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Cost Concepts

Last updated date: 09th Apr 2024
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The supply of a firm is determined by its costs. Now, supply and demands both indicate the price. Therefore, to determine the process of price and the forces for supply, one must unearth the nature of costs. The cost concept is an important chapter in economics, thus, both traditional and modern theories play a significant role in this study.

Cost concept is important, especially when it comes to financial decision making for your business. The study of the cost concept in accounting provides the base for understanding pricing. On the professional level, it helps managers in taking correct decisions like the concept of fixed cost, the concept of variable cost, price quotation, and others.  

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Accounting and Economic Costs

Accounting costs are expenses that are caused by form production. Therefore, all the payments that are made by a company to its suppliers and other clients come under the accounting costs. Accounting costs are also known as explicit costs. These include rent, utility bills, interest payments, etc. These costs are actually direct costs that are associated with the business. Accounting costs are accounted for each expense made and then recorded in ledgers or accounting software.

Economic costs are usually used for comparing two separate courses of action. It helps in the evaluation process of a particular action for a business. The costs are calculated based on the accounting costs and also subtracting implicit costs. Now, the calculation of implicit costs is analyzed based on the current resources and their cost estimation. Also, the impact on the business from these resources is taken into account. 

Outlay and Opportunity Costs

Outlay cost is incurred when a strategy is executed or is needed to acquire an asset. This is an important part of the cost concept. Outlay costs can also be paid to the vendors for the requirement of goods like services and inventory. These are actually concrete expenses incurred for achieving specific goals. Outlay costs are easily recognizable and measurable due to the payment done to outside vendors. However, in the case of opportunity costs, they are not actually incurred and directed to the outside parties by a company.

Coming to the opportunity costs, it represents the potential benefits missed out by an individual, investor, or even a company when choosing a better option over another. The idea of opportunity costs is a pivotal factor in the cost concept and classification. As per the studies of economics, opportunity costs can be easily overlooked if you are not careful. For this reason, you need to learn more about the cost concept in accounting. Most of the financial reports do not show opportunity costs, thus, business owners use this concept to make proper decisions. 

Direct and Indirect Costs

When it comes to the cost concept in accounting, learning these two variables can be of great help. Direct costs are simple expenses of a company that can be connected to specific cost objects. These can include anything from the costs of projects, departments, labour, equipment, raw materials, and so on. Most of the direct materials and labour constitute direct costs. In the study of cost concept and classification, direct cost varies. For example, smartphone hardware is a direct cost because the production is dependent on other units as well. 

Looking into the indirect costs, they often extend beyond the expenses that are incurred when creating a product including the costs required for maintenance and running business operations. After computing the direct costs, most of the overhead costs are leftover. Some of the clear examples are materials and supplies required by a company for everyday operations. These items may contribute as a whole from a business perspective but are not assigned when it comes to the creation of a service. To stay away from complications, it is good to make yourself more knowledgeable about the various aspects of cost concept and classification.

Fixed and Variable Costs

There are different measures of costs in a cost theory. These are the concept of fixed cost and the concept of variable cost. When it comes to the cost concept in accounting, determining these two variables is crucial. Remember, fixed costs do not vary based on production. For example, the rent paid for a facility. 

On the contrary, variable costs keep changing based on the quantity of production. The wages that are paid to the workers in a company are a form of variable costs. This is because the number of workers may need to increase if there is a hike in the production line. Producing more goods means the requirement for more costs. However, the costs vary based on the amount of work done by each worker.

  • Fixed costs demand the fixed expenditure of funds without considering the level of output like interest on loans, rents, depreciation, and others.

  • Variable costs are based on the function of output in the production line, including wages and costs of raw materials. 

Therefore, the total sum of fixed and variable costs determines a company's overall costs. 

The economic cost concept will only help you gain a better insight into the company's financial future and plan the business operations accordingly.

FAQs on Cost Concepts

Q1. Explain the Concept of Cost-Benefit Analysis.

Ans: The cost-benefit analysis is a process used by businesses for evaluating various decisions. The analyst or company sums the total benefits of a particular situation before subtracting the costs incurred when taking action. As per the cost concept, this will help in building models for assigning a dollar value, especially on intangible items, including costs and benefits associated with living conditions in a particular city. Prudent managers often use this method or concept for evaluating the potential costs and revenues generated from a project.

Q2. Define the Cost Concept.

Ans: The economic cost concept definition says that it is a framework to understand how companies and individuals allocate various resources in a way so that costs are kept low, and the benefits reaped are high. There are different types of cost concepts considered by a firm that is relevant in various situations. For example, getting on with a manufacturing plant for producing goods requires an outlay of money, and once the amount has been spent, it is no longer available for other goods.

Q3. Differentiate the Concept of Fixed Cost and the Concept of Variable Cost.

Ans: The costs required by a company for producing goods or providing services are known as variable costs. Depending on the production volume, a company's variable costs keep changing (increasing and decreasing). Fixed costs are expenses that do not vary depending on the volume of production. Therefore, fixed costs remain unchanged, and thus, a company cannot stay away from it. Some of the common examples include rent and lease payments, insurance, salaries, and others. If the fixed costs are higher, a company has to look for ways through which more revenues can be earned. For this, it needs to produce or provide more to balance or outnumber the fixed costs.