costs are those which vary with output when all the inputs are variable. Short-Run costs are otherwise called variable costs.

A firm wishing to change output quickly can do it only by increasing the variable factors. Short- Run cost concept helps the manager to take decision when a firm has to decide whether or not to produce more or less with a given plant. Long-Run cost analysis helps to take investment decisions. Long-Run increase in output may necessitate installation of more capital equipment.

 

Opportunity Costs and Outlay Costs

This distinction is made on the basis of the nature of the sacrifice made. Outlay costs are those expenses which are actually incurred by the firm. These are the actual payments made for labour, material, plant, building, machinery, traveling, transporting etc. These are the expense items that appear in the books of accounts. Outlay cost is an accounting cost concept. It is also called absolute cost or actual cost. Whenever the inputs are to be bought for cash the outlay concept is to be applied.

A businessman chooses and investment proposal from different investment opportunities. Before taking the decision he has to compare all the opportunities and choose the best. When he chooses the best he sacrifices the possibility of making profit from other investment opportunities. The cost of his choice is the return that he could have earned from other investment opportunities he has given up or sacrificed. A

businessman decides to use his own money to buy a machine for the business. The cost of that money is the probable return on the money from the next most acceptable alternative investment. If he invested the money at 12 percent interest, the opportunity cost of investing in his own business would be the 12 percent interest he has forgone.

The outlay concept is applied when the inputs are to be bought from the market. When a firm decides to make the inputs rather than buying it from the market the opportunity cost concept is to be applied. For example, in a cloth mill, instead’ of buying the yarn from the market they spin it themselves. The cost of this yam is really the price at which the yarn could be sold if it were not used by them for weaving cloth.

The opportunity cost concept is made use of for long-run decisions. For example, the cost of higher education of a student should not only be the tuition fees and book costs but it also includes the earnings foregone by not working. This concept is very important in capital expenditure budgeting. The cost of acquiring a petrol pump in Trivandrum City by spending Rs. 6 lakhs is not usually the interest for that borrowed money but it is the profit that would have been made if that Rs. 6 lakhs had been invested in an offset printing press, which is the next best investment opportunity.

 

Out-of-pocket and Book Costs

Out-of-pocket costs are those costs that involve current cash payment. Wages, rent, interest etc., are examples of this. The out-of-pocket costs are also called explicit costs. Book costs do not require current cash expenditure. Unpaid salary of the owner manager, depreciation, and unpaid interest cost of owner’s own fund are examples of book costs.

Book costs may be called implicit costs. But the book costs are taken into account in determining the legal dividend payable during a period. Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of self owned factors of production. The book cost can be converted into out-of-pocket cost. If a selfowned machinery is sold out and the service of the same is hired, the hiring charges form the out-of-pocket cost The distinction is very helpful in taking liquidity decisions.

 

Controllable and Non-controllable costs

Controllable costs are the ones which can be regulated by the executive who is in charge of it. The concept of controllability of cost varies with levels of management. If a cost is uncontrollable at one level of management it may be controllable at some other level.

Similarly the controllability of certain costs may be shared by two or more executives. For example, material cost, the price of which comes under the responsibility of the purchase executive whereas its usage comes under the responsibility of the production executive. Direct expenses like material, labour etc. are controllable costs.

 

References

http://economics-exposed.com/different-concepts-of-economic-costs/

http://wikieducator.org/Introduction_to_Cost_Concepts

http://www.slideshare.net/melamoon/cost-concepts-1727085

http://hspm.sph.sc.edu/COURSES/ECON/Cost/Cost.html

http://en.wikipedia.org/wiki/Opportunity_cost

http://www.trcollege.net/study-material/24-economics/35-concepts-of-cost

 

 

 

 

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