Following are the different types of cost, which a Production Manager should know: Accounting Cost All these expenses incurred by a producer that ente…
Accounting Cost
All these expenses incurred by a producer that enter the accounts of the accountant in the course of production is known as accounting cost. An entrepreneur pays wages to the labor employed, rent for hiring land and building, interest on the capital borrowed, and prices for raw materials, transport, electricity, etc. for doing the business. All these expenses are placed in the accounts.
Economic Cost
Economic cost takes into account the accounting cost of his production and the costs arising out of his personal labor and capital investment. His personal labor and capital invested could have earned remuneration otherwise employed somewhere else. But these remunerations are not received by the entrepreneur himself. When these remunerations are added to the accounting cost, this constitutes economic costs.
Historical Cost
In accounting, historical costs are the original monetary value of an economic item. Historical cost is based on the stable measuring unit assumption. In some circumstances, assets and liabilities may be shown at their historical cost, as if there had been no change in value since the date of acquisition. The balance sheet value of the item may therefore differ from the “true” value.
A measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company. The historical-cost method is used for assets in the U.S. under Generally Accepted Accounting Principles (GAAP).
For example, say the main headquarters of a company, which includes the land and building, was bought for Rs.100,000 in 1925, and its expected market value today is Rs.20 million. The asset is still recorded on the balance sheet at Rs.100,000.
Real Cost
The concept of real cost is another view of classical economists. The real cost is viewed in terms of pains and sacrifices. According to Marshall the real cost of production of a commodity is expressed not in money but in efforts and sacrifices undergone in the making of a commodity. A worker at work derives pain and displeasure and a capitalist sacrifices his present for the future by leaving his money.
While producing a commodity this pain and sacrifice are taken into consideration and constitute the cost of production. The concept of real cost has little significance in the analysis of price. The main difficulty with this concept is that effort and sacrifices are purely subjective and psychological and therefore can not be subjected to accurate measurement. The doctrine of real cost in the words of Prof. Henderson, “leads us into a quagmire of unreality and dubious hypothesis.”
Opportunity Cost
The concept of opportunity cost is based on scarcity and choice. The opportunity cost of a commodity is the next best alternative commodity sacrificed. In other words, the opportunity cost of a commodity is forgoing the opportunity to produce alternative goods and services.
This is because resources are scarce. In view of the scarcity of resources, every producer has to make a choice among several alternatives.
If one commodity is produced another commodity is sacrificed. So opportunity cost of producing a good is equal to the cost of not producing another commodity. For example, the opportunity cost of producing tomatoes is the amount of income from the cultivation of potatoes sacrificed. Suppose the cultivation of potatoes yields Rs.500.
The farmer cultivates tomatoes instead of potatoes. If he forgoes the cultivation of potatoes and takes up tomatoes to cultivation he should get a minimum of Rs.500 which is the amount to be received from the best alternative potatoes foregone. Thus Rs.500 is the opportunity cost of tomatoes.
Money Cost
As we have a monetary economy costs are generally expressed in terms of money. money cost includes various monetary expenditures made by a producer in the production. These are the Wages and salaries paid to labor, the expenditure on machinery, the payment for materials, power, transportation, advertisement, and insurance, etc. Therefore the sum of money spent for producing a particular quantity of the commodity is called its money cost.
Explicit Cost and Implicit Cost
Explicit cost includes these payments which are made by the employer to those factors of production which do not belong to the employer himself. These costs are explicitly incurred by the producer for buying factors from others on contract. For example, the payments made for raw materials, power, fuel, wages and salaries, the rent on land, and interest on capital are all contractual payments made by the employer. Explicit cost is also called accounting cost.
These costs are included in the accountant’s list. The implicit or imputed costs arise in case of those factors which are owned and supplied by the employer himself. An employer may contribute his own land, and his own capital and even work as the manager of the firm. He is entitled to receive remuneration for the use of these personal factors on his own enterprise.
All these items would be included in implicit or imputed costs and are payable to self. Usually, the producers ignore these implicit costs while computing total costs. Thus total cost should include both explicit cost and implicit cost.
Social Cost
Social cost is the total cost of the society which includes the direct and indirect costs that the society pays for the production of the commodity. The producer always tries to cover his private costs. But he never takes care of the costs that the society bears consequent upon his production of commodity. For example, a producer counts his costs of production and never those of people living around the factory. Production of commodity pollutes air and water which impair health and property. This is a cost to society that always exceeds the private cost.
Fixed Cost, Variable Cost, and Semi-variable Cost
In the short run, there are certain factors which are fixed. These factors can’t be changed. The costs incurred on these factors constitute fixed costs. Fixed cost does not change with the change in output. Whatever the volume of production fixed cost remains the same. Fixed cost is to be incurred if there is production or no production. Fixed cost includes those costs like interest on capital, salary of the permanent staff, insurance premium, property taxes, etc. Fixed cost is otherwise known as supplementary cost.
Variable cost is that cost which varies with the volume of output. Variable cost is to be incurred if there is production only. Variable cost is more or less depending on the increase and decrease in the volume of production. Variable cost is otherwise known as, prime cost. Thus labour, raw materials, chemicals, etc. are the factors that can be readily varied with the change in output.
Semi-Variable Cost – A cost composed of a mixture of fixed and variable components. Costs are fixed for a set level of production or consumption, becoming variable after the level is exceeded.
Also known as a “semi-fixed cost.”
This type of cost is variable in the sense that greater levels of production increase total cost. If no production occurs, then a fixed cost is still incurred.
Labor costs in a factory are semi-variable. The fixed portion is the wage paid to workers for their regular hours. The variable portion is the overtime pay they receive when they exceed their regular hours.
Semi-variable cost is an expense that contains both a fixed-cost component and a variable-cost component.
The fixed cost element shall be a part of the cost that needs to be paid irrespective of the level of activity achieved by the entity. On the other hand, the variable component of the cost is payable proportionate to the level of activity.
Transaction Costs
Costs incurred when buying or selling securities. These include brokers’ commissions and spreads (the difference between the price the dealer paid for a security and the price at which it can be sold).
a transaction cost is a cost incurred in making an economic exchange (restated: the cost of participating in a market).
[1] For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is the transaction cost of doing the stock deal. Or consider buying a spatula from a store; to purchase the spatula, your costs will be not only the price of the spatula itself, but also the energy and effort it requires to find out which of the various spatula products you prefer, where to get them and at what price, the cost of traveling from your house to the store and back, the time waiting in line, and the effort of the paying itself; the costs above and beyond the cost of the spatula are the transaction costs. When rationally evaluating a potential transaction, it is important to consider transaction costs that might prove significant.
Sunk Cost
A cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business may face, such as inventory costs or R&D expenses, because it has already happened. Sunk costs are independent of any event that may occur in the future.
When making business or investment decisions, individuals and organizations typically look at the future costs that they may incur, by following a certain strategy. A company that has spent Rs.5 million building a factory that is not yet complete, has to consider the Rs.5 million sunk since it cannot get the money back. It must decide whether continuing construction to complete the project will help the company regain the sunk cost, or whether it should walk away from the incomplete project.
In economics and business decision-making, sunk costs are retrospective (past) costs that have already been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken. Both retrospective and prospective costs may be either fixed (continuous for as long as the business is in operation and unaffected by output volume) or variable (dependent on volume) costs.
Marginal Cost
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good.
The marginal cost of an additional unit of output is the cost of the additional inputs needed to produce that output. More formally, the marginal cost is the derivative of total production costs with respect to the level of output.
Marginal cost and average cost can differ greatly. For example, suppose it costs Rs.1000 to produce 100 units and Rs.1020 to produce 101 units. The average cost per unit is Rs.10, but the marginal cost of the 101st unit is Rs.20
Absorbed Cost / Absorption costing
The indirect costs that are associated with manufacturing. Absorbed costs include such expenses as insurance, or property taxes for the building in which the manufacturing process occurs. When the total manufacturing costs are determined, the implicit absorbed costs are not considered but will be included in a separate account.
On a company’s income statement, the cost of goods sold entry does not reflect the absorbed costs; only the actual costs of the material is included. Incurring insurance and property tax expenses is a required part of the manufacturing process, but these absorbed costs are classified as separate expenses.
Absorption costing means that all of the manufacturing costs are absorbed by the units produced. In other words, the cost of a finished unit in inventory will include direct materials, direct labor, and both variable and fixed manufacturing overhead. As a result, absorption costing is also referred to as full costing or the full absorption method.
Summary:
These are all about a few costs that a production manager or personnel related to production should know for better operation and facilitating managerial decision-making. A general concept is needed because the details and practical portion will be done by the cost accountant of the firm.
ABOUT THE AUTHOR: Adri Mitra
