BCom 1st Year Theory of Costs Notes Study Material
BCom 1st Year Theory of Costs Notes Study Material: A2zNotes Presents study material Long Question Answer Notes Pdf by the Latest BCom Syllabus. A Collection of Question-Answers compiled and Edited by A2zNotes Well Experienced Authors Based on Latest BCom Curriculum. Here in this post, we will provide you with BCom 1st Year Theory of Costs Notes Study Material, Long Questions Answers and Notes in Pdf for BCom 1st Year.
The most important Topics Coming in the BCom examination are BCom Notes, BCom 1st Year Theory of Costs Notes Study Material, BCom Notes for English medium pdf, and BCom Study Material Notes. If you are preparing for the BEd examination, BSC examination, CCC examination, BBA examination, MBA examination, MCom examination, or Bcom examination this will help you a lot. On A2zNotes.com you will find all types of Notes including CBSE, Bcom, CCC, BSC, MCom, NEILET, UPTET, and TET.
Related Posts to see:-
Topic Wise BCom Books Study Material Notes Pdf Download
BCom Financial Accounting Topic Wise Study Material Notes Download Free PDF
BCom 1st Year Food Nutrition and Hygiene Notes Study Material
BCom 1st Year Efficiency of Labour Notes Study Material
BCom 1st Year Theories of Population Notes Study Material
BCom 1st Year Forms of Business Organisation Notes Study Material
BCom 1st Year Scale of Production Notes Study Material
BCom 1st Year Production Function Notes Study Material
BCom 1st Year Laws of Production and Isoquants Notes Study Material
View all BCom Notes ➜ <Click here>
BCom 1st Year Theory of Costs Notes Study Material
Meaning of Cost
In general, cost is a measure of what must be given up in order to obtain something whether by way of purchase, exchange or production. Two concepts of cost are distinguished which may, but need not necessarily, be equivalent. One is an accountant’s view of cost and the other is an economist’s view of cost.
An accountant concentrates on accounting, or explicit costs. ‘Explicit costs’, according to Truett and Truett, “are the costs for items for which the firm has made a specific payment in the past or for which it is obligated to do so in the future.” Accountants consider these costs because they are needed in firms’ formal income statements. Since explicit costs are based on facts so, they are taken as objective.
Firm’s decision-making is not based on explicit costs alone. For taking a decision, firms need to consider implicit or opportunity costs as well as explicit costs. ‘Implicit costs’, according to Truett and Truett, “represent opportunities that a firm gives up by using a resource in one-way rather than another.”
To an economist, economic cost of a firm includes both explicit and implicit costs. Thus,
Economic cost = Accounting or Explicit costs + Opportunity or Implicit costs.
Private Costs and Social Costs
Costs are classified into private costs and social costs too. The private costs of a firm are those explicit and implicit costs which it incurs. But a firm is also likely to impose some costs on the society which it does not bear itself.
Smoke coming out of the chimney of a factory, for example, pollutes the air in its neighbourhood and thereby, increases the laundry cost of the neighbours. These costs are not taken into account by the firm in its calculation of cost, but are costs to the society, Social costs have two constituents, namely, (i) the private costs of the resources which the firm uses and (ii) any additional costs imposed on the society by the operation of the firm.
Opportunity cost measures costs as the value of all of the things which must be foregone, lost or given up in obtaining something. Opportunity cost is also called alternative cost because it is the value of the alternative or the opportunity that is sacrificed.
Opportunity cost arises only in a world of scarcity. In other words, where the means or resources available to satisfy wants are limited so that all wants cannot be met, the problem of opportunity cost arises. It is obvious that in a world of plenty where resources are limitless, all wants can be satisfied. So in order to satisfy a want, no alternative or opportunity is sacrificed.
It means that the value of alternative sacrificed is zero. It has, therefore, been said that opportunity cost is like a ghost which vanishes when boldly confronted. Destroy the opportunity, cost itself will vanish. But in the actual world scarcity is a reality and the sacrifice of the alternative is also a reality. So opportunity cost is positive.
Economists express costs in terms of foregone alternative. If some course of action is adopted, there are typically many alternatives that might be foregone. Suppose the government takes a decision to construct a road. In order to do so it might cut expenditure on schools, on research laboratories or on modernizing the communication system. To get a precise measure of opportunity cost, economists count the sacrifice as that of the best available alternative, i.e. the next best alternative.
“The concept of opportunity cost emphasizes the need for choice by measuring the cost of anything that is chosen in terms of the best alternative that could have been chosen instead. The sacrificed alternative measures the cost of obtaining what is chosen.”
As noted above, one of the cardinal tenets of economics is that resources are scarce. It means that whenever we make a choice to use resources one way, we have to give up the opportunity to utilize it in another way. In each case of making a choice in effect costs us the opportunity to do something else. The alternative foregone is called the opportunity cost. As Samuelson and Nordhaus say,
“The opportunity costs of a decision include all its consequences, whether they reflect monetary transactions or not.
Decisions have opportunity costs because choosing one thing in a world of scarcity means giving up something else. The opportunity cost is the value of the good or service foregone.”
Business accounts include only those transactions where money actually changes hands. Further, the business accountant includes all transactions. But the economist tries to “pierce the veil” of money to uncover the real consequences that lie behind the money flows and to measure the true resource costs of an activity. Economists in this way include all costs, whether reflected in monetary transactions or not.
There are many important opportunity costs that are not included by the accountant. Let us take a few examples. In many small businesses, the family members may do important jobs which are not paid.
They are not included as costs. The owner may supply capital on which no charges are paid. Business accounts do not include such unpaid changes. A business dumps, say, toxic wastes into a river. In damages the environment, but cost of environmental pollution is not included in the business account. “But from an economic point of view, each of these is a genuine cost to the economy.”
Economists maintain that the value of a factor of production should be considered without regard to its ownership. “We should count the owner’s own labour as a cost even though the owner does not get paid directly but instead receive compensation in the form of profits. Because the owner has alternative opportune for work, we must value the owner’s labour in terms of the lost opportunities.
Such costs are known as implicit costs. They are opportunity costs of the use of factors which a producer does not buy or hire but already owns, such as owner-managed firm.
Such owner of the firm hires factors of production and also provides his own managerial and organisational abilities for which no payment is made. This labour could be sold to other producers and salary which could be earned elsewhere is the implicit cost of the use of these abilities in the producer’s own firm. Implicit cost is also called imputed cost.
To well-functioning markets price equals opportunity cost. Such markets are competitive markets where price works as an auction system and bids get closer to the highest bid, this is, the price. So it is equal to the opportunity cost.
This concept of the cost, i.e., opportunity cost, is particularly important when analyzing transactions taking place outside markets. Here the money outlays on various resources required to produce a product are inaccurate reflection of the opportunity cost of the resources. Further, the economists look at all the benefits sacrificed in taking an action, say, road construction. Thus economist’s concern is wider. This is clear from cost-benefit analysis carried on in a social perspective.
Opportunity cost may be divided into:
(i) private opportunity cost where foregone private benefits of an action are considered; and
(ii) social opportunity cost where foregone benefits are of a much wider range regardless of to whom they accrue.
We may conclude by stating that economists’ costs include explicit money outlays as well as those opportunity costs that arise because resources can be used in alternative ways.
Profit and Opportunity Cost
Profit is the difference between the revenue generated from the sale of output and the full opportunity costs of the factors used in the production of that output. Costs include here the premium charged for risk taking and the costs of using owner’s capital. These are not included as costs in the accountants’ measure of profit. So accountants’ profit and economic profit differ.
Economists count the opportunity cost of capital as a cost, accountants include it as a part of profits. Thus the word “profit’ is used to describe one thing by firms and another by economists. Firms are interested in the returns that they earn on their investment and they call these profit. Economists call the opportunity cost of capital normal profits and excess of revenue over normal profits is called supernormal profits. The alternative terminology of profits has been put in the tabular form by Lipsey and Chrystal thus:
Cost of Production
By cost of production is meant “the amounts of money paid out or contracted to be paid or otherwise sacrificed by the firm in order to secure the productive services with which to produce output.” Cost of production is divided into (i) money cost of production and (ii) real cost of production.
“The exertions of all different kinds of labour that are directly or indirectly involved in making a commodity”: says Marshall, “together with the abstinences or rather the waiting required for saving the capital used in making it: all these efforts and sacrifices together will be called the real cost of production of the commodity. The sums of money that have to be paid for these efforts and sacrifices will be called either its money cost of production, or, for shortness, its expenses of production.”
Thus the money cost of production is the amounts of money the firm actually pays or contracts to pay to purchase the productive services needed to produce a given output. As a general statement it is true, but it is not exact. It is so because the firm may use some productive services which it does not buy, such as the unpaid services of the owner of a firm used in management. In order to know the full cost of production it is necessary to add to payments made or contracted the imputed value of unpaid services used in production.
Money cost of production is in fact private money cost of production—the cost and the only cost which the firm takes into account in decision-making This cost is to be distinguished from social cost of production—the cost to society of producing a given output.
Determinants of private money cost of production are (i) the physical quantities of actual resources or services used in production and (ii) the prices which the firm pays for or imputes to these resources. It is this private money cost which will matter to the firm and it is this which will enter directly into the analysis of firm’s behaviour.
Social cost of production is used in two senses: (i) The cost to society of producing a given output is the value of the output foregone. It is the opportunity cost concept. (ii) Social cost may be expressed in terms of real cost of producing a given output, i.e., in terms of the amount of pain or unpleasantness or real human sacrifice spent in production.
For our purposes here it is the private money cost of production that is relevant. Social cost is of immense importance in welfare economics. Private money cost of production takes into consideration only explicit costs, i.e., outlays made by the firm that we usually think of as its expenses. They consist of explicit payments for resources bought outright or hired by the firm. Implicit costs of production are those of self-owned, self-employed resources. They are frequently overlooked in computing the expenses of the firm.
We now turn to analyse the relations between changes in the costs of a firm and changes in its output. This relationship is generally given the name of cost function which is determined by the production function of a firm and the prices it pays for its inputs. Like the production function, cost function can also take different forms. We concentrated on two types of production function, here we consider two types of cost function the short-run cost function and the long-run cost function. We shall examine these cost functions under the separate heads: (1) the traditional analysis and (2) the modern analysis.
(1) Traditional Theory of Costs
Costs of production of the firm change as it varies its output per unit of time. So a distinction is made between the time period called the short-run and the long-run.
The short-run is a short time period that some inputs of the firm are fixed in amount. The firm can vary its output by varying the amounts of other inputs. The fixed inputs are generally called the fixed factors, while the variable inputs are known as variable factors. Land and buildings, top management, plant and equipment are fixed factors, while labour and raw materials are variable factors.
The firm can increase or decrease its output in the short period by varying the aggregate amount of variable factors it uses. In other words, the firm, by varying the proportion between fixed and variable factors, can increase or decrease its output.
Corresponding to fixed factors and variable factors, the cost of production the firm in the short period is also divisible into two categories—fixed costs and variable costs.
Fixed Costs or Supplementary Costs
These are those costs which in aggregate are absolutely invariant in the short period. Even if output becomes zero, the whole of the aggregate fixed costs would be incurred. Fixed costs are also called overhead costs or supplementary costs or indirect costs.
Variable Costs or Prime Costs
These are costs which in the aggregate vary with output. These costs are added as a result of any increase of output above zero. These costs are also called direct or prime costs.
Fixed costs are incurred over fixed factors. They include depreciation of plant, interest cost on investment and salaries of permanent managerial staff. Variable costs are costs of variable factors, such as wages and material costs. “But the categories are not necessarily fully congruent, and there may be some fixed-factor costs which are variable and some variable-factor costs which are fixed. The distinction between fixed costs and variable costs is, therefore, an independent one.”
In the traditional theory of the firm total costs are divided into two groups: total fixed costs and total variance costs. Thus,
TC = TFC + TVC
where, TC = total costs
TFC = total fixed costs
TVC = total variable costs
The fixed costs include:
(a) salaries of administrative staff,
(b) depreciation (wear and tear) of machinery,
(c) expenses for building depreciation and repairs,
(d) expenses for land maintenance and depreciation.
The variable costs include:
(a) the raw materials,
(b) the cost of direct labour,
(c) the running expenses of fixed capital, such as fuel, ordinary repairs and routine maintenance.
Total cost, that is, the total amount that it costs the firm to produce increases in output is shown in fig.
It is clear from the figure that (a) there is some positive fixed cost at zero level of output. So the total cost curve has a positive origin on the vertical axis and begins from point A. (b) It is also clear from the graph that total cost curve slopes continually upward to the right with increase in output. (c) The third property of short-run total cost curve is that it increases at varying rates in response to increase in output. It first increases at a decreasing rate and then begins to increase at an increasing rate as output goes on increasing. This corresponds to the behaviour of the law of variable proportions.
Total Fixed Cost
In the short period the firm does not have time to vary the quantities of fixed resources used, total fixed cost will therefore remain at a constant level regardless of the output produced, as we given in fig.
The total fixed cost curve is parallel to the quantity axis and lies above it by the amount of total fixed costs.
Total Variable Cost
Total variable cost stands at a different footing. It rises as the firm’s output increases. It is so because larger output needs larger quantities of variable resources. It means larger expenditure on variable factors.
Total variable cost contains all the variations to which total cost is subject. In the traditional theory of the firm, total variable cost has broadly an inverse-S shape. It reflects the law of variable proportions. It has been presented in fig.
In the initial stage of the operation of the law of variable proportions, as more of the variable factor is employed with the given amount of the fixed factor, the productivity of the variable factor increases. When the optima combination of the fixed and variable factors is reached, productivity of the variable decreases.
As a result, the total variable cost curve for output increases in the range of increasing returns will be concave downward. In the region of diminishing returns for variable factor, the total variable cost curve is concave upward. When the output level of the reaches its maximum, still larger quantities of variable factor will cause no increase in output at all and the total variable cost curve will turn straight up.