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The kind of cost concept to be used in a particular situation depends upon the business decisions to be made. They are:- 1. Actual Cost and Opportunity Cost 2. Incremental Costs and Sunk Costs 3. Past Cost and Future Costs 4. Short-Run and Long-Run Costs 5. Fixed and Variable Costs 6. Direct and Indirect Costs 7. Sunk, Shutdown, and Abandonment Costs.
Type # 1. Actual Cost and Opportunity Cost:
Actual costs mean the actual expenditure incurred for acquiring or producing a good or service. In some other alternative uses, opportunity cost can be defined as the revenue forgone by not making the best alternative use. The concept of opportunity cost is more important and useful to management in making a decision aWmong alternatives.
Imputed costs are the costs which are not actually incurred but would have been incurred in the absence of employment of self-owned factors. For example, in the case of an owner-manager, very often the cost of managerial functions is ignored.
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An imputed cost is a real cost even though it is not recorded in account books of a company and management must not ignore it in making business decisions.
Type # 2. Incremental Costs (Differential Costs) and Sunk Costs:
Incremental cost is the additional cost due to a change in the level or nature of business activity. The change may take several forms, e.g., adding a new product line, changing the channel of distribution, adding a new machine, replacing a machine by better machine, expanding to additional markets, etc. Thus, the question of incremental or differential cost would not arise when a business is to be set up afresh. It arises only when a change is contemplated in the existing business.
Sunk cost is one which is not affected or altered by a change in the level or nature of business activity. It will remain the same whatever the level of activity is. The most important example of sunk cost is the amortization of past expenses, e.g., depreciation.
The distinction between sunk cost and increment cost assumes importance in evaluating alternatives. Incremental costs will be different in the case of different alternatives. Hence incremental costs are relevant to the management in the analysis for decision making.
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Sunk cost, on the other hand, will remain the same irrespective of the alternative selected. Thus, it need not be considered by the management in evaluating the alternatives as it is common to all of them.
If the machine is hired, the expenses of installation, servicing and maintenance become the responsibility of the supplier of the machine. If the machine is purchased, the supplier will merely deliver the machine to the buyer.
Now let us analyze the differential costs of the two alternatives. If the machine is hired, the acquisition cost will be confined to the periodic payments of rent. But if the machine is purchased, the acquisition costs will be equal to the price of the machine.
Service and maintenance costs will occur only if the machine is purchased; if it is hired, the rent would cover those costs. The operating costs and the space occupancy costs will be the same irrespective of the decision to buy or rent the machine. Thus, the differential costs would be the acquisition costs and the service and maintenance costs as they would be different under the two alternatives.
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On the other hand, the operating costs and the space occupancy costs are sunk costs as they would be the same under both the alternatives. And for decision making, we have to compare only the differential costs while ignoring the sunk costs.
Whether a cost is sunk cost or a differential cost is a question of fact and can be determined only in the light of the circumstances of each individual case. Thus, a particular cost of item can be a sunk cost in one case and a differential cost in another.
Sometimes, differential costs are considered as synonymous with variable costs and sunk costs as synonymous with fixed costs. But this need not always be the case. For example, operating costs are variable but they are not differential costs. The price of the machine, on the other hand, is a differential cost, though it is also a fixed cost. Hence both the variable and the fixed costs must be scrutinized decision.
Type # 3. Past Cost and Future Costs:
Past costs are actual costs incurred in the past and are generally contained in the financial accounts. The measurement of past costs is essentially a record-keeping activity and an essentially passive function insofar as the management is concerned. These costs can merely be observed and evaluated in retrospect.
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If they are regarded as excessive, management can indulge in post-mortem, just to find out the factors responsible for the excessive costs, if any, without being able to do anything for reducing them.
Future costs are costs that are reasonably expected to be incurred in some future period or periods. Their actual incurrence is a forecast and their management is an estimate. Future costs are the only costs that matter for managerial decisions because they are the only costs subject to management control. Unlike past costs, they can be planned for and planned to be avoided. If the future costs are considered too high, the management can either plan to reduce them or find out ways and means to meet them.
The major managerial uses where future costs are relevant are as follows – cost control, projection of future profit and loss statements, appraisal of capital expenditure, introduction of new products, expansion programs, and pricing.
Type # 4. Short-Run and Long-Run Costs:
Short-run costs are costs that vary with output when fixed plant and capital equipment remain the same. Long-run costs are those which vary with the output when all input factors including plant and equipment vary.
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Short-run costs become relevant when a firm has to decide whether or not to produce more in the immediate future. In this case setting up of a new plant is ruled out and the firm has to manage with the given plant. Long-run costs become relevant when the firm has to decide whether to set up a new plant.
Long-run costs can help the businessman in planning the best scale of plant or the best size of the firm for his purposes. Thus, long-run costs can be helpful both in the initiation of new enterprises and the expansion of existing ones.
Type # 5. Fixed and Variable Costs:
Total costs can be divided into two components – fixed costs and variable costs. Fixed costs remain constant in total regardless of changes in volume up to a certain level of output. They will have to be incurred even when output is nil. There is an inverse relationship between volume and fixed costs per unit. Thus, total fixed costs do not change with a change in volume but vary per unit of volume inversely with volume.
If the total production increases, fixed costs per unit will go down and vice versa. Total variable costs vary in direct proportion to changes in volume. An increase in volume means a proportionate increase in the total variable costs and decrease in volume results in a proportionate decline in the total variable costs. There is a linear relationship between volume and total variable costs, but variable costs are constant per unit.
The distinction between fixed and variable costs, however, is not a watertight one. Cost may be fixed and variable in each different management decision. Again, it may be noted that the variability of costs is in relation to output and not to the time factor, though in the long run all costs tend to be variable. What is fixed at one level of output may become variable at another level of output.
Figure 3.1 represents relation between the output and total cost (i.e., fixed and variable cost). Fixed cost remains the same at all levels of output whereas the variable cost varies directly with the output.
Type # 6. Direct and Indirect Costs (Traceable and Common Costs):
A direct or traceable cost is one which can be identified easily and indisputably with a unit of operation (costing unit/cost centre). Common or indirect costs are those that are not traceable to any plant, department or operation, or to any individual final product. To take an example, the salary of a divisional manager, when division is a costing unit, will be a direct cost.
The monthly salary of the general manager, when one of the divisions is a costing unit, will be an indirect cost. The salary of the manager of the other division is neither a direct nor an indirect cost. Thus, whether a specific cost is direct or indirect depends upon the costing unit under consideration. The concepts of direct and indirect costs are meaningless without identification of the relevant costing unit.
Common Production Costs (Costs of Multiple Products):
In some manufacturing enterprises, two or more different products emerge from a single, common production process and a single raw material. A familiar example is the variety of petroleum products derived from the refining of crude oil. So also in a shoe factory, the same piece of leather may be used for men’s, women’s, and children’s shoes.
However, for managerial analysis, these costs need not be identified with individual products unless it is meaningful and useful to identify them.
Type # 7. Sunk, Shutdown, and Abandonment Costs:
A past cost resulting from a decision which can no more be revised is called a sunk cost. In other words, sunk cost is a cost once incurred but cannot be retrieved. It is usually associated with the commitment of funds to specialized equipment or other facilities not readily adaptable to present or future use, e.g., brewery plant in times of prohibition.
Shutdown costs may be defined as those costs which would be incurred in the event of suspension of the plant operation and which would be saved if the operations are continued. Examples of such costs are the costs of sheltering the plant and equipment and construction of sheds for storing exposed property. Further, additional expenses may have to be incurred when operations are restarted. For example, re-employment of workers may involve cost of recruitment and training.
Abandonment costs are the costs of retiring altogether a plant from service. Abandonment arises when there is a complete cessation of activities and creates a problem as to the disposal of assets; for example, the costs involved in the discontinuance of tram services in Bombay and Delhi.
These costs become important when management is faced with the alternative of either continuing the existing plant or suspending its operations or abandoning it altogether.
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