Managerial Accounting Cost Terms total cost variable cost fixed cost

MA Module 6, Video 1, Cost Concepts Variable cost, fixed cost, Total cost

Cost of production Economic costs fixed cost, variable cost total cost

TYPES OF COSTS- Explicit and Implicit Costs - Direct and Indirect Cost - Private Costs versus Social Costs - Relevant Costs and Irrelevant Costs - Economic Costs and Profits - Separate and Common Costs -Fixed cost and Variable cost

TYPES OF COSTS

            There are many different types of costs that a firm may consider relevant for decision-making under varying situations. The manner in which costs are classified or defined is largely dependent on the purpose for which the cost data are being outlined.

Explicit and Implicit Costs: The opportunity cost (or cost of the foregone alternative) of a resource is a cost in the most basic form. While this particular definition of cost is the preferred baseline for economists in describing cost, not all costs in decision-making situations are completely obvious; one of the skills of a good manager is the ability to uncover hidden costs. For a long time, there has been a considerable disagreement among the economists and accountants on how costs should be treated. The reason for the difference of the opinion is that the two groups want to use the cost data for dissimilar purposes. Traditionally, the accountants have been primarily connected with collection of historical cost data for use in reporting a form's financial behavior and position and in calculating its taxes.  The main function of accountants have been reporting, stewardship and control. They report of what has happened, present information that will protect the interests of various shareholders in the firm, and provide standards against which performance can be judged. All these have indirect relationship to decision-making. Business economists, on the other hand, have been primarily concerned with using cost data in decision-making. These purposes call for different types of cost data and classification.

            Traditional accounting data is not directly suitable for decision-making. While accountants still rely primarily on historical cost in determining the profit or loss of a firm, economists prefer to use the opportunity cost baseline concept for this purpose.

            The opportunity cost of a resource can be defined as the value of the resource in its next best use, that is, if it were not being used for the present purpose. The opportunity cost is the benefit of using a resource for the next most attractive alternative. For example, the opportunity cost of a student's doing a full time MBA could be the income that he would have earned if he had employed his labor resource on a job, rather that spending them in studying economics, accounting, and so on. The time cost, in money terms, can be referred to as implicit cost of doing a MBA.

            The out-of pocket costs on tuition and teaching materials are the explicit costs that a student incurs while pursuing MBA. Thus the total cost of doing a MBA to a student is implicit costs (opportunity cost) plus the explicit (out-of pocket) costs.

            Accountants typically use those costs that are recorded in their books as representing an actual transfer of money. These are explicit or nominal costs and after to not represent full economic costs that should be considered in a given decision. In addition to explicit costs the business economist uses implicit or imputed cost in evaluation a decision.

            Furthermore, in measuring the cost of resource in use, the accountant is only concerned with its acquisition cost. But, for decision-making purposes, we necessarily talk about future costs and revenues, and therefore, past costs have very little relevance. Also, the traditional accounting procedure for valuing assets on the balance sheets is acquisition cost minus depreciation. This faulty as the true current market value of an asset may differ from its book value.

Direct and Indirect Costs: There are some costs, which can be directly attributed to production of a given product. The use of raw material, labor input, and machine time involved in the production of each unit can be determined. On the other hand, there are certain costs like stationery and other office and administrative expenses electricity charges, depreciation of plant and buildings, and other such expenses that cannot easily and accurately be separated and attributed to individual units of production, except on arbitrary basis. When referring to the separate costs of first category accountants call them the direct, or prime costs per unit. The accountants refer to the joint costs of the second category as indirect or overhead costs.

            Direct and indirect costs are not exactly synonymous to what economists refer to as variable costs and fixed costs. The criterion used by the economical to divide cost into either fixed or variable is whether or not the cost varies with the level of output, whereas the accountant divides the cost on the basis of whether or not the cost is separable with respect to the production of individual output units. The accounting statement often divides the overhead expenses into 'variable overhead' and 'fixed overhead' categories. If the variable overhead expenses per unit are added to the direct cost per unit, we arrive at what economists call as average variable cost.

Private Costs versus Social Costs: A further distinction that is useful to make especially in the public sector, is between private and social costs. Private costs are those that accrue directly to the individuals or firms engaged in relevant activity. External costs, on the other hand, are passed on to persons not involved in the activity in any direct way (i.e. they are passed on to society at large). Consider the case of a manufacturer located on the bank of a river that dumps the waste into water rather than disposing if of in some other manner. While the private cost of dumping to the firm is zero, it is definitely positive to the society. It affects adversely the people located down stream and incurs higher costs in terms of treating the water chemically for their use, or to travel long distances to fetch potable water. If these external costs were included in the production costs of producing firm, a true picture of real or social costs of the output would be obtained. Ignoring external costs may lead to an inefficient and undesirable allocation of resources in society.

Relevant Costs and Irrelevant Costs: The relevant costs for decision-making purposes are those costs, which are incurred as a result of the decision under consideration. The relevant costs are also referred to as the incremental costs. Costs that have incurred already and costs that will be incurred in the future regardless of the present decision are irrelevant costs as far as the current decision problem is concerned.

There are basically three categories of relevant or incremental costs. These are the present-period explicit costs, the opportunity costs implicitly involved in the decision, and the future cost implications that flow from the decision. for example, direct labor and material costs, and changes in the variable overhead costs are the natural  consequences of a decision to increase the output level. Also, if there is any expenditure on capital; equipment incurred as a result of such a decision, is should be included in full, not withstanding that the equipment may have a useful life remaining that the equipment may have a useful life remaining after the present decision has been carried out. Thus, the incremental costs of a decision to increase the output level will include all present-period explicit costs, which will be incurred as a consequence of this decision. It will exclude any present-period explicit cost that will be incurred regardless of the present decision.

The opportunity cost of a resource under use, as discussed earlier, becomes a relevant cost while arriving at the economic profit of the firm. Many decisions are having implications for future costs, both explicit and implicit. If a firm expects to incur some costs in the future as a consequence of the present analysis, such future costs should be included in the present value terms if known for certain.

Economic Costs and Profits: Our earlier discussion of economic costs suggests that economists and accountants use the term 'profits' differently. Accounting profits are the firm's total revenue less its economic costs. But economists define profits differently. Economic profits are the firm's total revenue less its explicit costs (explicit and implicit, the latter including a normal profit required to retain resources in a given line of production). Therefore, when an economist says that a firm is just covering its costs, it is meant that all explicit and implicit costs are being met, and that, the entrepreneur is receiving a return just large enough to retain his or her talents in the present line of production. If a firm's total receipts exceed all its economic costs, the residual accruing to the entrepreneur is called an economic or pure profit.

Total Revenue  Minus

Economic Cost = Economic Profit Accounting Cost =  Accounting Profit

            An economic profit is not a cost, because by definition it is a return in excess of the normal profit required to retain the entrepreneur in a particular line of production.

Separate and Common Costs: Costs can also be classified on the basis of their trace ability. The costs that can be easily attributed to a product, a division, or a process are called separate costs, and the rest are called non-separate or common costs. The distinction between separate and common costs is of particular significance in a multi-product firm for setting up economic prices for different products.

Fixed and variable Costs: Fixed costs are those costs, which in total do not vary with changes in output. Fixed costs are associated with the very existence of a firm's plant and therefore must be paid even if the firm's level of output is zero. Such costs as interest on borrowed capital, rental payments, a portion of depreciation charges on equipment and buildings, and the salaries of top level management and key personnel are generally fixed costs.

            On the other hand, variable costs are those costs, which increase with the level of output. They include payment of raw materials, charges on fuel and electricity, wages and salaries of temporary staff, depreciation charges associated with wear and tear of assets, and sales commission, etc. 

Accounting Cost and Economic Costs, Past Costs Vs. Future Costs, The Variable Cost Curve, The Short Run Total Cost Curve

I.     Accounting Cost and Economic Costs

            Economic costs are also known as Explicit Costs or expenditure Costs. There are the contractual payments made by the employer to those factors of production, which do not belong to the employer himself.

Accounting Costs, The accounting Costs are also known as the imputed costs or the implicit costs or non-expenditure costs. They arise in the case of those factors, which are possessed and supplied by the employer himself. An employer may contribute his own land, his own capital and even may himself work as the manager of the firm. As such he is entitled to receive rent on his land interest on the capital contributed by him and also salary for his work as manager of the firm. All these items should be included in accounting costs and would be payable by the employer to himself. The employer would calculate the on the basis of their alternative or opportunity costs. The depreciation of capital equipment is still another item in accounting costs. It is not contractual payment to be made by the employer to same one, but it is to be credited to the depreciation account by the employer himself.

II.    Past Costs Vs. Future Costs. Sometimes a distinction is made between actual costs and future costs. Actual costs or historical costs are records of past costs. Future costs on the other hand are based on forecasts. The costs which are relevant for most managerial decision-which are generally forward looking are forecasts of future costs or comparative connectives concerning future income statements, appraisal of capital expenditure, decisions on new projects and on expansion programmers and pricing.

Box: Calculating Total Cost
Number of workers employed	Total output (pairs of running shoes per week)	Fixed cost (Rs.)	Variable cost (Rs.)	Total cost (Rs.)
0 1 2 3 4 5 6 7 8 9 10 11 12	0 7 18 33 46 55 60 63 65 66 66 64 60s	500 500 500 500 500 500 500 500 500 500 500 500 500	0 300 600 900 1,200 1,500 1,800 2,100 2,400 2,700 3,000 3,300 3,600	500 800 1,100 1,400 1.700 2,000 2,300 2,600 2,900 3,200 3,500 3,800 4,100
The production of shoes is assumed to depend on only two factors of production: Capital and Labor. Cost of capital is fixed at Rs. 500 per week. Labor can be hired at Rs. 300 per week. Therefore, the variable cost depends on the number of workers employed. Total cost is equal to Fixed cost + variable cost. Total output reflects the law of diminishing returns to labor.

Box: The Variable Cost Curve

The shape of the variable cost curve reflects the law of diminishing marginal returns. When labor is the only variable input in a plant, variable cost is equal to the number of workers hired per week multiplied by the weekly wage.

Box: The Short Run Total Cost Curve

The total cost is the sum of fixed cost and variable cost. Because fixed cost does not vary with output, the shape of the total cost curves reflects the shape of the variable cost curve drawn in the pervious box.

RELATION BETWEEN PRODUCTION AND COST Money, Real and Opportunity Costs, Fixed Cost and Variable Costs, Explicit Costs and Implicit Costs, Accounting costs and Economic Costs, Past Cost and Future Cost

RELATION BETWEEN PRODUCTION AND COST

            The economists frequently assumes that the problem of optimum input combinations has been solved and conducts his analysis of the firm in terms of its revenues and costs expressed as functions of output. The cost function of the firm gives the functional relationship between total cost and total output. If C represents total cost and Q represents the level of the output, then the cost functions is represented as C=C (Q). The same level of output can be produced with the help of different cost combinations. The cost function gives the least cost combinations for the production of different levels of output.

            Cost functions are derived functions. They are derived from the production functions, which describes the available efficient methods of production at any particular point of time. The cost function can be deduced from the inputs combinations of the firm. The input prices of the two inputs of production labor (L) and capital (K) are given to be constant as the wage rate (w) and rent (r), respectively. If L and K are the amounts of the two inputs that are used for the production of the output level Q, the firm will always select those combinations of the two inputs, which lie on the expansion path. Along any expansion path the level of output increases as we gradually depart from the origin. Within the non-inferior zone of the factors of production, their total employment will also increase as we move along the expansion path. Therefore we can say that along any expansion path the demand for any factor of production will depend on the level of output to be produced. So, if L and K are the amounts of the factors of production and Q is the level of output then it can be said that L and K are functions of Q.

            That is,

                        L =  g₁(Q)

            And,     K =  g₂(Q)

            Now, following the equation of the costs line, the total cost (C) for producing the output level Q is given by

            C = L. w + K.r

or         C = w. g₁(Q) + r. g₂(Q)

or         C = C(Q).

            Since, w and r are constant C is only a function of Q. This function is called the total cost functions of the firm. The function shows that the total cost of the firm depends on the output to be produced. The costs function is deduced from the expansion path of the firm.

            The cost function derived from the expansion path of the firm represents the cost function in its long run nature as in this case we have assumed that both the factors of production are variable.

A firm's cost curves are linked to its product curves. Overt the range of rising marginal product marginal; cost if falling. When marginal product is a maximum, marginal; cost is a minimum. Over the rang4e of rising average product, average variable cost is falling. When average product is a maximum, average variable cost is a minimum. Over the range of diminishing marginal product, marginal cost is rising. And over the range of diminishing marginal product, average variable cost is rising.

Source: Addison-Wesley, Economics, 1997, 236

Cost Revenue Analysis and Market

            Price determination analysis is based on the demand and supply forces. These in turn depend on the revenue and the cost of production respectively. Thus cost and revenue analysis is indispensable. This analysis exhibit only the profits or losses earned by the firm but also helps in output determination and production planning.

Distinguish between 

i.      Money, Real and Opportunity Costs.

ii.    Fixed Cost and Variable Costs.

iii.   Explicit Costs and Implicit Costs.

iv.   Accounting costs and Economic Costs.

v.     Past Cost and Future Cost.  And others

i.     Money, Real and Opportunity Costs 

            Money costs mean the aggregate money expenditure incurred by a firm on the various items entering into the production of a commodity. Money costs relate to money expenditure by a firm on factors of production, on wages and salaries paid to labor, on machinery and equipment, for rent and insurance and payment to the Government by way of taxes.

            Real costs of production is expressed not in money but in efforts of workers and sacrifices of capitalists undergone in the making of a commodity. According to Marshall, it is, "The extent ions of all the different kinds of labor that are directly and indirectly involved in making it, together with the abstinences or rather the waiting required for saving the capital used in making it, all these efforts and sacrifice together will be called the real cost of production of that commodity, "Marshall had in mind the disability, pain and the discomfort involved for labor when it is engaged in production and also of the unpleasantness involved in saving and capital accumulation. The concept of real cost though of some importance lacks precision since it is expressed in subjective terms.

            Opportunity Cost. A person cannot satisfy all his wants since the money at his disposal is limited in supply. He has to choose between on thing and another. The satisfaction of one want involves the sacrifice of another. The cost of production of any unit of a commodity A is the value of the factors of production used in producing that unit. The value of these factors of production is measured by the best alternative use to which they might have been put, had a unit of A not been produced. In other words, the cost of any factor in the production of a particular good is the maximum amount which the factor unit could yield in the production of other goods since the firm has to pay to owners of factor units what these units can secure in alternative occupations, the costs are known as alternative or alternative or opportunity costs.

            The concept of opportunity cost is applicable to the determination of value in internal and international trade. But the main drawback of this concept in that is applicable to a specific factor, that is which can be put to one single use. Since the factor is a single use factor. It can have no alternative or opportunity cost. The opportunity cost stands for the cost of producing one unit of a commodity in terms of another that can be produced instead.

From Short run to Long run in Perfect Competition

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Least-cost combination of Production

Least-Cost Combination

The problem of least-cost combination of factors refers to a firm getting the largest volume of output from a given cost outlay on factors when they are combined in an optimum manner.

In the theory of production, a producer will be in equilibrium when, given the cost-price function, he maximizes his profits on the basis of the least-cost combination of factor. For this he will choose that combination of factors which maximizes his cost of production. This will be the optimum combination for him.

Assumptions

The assumptions on which this analysis is based are:

1.    There are two factors. Capital and labor.

2.    All units of capital and labor are homogeneous.

3.    The prices of factors of production are given and constant.

4.    Money outlay at any time is also given.

5.    Perfect competition is prevailing in the factor market.

            On the basis of given prices of factors of production and given money outlay we draw a line A, B.

            The firm cannot choose and neither combination beyond line AB nor will it chooses any combination below this line. AB is known as the factor price line or cost outlay line or iso-cost line. It is an iso-cost line because it represents various combinations of inputs that may be purchased for the given amount of money allotted. The slope of AB shows the price ratio of capital and labour, i.e., By combining the isoquants and the factor-price line, we can find out the optimum combination of factors. Fig. illustrates this point.

            In the Fig. equal product curves IQ₁, IQ₂ and IQ₃ represent outputs of 1,000 units, 2,000 units and 3,000 units respectively. AB is the factor-price line. At point E the factor-price line is tangent to iso-quant IQ_2­ representing 2,000 units of output. Iso-qunat IQ₃ falls outside the factor-price line AB and, therefore, cannot be chosen by the firm. On the other hand, iso-quant IQ, will not be preferred by the firm even though between R and S it falls with in the factor-price line. Points R and S are not suitable because output can be increased without increasing additional cost by the selection of a more appropriate input combination. Point E, therefore, is the ideal combination which maximizes output or minimizes cost per units: it is the point at which the firm is in equilibrium.

            What does the point of tangency tell us? At that point the slope of the factor-price line AB and the slope of the iso-quant IQ₂ are equal. The slope of the factor-price line reflects the ratio of prices of the two factors. Viz, capital and labour. The slope of the iso-quant reflects the marginal rate of technical substitution. At point E the ratio of prices of capital and labour is equal to the marginal rate of technical substitution. The condition of optimal combination is, therefore, given by the equality of the ratio of prices between any two factors and the rate of technical substitution between them. This is the point at which and firm is able to produce maximum quantity and at minimum cost.       

            Every firm, interested in maximising output or minimising cost, must therefore, consider (a) factor-price ratio which tells the firm the rate at which it can substitute one factor for another in purchasing, and (d) the marginal rate of technical substitution which tells the firm the rate at which it can substitute one factor for another in production. So long as the two are not equal, a firm can achieve a greater output or a lower cost by moving in the direction of equality.

Possibility of Operation of Production

Possibility of operation

            The law of variable proportions guides us about the possibility of operation. A rational producer will never choose first and third stage for its production he will always operate in the second stage, i.e. the stage of diminishing returns. The producer will not produce in the first and the third stages because in the first stage the fixed factor of production i.e. capital is underutilized and its marginal return is negative and in third stage the variable factor of production i.e. labor is over utilized and thus its marginal return becomes negative. In other words, the marginal return of fixed factor and variable factor is negative in first stage and third stage respective. It is the second stage where the return on both the fixed factors and variables though diminishing is positive. The producer will always produce in second stage. 

Returns to Scale Meaning

            In the run all factors are variable, hence the expansion of output may be achieved by varying all factor-inputs. When we change all factor-inputs in the same proportion, the scale of production is also changed. The study of the effect of change in the scale of production on the amount of output comes under the head of returns to scale.

            Thus, the term returns to scale refers to the changes in output as all factor-inputs change by the same proportion in the long run.

            Or, in other words, the law expressing the relations between varying scales of production and quantities of output is called returns to scale. In short, returns to scale refer to the effects of scale relationship.

Three Types

            Now the question is at what rate the output will increase when all factor- inputs are varied in the same proportion. There can be three possibilities in this regard. The increase in output may be more than, equal to, or less than proportional to the increase in factor-inputs. Accordingly, returns to scale are also of three types-increasing returns to scale, constant returns to scale and diminishing returns to scale.

S.N.	Returns to a Variable Factor	Returns to Scale
1	Operates in the short run	Operates in the long run.
2	Only the Quantities of factor are varied	All factor-inputs are varied in the same proportion
3	Changes in the factor-ratio.	No change in the factor-ratio
4	No change in the scale of production	Changes in the scale of production.

Three Stages of Productions

THE THREE STAGES OF PRODUCTION

            According to Cassels, there are three stages in the production process, when we vary one factor of production, the other factor remaining the same. In stage I, there is increasing average returns to the factor of production, i.e. > 0                              

i.e. MP_L > AP_L. In stage I, the average product is increasing and the marginal product is greater than the average product. If we refer to figure 4.3 we see that up to the point B on the TP curve, stage I exists. In stage I AP is increasing but MP is first increasing up to A and then decreasing. In stage II, the average product is decreasing and the marginal product is also decreasing, but marginal product is positive. This stage may be called the stage of decreasing returns. The portion of the total product curve between B and C represents this stage. In stage III, total product is diminishing and the marginal product is negative. This stage is called the stage of negative returns. The portion of the total product curve, which lies to the right of the point C, represents this stage.

            Let us now discuss the rationale behind the operation of the three stages of production. In the beginning the quantity of the fixed factor of production (which is capital in our case) is abundant relative to the variable factor of production, i.e. labor. Therefore, when more and more units of the variable factor is used, the fixed factor is used more intensively and efficiently. This causes the production to increase at a rapid rate implying increasing AP and MP. But once the point A is reached where the variable factor is used at such a rate that ensures the efficient utilization of the fixed factor, any further increase in the variable factor will cause MP and AP to fall because the quantity of the fixed factor has now become limiting compared to the amount of the variable factor. Again in the stage III the quantity of the variable factor is so large compared to the fixed factor that the formed comes in each other's way, thereby reducing the efficiency of the fixed factor, which results in a fall in the total product instead of rising. This is the reason behind the negativity of the marginal productivity in this stage. Comparing stage I and stage III, it can be said that, stage III is the mirror image of stage I.

            Now the question, which immediately comes in our mind, is that, in which stage would the rational entrepreneur like to be? The answer is the rational entrepreneur will always like to operate in stage II of the production function. Let us analyze the reason behind this.

            In stage I, MP and AP both are rising, and MP is more than AP. This has two implications:

i.      A given increase in the variable factor leads to a more than proportionate increase in the output.

ii.    The entrepreneur is not making the best possible use of the fixed factor.

            In this case the entrepreneur will employ more of the variable factor keeping the fixed factor constant, i.e. a particular portion of the fixed factor remains unutilized.

            Considering the stage III we will see that the MP of the variable factor is negative and the TP is also decreasing. Hence the national entrepreneur will not operate in this stage.

            However, if we consider stage II, we find that MP and AP are both falling and MP, though positive, is less than AP. Moreover, at this stage, there is less than proportionate change in output due to change in labor. Hence, at this stage the entrepreneur will employ the variable factor in such a manner that the utilization of the fixed factor is most efficient. So this is the stage in which the entrepreneur can use both of the available resources in an optional manner.