The supply of a firm is determined by its costs. Now, supply and demands both indicate the price. Therefore, to determine the process of price and the forces for supply, one must unearth the nature of costs. The cost concept is an important chapter in economics, thus, both traditional and modern theories play a significant role in this study.
Cost concept is important, especially when it comes to financial decision making for your business. The study of the cost concept in accounting provides the base for understanding pricing. On the professional level, it helps managers in taking correct decisions like the concept of fixed cost, the concept of variable cost, price quotation, and others.
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Accounting and Economic Costs
Accounting costs are expenses that are caused by form production. Therefore, all the payments that are made by a company to its suppliers and other clients come under the accounting costs. Accounting costs are also known as explicit costs. These include rent, utility bills, interest payments, etc. These costs are actually direct costs that are associated with the business. Accounting costs are accounted for each expense made and then recorded in ledgers or accounting software.
Economic costs are usually used for comparing two separate courses of action. It helps in the evaluation process of a particular action for a business. The costs are calculated based on the accounting costs and also subtracting implicit costs. Now, the calculation of implicit costs is analyzed based on the current resources and their cost estimation. Also, the impact on the business from these resources is taken into account.
Outlay and Opportunity Costs
Outlay cost is incurred when a strategy is executed or is needed to acquire an asset. This is an important part of the cost concept. Outlay costs can also be paid to the vendors for the requirement of goods like services and inventory. These are actually concrete expenses incurred for achieving specific goals. Outlay costs are easily recognizable and measurable due to the payment done to outside vendors. However, in the case of opportunity costs, they are not actually incurred and directed to the outside parties by a company.
Coming to the opportunity costs, it represents the potential benefits missed out by an individual, investor, or even a company when choosing a better option over another. The idea of opportunity costs is a pivotal factor in the cost concept and classification. As per the studies of economics, opportunity costs can be easily overlooked if you are not careful. For this reason, you need to learn more about the cost concept in accounting. Most of the financial reports do not show opportunity costs, thus, business owners use this concept to make proper decisions.
Direct and Indirect Costs
When it comes to the cost concept in accounting, learning these two variables can be of great help. Direct costs are simple expenses of a company that can be connected to specific cost objects. These can include anything from the costs of projects, departments, labour, equipment, raw materials, and so on. Most of the direct materials and labour constitute direct costs. In the study of cost concept and classification, direct cost varies. For example, smartphone hardware is a direct cost because the production is dependent on other units as well.
Looking into the indirect costs, they often extend beyond the expenses that are incurred when creating a product including the costs required for maintenance and running business operations. After computing the direct costs, most of the overhead costs are leftover. Some of the clear examples are materials and supplies required by a company for everyday operations. These items may contribute as a whole from a business perspective but are not assigned when it comes to the creation of a service. To stay away from complications, it is good to make yourself more knowledgeable about the various aspects of cost concept and classification.
Fixed and Variable Costs
There are different measures of costs in a cost theory. These are the concept of fixed cost and the concept of variable cost. When it comes to the cost concept in accounting, determining these two variables is crucial. Remember, fixed costs do not vary based on production. For example, the rent paid for a facility.
On the contrary, variable costs keep changing based on the quantity of production. The wages that are paid to the workers in a company are a form of variable costs. This is because the number of workers may need to increase if there is a hike in the production line. Producing more goods means the requirement for more costs. However, the costs vary based on the amount of work done by each worker.
Fixed costs demand the fixed expenditure of funds without considering the level of output like interest on loans, rents, depreciation, and others.
Variable costs are based on the function of output in the production line, including wages and costs of raw materials.
Therefore, the total sum of fixed and variable costs determines a company's overall costs.
The economic cost concept will only help you gain a better insight into the company's financial future and plan the business operations accordingly.
FAQs on Cost Concepts: A Complete Overview
1. What is the fundamental cost concept in business and economics?
The fundamental cost concept refers to the total expenditure incurred by a firm in the process of producing a good or providing a service. It's a framework that helps in understanding how resources are allocated to keep production expenses low while maximising benefits and profits. All business decisions, from production levels to pricing, are based on a thorough understanding of different cost types.
2. How do accounting costs differ from economic costs?
This is a key distinction in cost analysis. Accounting costs, also known as explicit costs, are the actual monetary expenses recorded in a company's books, such as wages, rent, and material costs. In contrast, economic costs include both these explicit costs and the implicit costs, which represent the value of the next-best alternative that was given up (i.e., opportunity cost). For example, the salary a business owner forgoes by running their own company is an implicit cost.
3. What is the main difference between fixed costs and variable costs?
The primary difference lies in their relationship with the volume of production. Fixed costs are expenses that do not change regardless of the level of output, such as building rent, insurance, and salaries of administrative staff. Variable costs, on the other hand, fluctuate directly with the production volume. Examples include costs of raw materials, packaging, and wages for production workers.
4. Can you explain direct and indirect costs with an example?
Certainly. Direct costs are expenses that can be directly traced to a specific product, department, or project. For instance, the cost of wood used to manufacture a chair is a direct cost. Indirect costs, often called overheads, cannot be easily assigned to a single cost object. An example is the factory's electricity bill or the salary of a security guard, as these costs support overall production rather than a single chair.
5. What are outlay costs and how are they different from opportunity costs?
Outlay costs refer to the actual, out-of-pocket expenditure of funds required to acquire an asset or execute a strategy, like paying cash for new machinery. They are recorded in financial statements. Opportunity cost, conversely, is not a direct payment. It represents the potential benefit or income missed by choosing one alternative over another. For example, the opportunity cost of investing in machinery is the interest you could have earned by keeping the money in a bank.
6. Why is understanding opportunity cost so important for business decisions if it isn't recorded in account books?
Understanding opportunity cost is crucial because it reveals the true economic cost of any decision, not just the monetary one. While accounting books track historical expenses, opportunity cost forces a forward-looking perspective. It helps managers compare the full potential of different investment options, ensuring they allocate scarce resources not just to a profitable project, but to the most profitable one. Ignoring it can lead to poor strategic choices that leave better opportunities on the table.
7. How can the same cost be considered 'fixed' in the short run but 'variable' in the long run?
This highlights the importance of the time horizon in cost analysis. In the short run, a company has commitments it cannot easily change, like a one-year lease on a factory. This lease payment is a fixed cost. However, in the long run, all costs can become variable because the company has the flexibility to make larger changes. For instance, after the lease expires, the company can choose to downsize, expand, or relocate, thus changing its factory rental expense based on its strategic needs.
8. What is a 'sunk cost' and how should it influence future business strategy?
A sunk cost is an expense that has already been incurred and cannot be recovered, regardless of future decisions. For example, money spent on market research for a product that is ultimately not launched is a sunk cost. Rationally, sunk costs should have zero influence on future business strategy. Decisions should only be based on future potential costs and benefits. A common mistake (the 'sunk cost fallacy') is to continue investing in a failing project just because a lot of money has already been spent on it.
9. What is the difference between marginal cost and average cost?
Both are critical for pricing and production decisions, but measure different things. Average cost (or Average Total Cost) is the total cost of production divided by the total number of units produced (cost per unit). Marginal cost, however, is the additional cost incurred to produce just one more unit of a good or service. A business will ideally continue to produce as long as the revenue from one more unit (marginal revenue) is greater than its marginal cost.
