Cost concept – Importance of cost concept

Cost Concept
  • Meaning of Accounting cost concept/ Economic cost concept, Money Cost/ Real Cost.
  • Meaning of private cost/social cost, fixed cost, opportunity cost.
  • Concept of public goods.

Every field is trying to lower the cost of resources with more and more output and if want to understand and apply the concept of efficiency we will have to understand the basic concepts of cost, not only for material benefits even for the social benefits and for the welfare aspects of the society the cost concepts become the handy tools. As if government wants to start any public work or scheme there is a cost concept benefit analysis which tells that resources going this way will work more for the fulfillment of same goal rather than this way.

Cost Concept

What is the cost concept ?

The other concept is also related to this only that is the concept of public goods and private goods with merit goods. How much of these goods to be provided by the government, by market is also decided by the cost concept and the benefits to the society with the nature of these goods.

The concept of production function shows the functional relationship be- tween output and inputs, it is worth mentioning here that cost concept is necessary before making any production function because cost of input is important for success of any business plan or for that matter production function.

Types of cost concept:

Accounting cost concept / Economic cost concept:

Accounting Cost includes all such business expenses that are recorded in the book of accounts of a business firm as acceptable business expenses. Such expenses include expenses like Cost of Raw Material, Wages and Salaries. Various Direct and Indirect business Overheads, Depreciation, Taxes etc.

When such business expenses or accounting expenses are deducted from the Sales income of any firm the accounting profit is obtained. Such Accounting/ Business expenses or costs are also termed as Explicit Costs

Accounting Cost: Various allowed business expenses cost concept in accounting. Such as Cost of Raw Material, Salaries and Wages, Electricity Bill, Telephone Charges, Various Administrative Expenses, Selling and Distribution Expenses, Production Overhead Expenses, Other Indirect Overhead Expenses etc.

Accounting Profit = Sales Income – Accounting Cost

Money cost/Real cost. Money cost and Real cost:

Money Cost of production is the actual money cost made by company in the manufacture process. So the cost includes all the business expenses which involve amount of money to support business tasks. For example the money expenditure on purchase of raw material, payment of labor cost, rent and other costs of business etc. can be termed as Money Cost is the cost principle .

Real Cost of manufacture or business operation on the other side contains all such costs of business which might involve actual monetary expenditure. For example if owner of a business venture uses his personal land and building for running the business venture and he/she does not charge any rent for the same then such head will not be considered/included while computing the Money Cost but this head will be part of Real Cost computation. Here the cost involved is the Opportunity Cost of the land and building. If the promoted of the company had not used the land and building for the business venture then the land and building could have been used elsewhere for some other venture and could have generated some income for the promoter. This income/rent which could have been earned under the next best investment option is the opportunity cost which needs to be considered while calculating the Real Cost for the firm.

Cost Concept image

example of cost concept :

Social cost:

Social Cost on the other hand includes Private Cost and also such costs which are not endured by the firm but by the society at large. For example the cost of loss or dis utility caused by the tasks of a firm in an economy may not be abides by the firm in question but it impacts the society at large and thus such cost is added to the Private Cost to find the Social Cost of manufacturing the product. Such Cost is also known as External Cost. Another example of external cost can be the cost of giving the basic infrastructure facilities like good roads, sewage system or network, street lights etc. Cost of such kind of services is not swallowed by a business firm even though the firm is benefits from such facilities. Such costs (External Costs) are thus added to the Private Cost to find the Social Cost of producing a product or good.

Above can be understood by following example: If a Tannery firm (A firm processing animal skins) releases its toxic wastes in the river flowing nearby its factory premises then this act of the Tannery firm results in water pollution and environmental damage. The Cost of such damage/loss (also known as External Cost) is added to the private costs of the tannery firm to get fair idea of Social cost involved in the production of the product in question.

Social Cost of an individual will include his private cost and the cost of damage on account of his actions (that has resulted in doing harm/damage to the environment/society at large).

Opportunity cost:

The resources of any firm operating in the market are limited and investing options are many. The firm therefore has to decide or select only those investment opportunities/options which provide the firm with the best return or best income on investment. This means that if a firm can invest money re sources only in one investment option then the firm will select that investment option which promises best return on investment to the firm. In other words while doing so the firm gives up/rejects the next best option for investing the funds. The opportunity cost of a company is thus this income return which the firm could have earned on the next best investment alternative

This can also be understood by a simple example – Let us assume that an individual has two job offers in hand. One job offer is promising him a salary of Rs. 30,000 per month while the other job offer will ensure salary of Rs. 25, 000 per month. If the job profile and other factors related to the job offers are more or less same then it can be easily expected that the individual will select the offer which will provide him with higher salary that is salary of Rs. 30, 000 per month. Thus, in this case, the opportunity cost is the return involved in the next best alternative i.e: Salary of Rs. 25, 000 in the next best job offer

Concept of opportunity cost is closely related to the concept of Economic profit or Economic Rent. A firm earns or makes Economic profit only when besides covering various costs of operation, a firm is also able to earn more than its opportunity cost (or its possible earnings under the next best investment alternative). Opportunity Cost is also termed as Implicit Cost.

Economic Profit is thus earned only when following is true for the Firm Income of a Firm > Various Costs of Operations + Opportunity Cost OR Economic Profit = Earnings or Revenue of Firm – Economic Costs. Here Economic Cost is various expenses of the business plus the opportunity cost

Some simple examples of Opportunity Cost and Economic Profit are discussed in following three brief case studies.

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