What are the difference types of cost in economic and it’s Importance?

What is Cost in Economic? 

Costs in economics is an accounting process that measures all of the costs associated with production, including both fixed and variable costs. The purpose of cost accounting is to assist management in decision-making processes that optimize operations based on efficient cost management.

Costs are the necessary expenditures that must be made in order to run a business. Every factor of production has an associated cost. The cost of labor, for example, used in the production of goods and services is measured in terms of wages and benefits. The cost of a fixed asset used in production is measured in terms of depreciation. The cost of capital used to purchase fixed assets is measured in terms of the interest expense associated with raising the capital.

Businesses are vitally interested in measuring their costs. Many types of costs are observable and easily quantifiable. In such cases there is a direct relationship between cost of input and quantity of output. Other types of costs must be estimated or allocated. That is, the relationship between costs of input and units of output may not be directly observable or quantifiable. In the delivery of professional services, for example, the quality of the output is usually more significant than the quantity, and output cannot simply be measured in terms of the number of patients treated or students taught. In such instances where qualitative factors play an important role in measuring output, there is no direct relationship between costs incurred and output achieved.

Different types of Costs in economics

Costs can have different relationships to output. Costs also are used in different business applications, such as financial accounting, cost accounting, budgeting, capital budgeting, and valuation. Consequently, there are different ways of categorizing costs according to their relationship to output as well as according to the context in which they are used. Following this summary of the different types of costs are some examples of how costs are used in different business applications is as follows:

Direct costs: Are related to producing a good or service. A direct cost includes raw materials, labor, and expense or distribution costs associated with producing a product. The cost can easily be traced to a product, department, or project. For example, Ford Motor Company manufactures cars and trucks. A plant worker spends eight hours building a car. The direct costs associated with the car are the wages paid to the worker and the cost of the parts used to build the car.

Indirect costs: Indirect costs, on the other hand, are expenses unrelated to producing a good or service. An indirect cost cannot be easily traced to a product, department, activity, or project. For example, with Ford, the direct costs associated with each vehicle include tires and steel. However, the electricity used to power the plant is considered an indirect cost because the electricity is used for all the products made in the plant. No one product can be traced back to the electric bill.

Variable costs: Fluctuate as the level of production output changes, contrary to a fixed cost. This type of cost varies depending on the number of products a company produces. A variable cost increases as the production volume increases, and it falls as the production volume decreases. For example, a toy manufacturer must package its toys before shipping products out to stores. This is considered a type of variable cost because, as the manufacturer produces more toys, its packaging costs increase, however, if the toy manufacturer’s production level is decreasing, the variable cost associated with the packaging decreases.

Fixed costs: Fixed costs do not vary with the number of goods or services a company produces over the short term. For example, suppose a company leases a machine for production for two years. The company has to pay N2,000 per month to cover the cost of the lease, no matter how many products that machine is used to make. The lease payment is considered a fixed cost as it remains unchanged.

Operating costs: Operating costs are expenses associated with day-to-day business activities but are not traced back to one product. Operating costs can be variable or fixed. Examples of operating costs, which are more commonly called operating expenses, include rent and utilities for a manufacturing plant. Operating costs are day-to-day expenses, but are classified separately from indirect costs – i.e., costs tied to actual production. Investors can calculate a company’s operating expense ratio, which shows how efficient a company is in using its costs to generate sales.

Opportunity cost: Is the benefits of an alternative given up when one decision is made over another. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it’s the difference in return between a chosen investment and one that is passed up. For companies, opportunity costs do not show up in the financial statements but are useful in planning by management.  For instance, a company decides to buy a new piece of manufacturing equipment rather than lease it. The opportunity cost would be the difference between the cost of the cash outlay for the equipment and the improved productivity vs. how much money could have been saved in interest expense had the money been used to pay down debt.

Sunk costs: Are historical costs that have already been incurred and will not make any difference in the current decisions by management. Sunk costs are those costs that a company has committed to and are unavoidable or unrecoverable costs. Sunk costs are excluded from future business decisions. 

Controllable cost: Are expenses managers have control over and have the power to increase or decrease. Controllable costs are considered so when the decision of taking on the cost is made by one individual. Common examples of controllable costs are office supplies, advertising expenses, employee bonuses, and charitable donations. Controllable costs are categorized as short-term costs as they can be adjusted quickly.

The Bottom Line: Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company’s cost structure allows management to improve the way it runs its business and therefore improve the value of the firm.

Importance of Cost in Economics

1. One of the major motives of any farmer is profit maximization. Profit is obtained by subtracting total cost from total revenue (π = TR – TC).

2. It is important therefore, for farmers to understand the nature and structure of production costs and how they affect the decision making process.

3. Understanding of Cost in economics also helps economics to determine the most profitable level of production as well as the level of output in which production process depends.

4. Cost in economics also helps to determine the least cost combination (cost minimization) that will determine maximum profit.

5. Cost in economics also helps the farmer to determine how much variable factor to be employed in combination with fixed factors in the production of an output for maximum benefit.

 
 Applications use of Different Types of Costs in Business

Costs as a business concept are useful in measuring performance and determining profitability. What follows are brief discussions of some business applications in which costs play an important role.

Financial Accounting

One of the major objectives of financial accounting is to determine the periodic income of the business. In manufacturing firms a major component of the income statement is the cost of goods sold (COGS). COGS are that part of the cost of inventory that can be considered an expense of the period because the goods were sold. It appears as an expense on the firm’s periodic income statement. COGS is calculated as beginning inventory plus net purchases minus ending inventory.

Depreciation is another cost that becomes a periodic expense on the income statement. Every asset is initially valued at its cost. Accountants charge the cost of the asset to depreciation expense over the useful life of the asset. This cost allocation approach attempts to match costs with revenues and is more reliable than attempting to periodically determine the fair market value of the asset.

In financial accounting, costs represent assets rather than expenses. Costs only become expenses when they are charged against current income. Costs may be allocated as expenses against income over time, as in the case of depreciation, or they may be charged as expenses when revenues are generated, as in the case of COGS.

Budgeting Systems

Budgeting systems rely on accurate cost accounting systems. Using cost data collected by the business’s cost accounting system, budgets can be developed for each department at different levels of output. Different units within the business can be designated cost centers, profit centers, or departments. Budgets are then used as a management tool to measure performance, among other things. Performance is measured by the extent to which actual figures deviate from budgeted amounts.

In using budgets as measures of performance, it is important to distinguish between controllable and uncontrollable costs. Managers should not be held accountable for costs they cannot control. In the short run, fixed costs can rarely be controlled. Consequently, a typical budget statement will show sales revenue as forecast and the variable costs associated with that level of production. The difference between sales revenue and variable costs is the contribution margin. Fixed costs are then deducted from the contribution margin to obtain a figure for operating income. Managers and departments are then evaluated on the basis of costs and those elements of production they are expected to control.

Cost of Capital

Capital budgeting and other business decisions—such as lease-buy decisions, bond refunding and working capital policies—require estimates of a company’s cost of capital. Capital budgeting decisions revolve around deciding whether or not to purchase a particular capital asset. Such decisions are based on a cost-benefit analysis, an estimate of the net present value of future revenues that would be generated by a particular capital asset. An important factor in such decisions is the company’s cost of capital.

Cost of capital is a percentage that represents the interest rate the company would pay for the funds being raised. Each capital component—debt, equity, and retained earnings—has its own cost. Each type of debt or equity also has a different cost. While a particular purchase or project may be funded by only one kind of capital, companies are likely to use a weighted average cost of capital when making financial decisions. Such practice takes into account the fact that the company is an ongoing concern that will need to raise capital at different rates in the future as well as at the present rate.

Cost Accounting

Cost accounting, also sometimes known as management accounting, provides appropriate cost information for budgeting systems and management decision making. Using the principles of general accounting, cost accounting records and determines costs associated with various functions of the business. These data are used by management to improve operations and make them more efficient, economical, and profitable.

Two major systems can be used to record the costs of manufactured products. They are known as job costing and process costing. A job cost system, or job order cost system, collects costs for each physically identifiable job or batch of work as it moves through the manufacturing facility and disregards the accounting period in which the work is done. With a process cost system, on the other hand, costs are collected for all of the products worked on during a specific accounting period. Unit costs are then determined by dividing the total costs by the number of units worked on during the period. Process cost systems are most appropriate for continuous operations, when like products are produced, or when several departments cooperate and participate in one or more operations. Job costing, on the other hand, is used when labor is a chief element of cost, when diversified lines or unlike products are manufactured, or when products are built to customer specifications.

When costs are easily observable and quantifiable, cost standards are usually developed. Also known as engineered standards, they are developed for each physical input at each step of the production process. At that point an engineered cost per unit of production can be determined. By documenting variable costs and fairly allocating fixed costs to different departments, a cost accounting system can provide management with the accountability and cost controls it needs to improve operations.

Other Applications

Costs are sometimes used in the valuation of assets that are being bought or sold. Buyers and sellers may agree that the value of an asset can be determined by estimating the costs associated with building or creating an asset that could perform similar functions and provide similar benefits as the existing asset. Using the cost approach to value an asset contrasts with the income approach, which attempts to identify the present value of the revenues the asset is expected to generate.

Finally, costs are used in making pricing decisions. Manufacturing firms refer to the ratio between prices and costs as their markup, which represents the difference between the selling price and the direct cost of the goods being sold. For retailers and wholesalers, the gross margin is the difference between their invoice cost and their selling price. While costs form the basis for pricing decisions, they are only a starting point, with market conditions and other factors usually determining the most profitable price.