What is meant by the Theory of Cost?
The determination of the price for a product or service is not easy. Several other factors govern it. The theory of cost definition states that the costs of a business highly determine its supply and spendings. The modern theory of cost in Economics looks into the concepts of cost, short-run total and average cost, long-run cost along with economy scales.
The cost function varies concerning factors such as operation scale, output size, price of production, and more. The theory of cost production needs to be understood in detail by economists to run their company and increase its profit and productivity. This article covers all you need to know about cost concepts.
Types of Costs
Accounting Costs / Explicit Costs: The cost of production including employee salaries, raw material cost, fuel costs, rent expenses and all the payments made to the suppliers from the accounting costs.
Economic Costs / Implicit Costs: According to the modern theory of cost in economics, the investment return amount of a businessman, the amount that could have been earned but not paid to an entrepreneur and monetary rewards for all estates owned by the businessman form the economic costs. These costs include accounting costs and the money also returned which the owner could have earned from elsewhere apart from the business.
Outlay Costs: These are the recorded account costs or actual expenditure spent on wages, rent, raw materials and more.
Opportunity Costs: These are the missed opportunity costs. They are not recorded in the account books but show the cost of sacrificed or rejected policies.
Direct / Traceable Costs: These costs are easily pointed out or identified expenditures such as manufacturing costs. Such costs cater to specific operations or goods.
Indirect / Non-Traceable Costs: These costs are not related directly or identifiable to any operation or service. Costs such as electric power or water supply are some examples because these expenses vary with output. They generally have a functional relationship with production.
Fixed Costs: Such costs do not vary with output and are fixed expenditure of the company. For example, taxes, rent, interests are all fixed costs as they do not vary within a constant capacity. Any company cannot avoid these costs.
Variable Costs: These costs vary with output and are known as a variable cost. For example, salaries of the employee, raw material costs all fall under variable costs. These directly depend on the fixed amount of resources.
Theory of Cost in Economics
The modern theory of cost in Economics also specifies economies of scale where an increased production decreases the cost per unit of production. The returns to scale first increase, then stabilize for some time and then decrease. Let's take a look at the different types of economies—
Technical: Technical economies include investment in machinery and more efficient capital equipment to increase production efficiency.
Effective Management: When an organization increases operation, they need a better division of labor into various sub-departments for efficient management.
Commercial: A large amount of components and raw materials is needed with increased production. Hence raw material costs decrease. The advertisement cost for a unit of production also falls, which increases.
Finance: With a raised Finance, any company becomes popular. Their banking securities increase and Finance is raised at a much lower cost.
Risk Management: As the firm becomes more diverse, risk-taking factors also increase.
Comparing Short Run and Long Run Costs
As per the theory of cost analysis, during the short run period, a company tries to increase its output by changing only the variable factors such as raw materials or labor. The fixed variables remain untouched. The long-run period is where the company can change any factor to obtain desirable outputs as per their interests. Ultimately all these factors result in cost.
Solved Examples
1. Draw a relationship between Total Cost, Total Fixed Cost and Total Variable Cost of a Business.
For any business,
Total Costs (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC).
2. What is the average fixed cost?
Average fixed cost is defined as the total fixed cost per unit of production. The total fixed cost divided by the number of units gives the average fixed cost.
Fun Facts
The average total cost is the sum of the average variable cost and average fixed cost.
Marginal cost can be calculated as the total change in cost upon a total change in output.
Electricity charges are neither fixed nor variable costs. Instead, they are semi-variable costs.
Stair Step variable cost remains constant for a fixed output. But when the output suddenly exceeds its limit, the cost immediately jumps to a new higher level. The graph of total variable cost v/s output looks exactly like a staircase for such cases.
According to the modern theory of cost in Economics, the positive slope in the long-run total cost average curve is due to diseconomies of scale.
FAQs on Theory of Cost: Key Concepts
1. What is meant by the theory of cost?
The theory of cost explains how the costs of producing goods or services change as a company increases or decreases its level of production. It studies various cost behaviors, such as fixed, variable, and total costs, to show how these impact business decisions. Understanding the theory of cost is crucial for firms to set prices, plan production, and maximize profits. The theory helps managers predict how costs change with output and allows for better budgeting and strategic planning. In summary, the theory of cost analyzes production expenses and provides insight for efficient resource allocation within an organization.
2. What are the 4 types of cost?
In economics and business, costs are often classified into four main types based on how they behave relative to output. These categories help managers make informed production and financial decisions. The four main types of costs are:
- Fixed Costs: Do not change with the level of production (e.g., rent, salaries).
- Variable Costs: Change proportionally with output (e.g., raw materials, direct labor).
- Total Costs: The sum of fixed and variable costs for a given level of production.
- Marginal Cost: The extra cost incurred by producing one additional unit.
3. What is costing theory?
Costing theory is a concept within economics and business that deals with different ways of assigning and analyzing the costs associated with producing goods or services. It encompasses various approaches, such as marginal costing, absorption costing, and standard costing, to determine how much it actually costs to produce a product. By applying costing theory, organizations can better monitor expenses, control budgets, and make informed pricing decisions. Ultimately, costing theory aids in efficient cost management and supports strategic planning for increased profitability.
4. What are the 7 types of cost?
Understanding the different types of costs is crucial in cost accounting and economics for managing resources and making decisions. The seven common types of costs are:
- Fixed Cost: Remains constant regardless of production volume.
- Variable Cost: Changes with the number of items produced.
- Total Cost: Sum of fixed and variable costs.
- Average Cost: Total cost divided by the number of units produced.
- Marginal Cost: Cost of producing one additional unit.
- Opportunity Cost: The next best alternative foregone.
- Sunk Cost: Expenses already incurred and unrecoverable.
5. Why is the theory of cost important in economics?
The theory of cost is important in economics because it helps businesses and policymakers understand how production costs change as output changes. This understanding is vital for determining pricing strategies, setting production levels, and ensuring profitability. By analyzing cost structures, organizations can identify opportunities for cost reduction and increased efficiency. The theory also aids in making decisions about resource allocation and investment. In essence, the theory of cost provides a foundation for optimizing business performance and economic growth.
6. What is the difference between fixed cost and variable cost?
Fixed costs and variable costs are two key components in cost theory, each behaving differently as production output changes. Fixed costs stay the same regardless of the level of production—examples include rent, salaries, or insurance. In contrast, variable costs change directly with production volume, such as raw materials or energy used in manufacturing. Recognizing the difference allows managers to predict expenses and plan more effectively, especially when considering changes in production output or scaling operations.
7. What is marginal cost, and why is it important?
Marginal cost is the additional cost incurred by producing one more unit of a product or service. It plays a vital role in decision-making because it helps determine the optimal level of production. If the selling price of a product is greater than its marginal cost, producing additional units can be profitable. Marginal cost is also essential for understanding economies of scale and for setting competitive prices. Monitoring marginal cost enables businesses to maximize profits while minimizing unnecessary expenses.
8. How do average cost and total cost relate to each other?
Average cost and total cost are both important concepts in cost analysis. Total cost refers to the entire expense incurred in producing a certain number of goods or services, including both fixed and variable costs. Average cost, on the other hand, is calculated by dividing the total cost by the number of units produced, giving the cost per unit. Understanding their relationship helps businesses evaluate production efficiency and set appropriate prices for their products.
9. What factors can cause costs to change in the theory of cost?
Costs can fluctuate due to a variety of internal and external factors. In the context of the theory of cost, the most common causes include:
- Changes in production volume: Higher output can spread fixed costs but may raise variable costs.
- Input prices: Increases or decreases in raw material costs directly impact total production costs.
- Technology: Improvements can lower per-unit costs by increasing efficiency.
- Economies of scale: Larger operations often result in cost savings per unit.
- Government policies: Taxes, subsidies, or regulations can affect overall costs.
10. What role does opportunity cost play in the theory of cost?
Opportunity cost is a key element of the theory of cost, representing the value of the next best alternative forgone when a resource is used for a specific purpose. In economic decision-making, understanding opportunity cost helps firms compare different options and allocate resources more efficiently. This concept ensures that the real cost of choosing one action over another—including non-monetary factors—is considered. Opportunity cost is crucial for maximizing economic profit and making informed business choices.
