THEORY OF COST

CONCEPT OF COST
• For the production of commodities and services, organisations incur
various expenditures on different activities, such as purchase of raw
material, payment of salaries/wages to the labour and purchase or
leasing machines and building.

• These expenditures constitute the cost borne by the organisation for the
production of its products and services.

• Inputs utilised multiplied by their respective prices, when added together constitute the money value of these
inputs referred to as the cost of production.
• In other words, cost refers to the amount of resources required for the production of commodities and services.

• The resources utilised in the production would be money or money's worth usually expressed in monetary units.
• Cost is the expenditure, measured in monetary terms, incurred or to be incurred in order to achieve a specific
objective.

Chartered Institute of Management Accountants, CIMA defines cost as, "the amount of expenditure (actual or notional)
incurred on, or attributed to, a specified thing or activity".
 CONCEPT OF COST
Cost Per Unit

Marginal Cost = Average Total Cost

Slope 0

Quantity

Cost is an important factor in business analysis and decision making especially pertaining to the
following aspects:

Identifying the weak Determining the price

Estimating the cost of Minimizing the cost of Finding the optimum
points in production margins for selling
business operations. production. level of production.
management. the goods produced.
 DIFFERENT TYPES OF COST

Opportunity Cost Explicit Cost Implicit Cost

• Unlike explicit costs, there are
• Opportunity cost is also referred to as certain other costs which cannot be
alternative cost. reported as cash outlays.in
• An organisation has limited • Explicit costs, also referred to as accounting books. These costs are
resources, such as land, labour, actual costs, include those payments referred to as implicit costs.
capital, etc., which can be put to that the employer makes to
alternative uses having different purchase or own the factors of • Opportunity costs are examples of
returns. production. implicit cost borne by an
• Organisations tend to utilize their organisation.
limited resources for the most • These costs comprise payments for
productive alternative and forgo the raw materials, interest paid on loans, • Implicit costs are added to the
income expected from the second rent paid for leased building or explicit cost to establish a true
best use of these resources. machinery and taxes paid estimate of the cost of production.
Therefore, opportunity cost may be to the government.
defined as the return from the • Implicit costs are also referred to as
second best use of the firm's limited imputed costs, implied costs
resources, which it forgoes in order to or notional costs.
benefit from the best use of
these resources.
 BASIS FOR COMPARISON EXPLICIT COST IMPLICIT COST

Meaning The costs which involve The costs in which there is no

outflow of cash due to the use cash outlay, is known
of factors of production is as Implicit Cost
known as Explicit Cost.
Alternatively known as Out-of-pocket costs Imputed Cost

Occurrence Actual Implied

Recording and Reporting Yes No

Estimation of Cost Objective Subjective

Which profit can be calculated Accounting Profit and Economic Profit

with the help of cost? Economic Profit
Example Salaries, rent, advertisement, Interest on owner's capital,
wages, etc. Salary to owner, rent of
owner's building, etc. which
do not occur in reality.
 DIFFERENT TYPES OF COST

Accounting Costs Economic Costs Business Costs

• Business costs include all the

• Accounting costs include the financial expenditures incurred to carry out
expenditure incurred by a firm in • Economic costs include the total cost a business. The concept of business
acquiring inputs for the production of of opting for one alternative over cost is similar to the explicit costs.
a commodity. These expenditures another.
include salaries/wages of labour, • Business costs comprise all the
payment for the purchase of raw • The concept of economic costs is payments and contractual
materials and machinery, etc. similar that of opportunity costs or obligations made by a business,
implicit costs with the only difference added to the book cost of
• Accounting costs are recorded in the that economic costs include the depreciation of plant and
books of accounts of a firm and accounting cost (or explicit cost) as equipment.
appear on the firm's income well as the opportunity cost (or
statement. Accounting costs include implicit cost) incurred to carry out an • These costs are used to calculate
all explicit costs along with certain action over the forgone action. the profit or loss made by a
implicit costs of an organisation. business, filing for income tax
returns and other legal procedures.
 DIFFERENT TYPES OF COST

Fixed Costs Full Costs Variable Costs

• Variable costs refer to the costs that

are directly dependent on the output
• Fixed costs refer to the costs born by level of the firm. In other words,
a firm that do not change with variable costs vary with the changes in
• The full costs include the business
changes in the output level. Even if the volume or level of output.
costs, opportunity costs, and
the firm does not produce anything,
normal profit.
its fixed costs would still remain the • For example, if an organisation
same. increases its level of output, it would
• Full costs of an organisation
require more raw materials. Cost of
include cost of materials, labour
• For example, depreciation, raw material is a variable cost for the
and both variable and fixed
administrative costs, rent of land and firm.
manufacturing overheads that are
buildings, taxes, etc. are fixed costs of
required to produce a commodity.
a firm that remain unchanged even • The sum of fixed costs and variable
though the firm's output changes. costs of a firm constitutes its total cost
of production. This can be expressed as
follows:
• Total Costs of a firm (TC) = Fixed costs
(FC) + Variable costs (VC)
 DIFFERENT TYPES OF COST

Incremental Cost Real Cost Social Cost

• Social cost refers to the total of all
private and external costs that an
entire society has to suffer in any
• Incremental costs involve the
• Real cost refers to the actual economic activity.
additional costs resulting due to a
expenses carried out by the
change in the nature of level of
various members of the society in • For example, suppose a new airport is
business activity. It characterizes the
the process of production of built in the your city then the cost of
additional cost that would have not
goods and services. In simple constructing, salary of workers,
been incurred if an additional unit
words, it is the total expenses of maintenance expenses, etc. will be
was not produced.
raw material, direct labour, considered as the private costs while
advertising, transportation, etc. loss of landscape, noise and air
• As these costs may be avoided by
which emerges in the process of pollution, risks of accidents, etc. will be
avoiding the possible variation in the
producing goods or services considered as external costs.
production, they are also referred to
for the customers.
as avoidable costs or escapable costs.
• In this case, social cost will be
calculated by adding both private and
external costs.
 DIFFERENT TYPES OF COST

Replacement Cost Direct Costs

• Direct costs are those expenses which are directly

• Replacement cost is also known as replacement related with the production of specific commodity and
value. It is the cost which refers to the total an organisation can directly connect these costs with
amount of expenses that an organisation suffers in the production of specific commodity. Direct cost is
replacing an old asset with a similar kind of new generally considered as variable cost because it changes
asset. with the changes in level of production.

• For example, suppose a company buys a new • For example, cost of direct raw material, wages of labour,
machinery worth 1 crore and on the same day it packaging costs, etc.
sells old machinery of similar kind for 25 lakh.
Then in this case replacement cost of machinery • On the other hand, indirect costs are those costs which
will be calculated by deducting sale proceeds from are hard to assign or attributed to the production of
old machinery from price of new machinery or specific commodity because these costs involves the cost
replacement cost for of maintaining entire organisation. Indirect costs are
• machinery = 10000000-2500000 = 7500000. generally considered as fixed costs because it remains
fixed whether the production is zero or maximum.
• For example, depreciation, rent of building, advertising,
insurance premium, etc.
 BASIS FOR COMPARISON FIXED COST VARIABLE COST

Meaning The cost which remains same, The cost which changes with the change
regardless of the volume produced, is in output is considered as a variable cost.
known as fixed cost.

Nature Time Related. Volume Related.

Incurred when Fixed costs are definite, they are Variable costs are incurred only when the
incurred whether the units are units are produced.
produced or not.

Behaviors It remains constant for a given period of It changes with the change in the output
time. level.
Combination of Fixed Production Overhead, Fixed Direct Material, Direct Labor, Direct
Administration Overhead and Fixed Expenses, Variable Production Overhead,
Selling and Distribution Overhead. Variable Selling and Distribution Overhead.

Unit Cost Fixed cost changes in unit, i.e. as the Variable cost remains same, per unit.
units produced increases, fixed cost per
unit decreases and vice versa, so the
fixed cost per unit is inversely
proportional to the number of output
produced.
 BASIS FOR COMPARISON PRODUCT COST PERIOD COST

Meaning The cost that can be apportioned to the The cost that cannot be assigned to the
product is known as Product Cost. product, but charged as an expense is
known as Period cost.

Basis Volume Time

Comprises of Manufacturing or Production cost. Non-manufacturing cost, i.e. office &

administration, selling & distribution, etc.

Part of cost of production Yes No

Which cost is regarded as Variable Cost Fixed Cost

Product/Period Cost?

Are these costs included in inventory Yes No

valuation?
 BASIS FOR COMPARISON DIRECT COST INDIRECT COST

Meaning A cost that is easily attributable to a cost Indirect Cost is defined as the cost that
object is known as Direct Cost. cannot be allocated to a particular cost
object.

Classification Direct material, direct labor, direct Indirect material, indirect labor, indirect
expenses overheads

Benefits Specific projects Multiple projects

Aggregate When all the direct costs are taken Total of all the indirect costs is called as
together they are known as prime costs. overheads or on cost.

Traceable Yes No