Theory of Cost in Business Management

Theory of Cost

• Cost is defined as the monetary value of all sacrifices made to achieve an objective, such as producing goods or services.
• Cost is crucial for business decision-making, providing a pricing floor and aiding managers in decisions like input ordering, product additions/removals, and pricing.
• Cost typically refers to the monetary expenses incurred by a firm during production. This includes imputed values of owner resources and manager salaries.

Determinants of Cost

• Plant Size: There's an inverse relationship between plant size and cost. Larger plants tend to have lower costs per unit.

Cost Concepts

• Actual Cost: This represents the actual expenditure incurred in producing goods or services. Examples include raw materials, wages, rent, salaries, and interest on loans. Also known as absolute cost or outlay cost or money cost.

• Opportunity Cost: Measured in terms of forgone benefits from the next best alternative use of a given resource. For example, resources used to produce a car could have been used to create military equipment.

• Explicit Cost: Direct costs incurred by a company, recorded by accountants. Examples are salaries, wages, rent, and raw materials. Also known as out-pocket costs.

• Implicit Cost: Indirect costs not directly recorded. Examples include interest on owner's capital or the salary forgone by the owner-manager. Also known as imputed costs. The implicit cost is crucial to calculating economic profit.

• Incremental Cost: Costs added by a change in production level or activity, like adding a new product or upgrading machinery. It's somewhat similar to marginal cost, but not a managerial cost.

• Sunk Cost: Costs that cannot be recovered or altered, such as factory construction costs, which have already been incurred. These are past costs and unrelated to future decisions.

• Shutdown Cost: Costs incurred when a plant is closed down. These are costs that could be avoided if the plant operated.

• Book Cost: Business costs where no payment is made, but a provision is recorded in accounts to reflect their inclusion in profit and loss accounting.

• Out-of-pocket Cost: Current payments made to external parties, encompassing all explicit costs.

• Past Cost: Costs already incurred and irrelevant for future decision-making; these are recorded in financial accounts but not relevant for future decision-making.

• Future Cost: Potential future costs, representing forecasts. The management uses these to assess cost-benefit relations and guide decisions; crucial for making future decisions, not past accounting.

• Direct Cost: Costs directly traced to a specific process, product, or activity. Examples include manufacturing and customer acquisition costs.

• Indirect Cost: Costs not directly tied to a specific activity, product, or component of a business; e.g., general overhead expenses.

Other Cost Concepts

• Fixed Cost: Constant costs regardless of production output (e.g., rent, machinery). These costs do not change, regardless of production levels; they are also known as supplementary costs or overhead costs.

• Variable Cost: Costs changing directly with production volume (e.g., raw materials, labor). These costs change with volume.

• Semi-variable Cost: Costs partially fixed and partially variable in relation to output changes; e.g., electricity bills (with a base charge and per-unit consumption).

• Stair Step Cost: Costs that remain constant over a range of output but increase suddenly at specific output points; like adding supervisory staff.

• Total Cost: The sum total of all costs involved in production and/or service delivery (includes fixed and variable costs).

• Average Cost: Total cost divided by the total output; helpful for measuring efficiency levels per unit.

• Marginal Cost: The change in total cost due to a one-unit increase in output.

Cost Function

• The relationship between cost and output is crucial for optimal production decisions.
• Short-run costs are those where some factors are fixed, and changes in output are achieved by changing variable factors.
• Long-run costs allow for the adjustment of all factors, leading to a more flexible production capacity.

Cost Output Relationships (Short-run and Long-run)

• Short-run: Cost relationship is analyzed based on fixed and variable costs.
• Long-run: Cost relationship analyzes the relationship between output and total costs when all input factors, including plant size, can change.

Average & Marginal Costs (AFC, AVC, ATC, MC)

• AFC, AVC , ATC and MC curves are essential for understanding optimal production at different output levels. The relationships among these provide insight into short-run efficiency.