The following points highlight the eight main types of cost. The types are: 1. Money Cost 2. Real Cost 3. Opportunity Cost 4. Direct Cost and Indirect Cost 5. Incremental Costs and Sunk Costs 6. Replacement Costs and Historical Costs 7. Fixed Costs and Variable Costs 8. Short Run Costs and Long Run Costs.
Type # 1. Money Cost:
Money cost is that type of cost which is expressed or calculated in monetary terms. It is the cost concept based on an accountant’s point of view. It is the cost in which the expenses are included, namely, price of raw materials, wages of labour, interest on capital, rent on land, salaries of managers and the normal profit of entrepreneur. Money cost is called accounting cost of production. Money cost consists of three elements in it.
(i) Explicit Costs:
These costs consist of all the payments made on the basis of contract to various factors of production employed by a firm, namely, factor prices, prices of raw materials, rent, wages, interest, salaries, depreciation of plant and machinery and selling cost incurred during a given period of time. The record of such costs is maintained by the accountant.
(ii) Implicit Costs:
These costs are invisible costs of production. The payment made to the owned factors of production is included in these costs. Interest on owned capital, wages to owned labour, salary to owned managers, owned building, furniture and other infrastructures of the owner of the firm are part and parcel of implicit costs. The calculation of implicit cost is not an easy task.
(iii) Normal Profit:
It is also a part of money cost. It is the minimum remuneration which a firm should get in order to remain in an industry. It is over and above the explicit and implicit cost of an individual firm. It is motivational factors for a firm to keep the production continue.
A business manager should take into consideration all these three parts of money cost because they affect his business decisions. Explicit costs can easily be calculated as their record is maintained by the accountant in a business firm while the calculation of implicit cost is difficult.
Hence, money cost can be calculated by the following formula:
Money Cost = Explicit Cost + Implicit Cost + Normal Profit
Type # 2. Real Cost:
This type of cost is calculated by a sociologist. He is concerned with pains, sacrifices and efforts made by the society in the production of a commodity. According to Professor Alfred Marshall, all the physical and mental labour in the production activity directly and indirectly involved, the pains and sacrifices made by the owner of capital in accumulation of capital are included in real cost.
Water pollution, air pollution, noise pollution, industrial diseases, pressure on transport facilities, emergence of dirty colonies, prostitution and gambling are the vices which are caused by the growth and development of industries in any country.
All these are causing social cost. Shri Sunder Lal Bahugna and Megha Patkar have also opposed the Narmada Project because of high social cost in the form of ecological imbalance, displacement and rehabilitation of the affected people and adverse impact on socio-cultural life in the area.
The real or social cost can be calculated from the following formula:
Real Cost = Pains + Sacrifices + Efforts + Inconveniences + Ill Effects
Real cost is also called social cost. It is based on the sacrifices and pains taken by the society on the production of a commodity.
The concept of real cost or social cost has been criticised on the following grounds:
(i) The cost is based on sacrifices and pains of the society which is related with the persons concerned and psychology of the people. It is not measureable on account of subjectivity and psychology of the people.
(ii) It is not a practical concept of cost. The remuneration of an unskilled labour should be high because of more pains and sacrifices made by him but an actor gets high remuneration.
Type # 3. Opportunity Cost:
According to an economist point of view there is also a concept of cost known as opportunity cost. Modern economists have propounded this concept. It is also called alternative cost, transfer income and transfer cost. It is economic cost of production of a commodity. Economics deals with unlimited wants and limited or scarce means which have alternative uses.
Hence, every economic decision involves a choice between alternative uses. According to opportunity cost production of each commodity involves the cost in the form of sacrifice in the sense that a commodity is not produced because of alternative uses and scarce means in the economy. For example, X commodity is produced and production of commodity Y forgone.
Hence, the cost of production of X is the commodity Y foregone. The alternative forgone is the opportunity cost of alternative chosen. Professor Benham has rightly pointed out that the opportunity cost of any commodity is the second best alternate by which another production of a commodity from the same means was possible.
The concept of opportunity cost can be explained with the help of production possibility curve as given below:
The diagram shows sugarcane on OX-axis and rice on OY- axis. If a farmer decides to grow OS of sugarcane he has to forgo RP units of rice. Hence opportunity cost of growing OS of sugarcane is RP of rice which the farmer might have grown instead.
Opportunity cost is also called transfer earnings or transfer price. It is the minimum payment to be paid to a factor of production to keep it in the present use otherwise it has gone in another alternative.
Professor A.C. Pigou has given an example of a maid servant that she has been paid for her services and the remuneration is a part and parcel of national income. But as soon as she is married by his master she is not paid any remuneration and her services are not included while calculating the national income. Thus, the opportunity earning of a housewife is zero and the opportunity cost is the cost of next best alternative.
Uses and Importance of Opportunity Cost:
The concept of opportunity cost has importance and uses in the study of economic analysis as given below:
(i) Allocation of Inputs in Competitive Uses:
Production inputs are scarce and they have alternative uses. When the factors of production are demanded for various uses then they will go to those alternatives where they will get high rate of remuneration and leave these where they are getting low rate of remuneration. Such transfer of resources goes on till the demand price of all inputs in all the uses is equalised.
(ii) Determination of Rent:
According to modern theory of rent, surplus r the opportunity cost is called rent and it is calculated by the formula given below-
Rent = Actual Earning – Opportunity Cost
Limitations to Opportunity Cost:
Opportunity cost has been criticised by the opponents of the concept.
It has the following limitations:
(i) The concept does not apply on specific factors of production. A specific factor is that which has no alternative use. It means its opportunity cost is zero.
(ii) The concept is based on the assumption that factors of production have perfect mobility. But in actual practice we see that the mobility of factors or production is also affected by non-economic factors, namely, environment, language, caste, religion, etc.
(iii) The concept is also based on the assumption of perfect competition. This assumption is imaginary and unrealistic one.
(iv) The concept of opportunity cost is based on the assumption that all the units of a factor of production are homogeneous which is also not correct. For example, labour can be classified into skilled, unskilled and semiskilled.
Type # 4. Direct Cost and Indirect Cost:
Direct cost is concerned with the production of a commodity. It is incurred directly on the factors of production. Any expenditure incurred on raw material, wages, fuel, etc. Such cost can easily be identified and it is directly concerned with the process of production. For example, in the production of commodity X the direct cost can be calculated by taking into consideration the salaries of all the employees, cost of raw material, energy charges, etc.
Indirect costs are those costs which are not concerned directly with the production of a commodity. Such costs consist selling cost, office overheads, rent of the building, depreciation of the machines, etc. The allocation of these costs should be done judiciously on all the departments, processes or goods. Thus indirect cost can be calculated by deducting production cost of goods and services from the total cost.
Indirect Cost = Total Cost — Direct Cost
On the basis of the analysis of direct and indirect costs a business manager can take the decision regarding the contraction and expansion of any production activity, working of any department or process.
Type # 5. Incremental Costs and Sunk Costs:
When a business firm changes its business activities or nature of its business, then the incremental costs are incurred by the firms. It is the cost due to change in the total cost due to change in the level of business activity.
For example, a business firm purchases new machinery in place of old machinery or a new product is included in the process or production and all such changes increases the total cost of production of that firm then it is called incremental costs. The difference between the changed total cost and initial total cost (before such change) is incremental cost.
It is calculated on the basis of the following formula:
Incremental Cost = Changed Total Cost – Initial Total Cost
Sunk costs are those costs which are not affected by the changes in the level of business activity or nature of business of a business firm. These costs remain unchanged. Depreciation is an example of such costs. Such costs are also known as bad debt costs. When investment is made in a sick unit it is a bad debt because the investment made by the business manager may be recovered or may not be recovered. When such business firm is auctioned and whatever receivables they are included in the sunk cost.
Both incremental and sunk costs are important when the various alternatives are evaluated by the business manager while taking the business decisions. The incremental costs differ from one alternate to another while sunk costs do not change.
Type # 6. Replacement Costs and Historical Costs:
When an old machine is replaced with a new machine the cost incurred in such replacement is called replacement cost. It is also called substitution cost. It is important for such business firm where projects are replaced and production process is changed.
Historical cost is that type of cost which is based on the purchase price of machinery initially. This cost is based on the point of view of an accountant because an accountant will show machine in his balance sheet at the original cost rather than the present cost prevailing in the market or market cost of the machine.
Replacement cost plays an important role in business decision-making because it affects the total cost of a business firm.
Type # 7. Fixed Costs and Variable Costs:
Fixed costs are those costs which are fixed whether production is being carried on or there is no production at all. These costs are short run costs wherein they remain fixed from zero production to the maximum possible production of a business firm. These costs are borne by the firm. These costs are called supplementary costs, general costs, indirect costs and overhead costs. Rent of building, land tax, insurance premium, depreciation, salaries to managers, interest on permanent or fixed capital, etc., are examples of such costs.
Variable costs are those costs which are directly related to production of a firm. They vary with the production. When production is not carried on such costs will not arise. Cost of raw materials, direct wages, expenses on fuel, etc., are the examples of such costs. These costs depend upon the volume of output.
Type # 8. Short Run Costs and Long Run Costs:
Short run costs are those costs which are concerned with the short run production of a firm. They are of two types, namely, fixed costs and variable costs.
Long run costs are those costs which are concerned with the long run process of production. In the long run all the factors of production are variable and even the scale of production can be changed. All the costs during long run are variable costs.