BUSINESS

ECONOMICS NOTES

BBA 1st Semester

Unit- 3 By- Ruba Nasim

Cost Concept: Various Cost Concepts

and Classification
According to the Chartered Institute of Management Accountants, cost is “the amount of expenditure (actual or
notional) incurred on or attributable to a specified thing or activity.” Similarly, according to Anthony and Wilsch
“cost is a measurement in monetary terms of the amount of resources used for some purposes.”

Cost has been defined by the Committee on Cost Terminology of the American Accounting Association as “the
foregoing, in monetary terms, incurred or potentially to be incurred in the realization of the objective of
management which may be manufacturing of a product or rendering of a service.”

From the above, it may be stated that cost means the total of all expenses incurred for a product or a service.
Thus, cost of an article means the actual outgoings or ascertained changes incurred in its production and sale
activities. In short, it is the amount of resources used up in exchange for some goods or services.

The so-called resources are expressed in terms of money or monetary units. What we stated above will not be a
meaningful one until the same is used with an adjective only, i.e. when it communicates the meaning for which it
is intended.

Thus, when we say Prime Cost or Works Cost or Fixed Cost etc., we want to explain a particular meaning which
is essential while computing, measuring or analyzing the various aspects of cost.

Classification of Cost

Classification of costs implies the process of grouping costs according to their common characteristics. A proper
classification of costs is absolutely necessary to mention the costs with cost centres. Usually, costs are classified
according to their nature, viz., material, labour, over-head, among others. An identical cost figure may be
classified in various ways according to the needs of the firms.

The above classification may be outlined as:

The classification of cost may be depicted as given:

1. According to Elements

Under the circumstances, costs are classified into three broad categories Material, Labour and Overhead. Now,
further subdivision may also be made for each of them. For example, Material may be subdivided into raw
materials, packing materials, consumable stores etc. This classification is very useful in order to ascertain the
total cost and its components. Same classification may also be made for labour and overhead.

2. According to Functions

The total costs are divided into different segments according to the purpose of the firm. That is why costs are
grouped as per the requirements of the firm in order to evaluate its functions properly. In short, the total costs
include all costs starting from cost of materials to the cost of packing the product.
It takes the cost of direct material, direct labour and chargeable expenses and all indirect expenses under the head
Manufacturing/Production cost.

At the same time, administration cost (i.e. relating to office and administration) and Selling and Distribution
expenses (i.e. relating to sales) are to be classified separately and to be added in order to find out the total cost of
the product. If these functional classifications are not made properly, true cost of the product cannot accurately
be ascertained.

3. According to Variability

Practically, costs are classified according to their behaviour relating to the change (increase or decrease) in their
volume of activity.

These costs as per volume may be subdivided into:

(i) Fixed Cost;

(ii) Variable Cost;

(iii) Semi-variable Cost

Fixed Costs are those which do not vary with the change in output, i.e., irrespective of the quantity of output
produced, it remains fixed (e.g., Salaries, Rent etc.) up to a certain limit. It is interesting to note that if more units
are product, fixed cost per unit will be reduced, and, if less units are produced, obviously, fixed cost per unit will
be increased.

Variable Costs, on the other hand, are those which vary proportionately with the volume of output. So the cost
per unit will remain fixed irrespective of the quantity produced. That is, there is no direct effect on the cost per
unit if there is a change in the volume of output (e.g. price of raw material, labour etc.,).

On the contrary, semi-variable costs are those which are partly fixed and partly variable (e.g. Repairs of
building).

4. According to Controllability

Costs may, again, be subdivided into two broad categories according to the performance done by any member of
the firm.

They are:

(i) Controllable Costs; and

(ii) Uncontrollable Costs.

Controllable Costs are those costs which may be influenced by the decision taken by a specified member of the
administration of the firm or, it may be stated, that the costs which at least partly depend on the management and
is controllable by them, e.g. all direct costs, direct material, direct labour and chargeable expenses (components
of Prime Cost) are controllable by lower management level and is done accordingly.

Uncontrollable Costs are those which are not influenced by the actions taken by any specific member of the
management. For example, fixed costs, viz., rent of building, payment for salaries etc.

5. According to Normality
Under this condition, costs are classified according to the normal needs for a given level of output for a normal
level of activity produced for such output.

They are divided into:

(i) Normal Costs; and

(ii) Abnormal Costs.

Normal Costs are those costs which are normally required for a normal production at a given level of output and
which is a part of production.

Abnormal Costs, on the other hand, are those costs which are not normally required for a given level of output to
be produced normally, or which is not a part of cost of production.

6. According to Time

Costs may also be classified according to the time element in it. Accordingly, costs are classified into:

(i) Historical Costs; and

(ii) Predetermined Costs.

Historical Costs are those costs which are taken into consideration after they have been incurred. This is possible
particularly when the production of a particular unit of output has already been made. They have only historical
value and cannot assist in controlling costs.

Predetermined Costs, on the other hand, are the estimated costs. Such costs are computed in advanced on the
basis of past experience and records. Needless to say here that it becomes standard cost if it is determined on
scientific basis. When such standard costs are compared with the actual costs, the reasons of variance will come
out which will help the management to take proper steps for reconciliation.

7. According to Traceability

Costs can be identified with a particular product, process, department etc. They are divided into:

(i) Direct (Traceable) Costs; and

(ii) Indirect (Non-Traceable) Costs.

Direct/Traceable Costs are those costs which can directly be traced or allocated to a product, i.e. it includes all
traceable costs, viz., all expenses relating to cost of raw materials, labour and other service utilised which can be
traced easily.

Indirect/Non-Traceable Costs are those costs which cannot directly be traced or allocated to a product, i.e. it
includes all non-traceable costs, e.g. salary of store-keepers, general administrative expenses, i.e. which cannot
properly be allocated directly to a product.

8. According to Planning and Control

Costs may also be classified into:

(i) Budgeted Costs; and

(ii) Standard Costs.

Budgeted Costs refer to the expected cost of manufacture computed on the basis of information available in
advance of actual production or purchase. Practically, budgeted costs include standard costs, both are
predetermined costs and their amount may coincide but their objectives are different.

Standard Costs, on the other hand, is a predetermination of what actual costs should be under projected
conditions serving as a basis of cost control and, as a measure of product efficiency, when ultimately aligned
actual cost. It supplies a medium by which the effectiveness of current results can be measured and the
responsibility for derivations can be placed.

Standard Costs are predetermined for each element, viz., material, labour and overhead.

Standard Costs include

(i) The cost per unit is determined to make an estimated total output for the future period for:

(a) Material;

(b) Labour; and

(c) Overhead.

(ii) The cost must depend on the past experience and experiments and specification of the technical staff.

(iii) The cost must be expressed in terms of rupees.

9. According to Management Decisions

Under this, costs may also be classified as:

(a) Marginal Cost: Marginal Cost is the cost for producing additional unit or units by segregation of fixed costs
(i.e., cost of capacity) from variable cost (i.e. cost of production) which helps to know the profitability.
Moreover, we know, in order to increase the production, certain expenses (fixed) may not increase at all, only
some expenses relating to materials,labour and variable expenses are increased. Thus, the total cost so increased
by the production of one unit or more is the cost of marginal unit and the cost is known as marginal cost or
incremental cost.

(b) Differential Cost: Differential Cost is that portion of the cost of a function attributable to and identifiable
with an added feature, i.e. the change in costs as a result of change in the level of activity or method of
production.

(c) Opportunity Cost: It is the prospective change in cost following the adoption of an alternative machine,
process, raw materials, specification or operation. In other words, it is the maximum possible alternative earnings
which might have been earned if the existing capacity had been changed to some other alternative way.

(d) Replacement Cost: It is the cost, at current prices, in a particular locality or market area, of replacing an item
of property or a group of assets.

(e) Implied Cost: It is the cost used to indicate the presence of arbitrary or subjective elements of product cost
having more than usual significance. It is also called notional cost, e.g., interest on capital —although no interest
is paid. This is particularly useful while decisions are taken regarding alternative capital investment projects.
(f) Sunk Cost: It is the past cost arising out of a decision which cannot be revised now, and associated with
specialised equipment’s or other facilities not readily adaptable to present or future purposes. Such cost is often
regarded as constituting a minor factor in decisions affecting the future.

Cost Output Relationship in Short Run &

Long Run Cost Curves
Cost Output Relationship in Short Run

Time element plays an important role in price determination of a firm. During short
period two types of factors are employed. One is fixed factor while others are
variable factors of production. Fixed factor of production remains constant while
with the increase in production, we can change variable inputs only because time
is short in which all the factors cannot be varied.

Raw material, semi-finished material, unskilled labour, energy, etc., are variable
inputs which can be changed during short run. Machines, capital, infrastructure,
salaries of managers and technical experts are included in fixed inputs. During
short period an individual firm can change variable factors of production according
to requirements of production while fixed factors of production cannot be
changed.

Cost-Output Relationship in the Short Run:

(i) Average Fixed Cost Output

The greater the output, the lesser the fixed cost per unit, i.e., the average fixed
cost. The reason is that total fixed costs remain the same and do not change with
a change in output.

The relationship between output and fixed cost is a universal one for all types of
business.

Thus, average fixed cost falls continuously as output rises. The reason why total
fixed costs remain the same and the average fixed cost falls is that certain factors
are indivisible. Indivisibility means that if a smaller output is to be produced, the
factor cannot be used in a smaller quantity. It is to be used as a whole.

(ii) Average Variable Cost and Output

The average variable costs will first fall and then rise as more and more units are
produced in a given plant. This is so because as we add more units of variable
factors in a fixed plant, the efficiency of the inputs first increases and then
decreases. In fact, the variable factors tend to produce somewhat more efficiently
near a firm’s optimum output than at very low levels of output.
But once the optimum capacity is reached, any further increase in output will
undoubtedly increase average variable cost quite sharply. Greater output can be
obtained but at much greater average variable cost. For example, if more and
more workers are appointed. It may ultimately lead to overcrowding and bad
organization. Moreover, workers may have to be paid higher wages for overtime
work.

(iii) Average Total Cost and Output

Average total costs, more commonly known as average costs, will decline first
and then rise upward. The significant point to note here is that the turning point in
the case of average cost comes a little later in the case of average variable cost.

Average cost consists of average fixed cost plus average variable cost. As we
have seen, average fixed cost continues to fall with an increase in output while
average variable cost first declines and then rises. So long as average variable
cost declines the average total cost will also decline. But after a point, the
average variable cost will rise. Here, if the rise in variable cost is less than the
drop in fixed cost, the average total cost will still continue to decline.

It is only when the rise in average variable cost is more than the drop in average
fixed cost that the average total cost will show a rise. Thus, there will be a stage
where the average variable cost may have started rising yet the average total cost
is still declining because the rise in average variable cost is less than the drop in
average fixed cost. The net effect being a decline in average cost.

The least cost-output level is the level where the average total cost is the
minimum and not the average variable cost. In fact, at the least cost-output level,
the average variable cost will be more than its minimum (average variable cost).
The least cost- output level is also the optimum output level. It may not be the
maximum output level. A firm may decide to produce more than the least cost-
output level.

(iv) Short-Run Output Cost Curves

The cost-output relationships can also be shown through the use of graphs. It will
be seen that the average fixed cost curve (AFC curve) falls as output rises from
lower levels to higher levels. The shape of the average fixed cost curve, therefore,
is a rectangular hyperbola.

However, the average variable cost curve (AVC curve) starts rising earlier than the
ATC curve. Further, the least cost level of output corresponds to the point L T on
the ATC curve and not to the point LV which lies on the AVC curve.
Another important point to be noted is that in Fig. the marginal cost curve (MC
curve) intersects both the AVC curve and ATC curve at their minimum points. This
is very simple to explain. If marginal cost (MC) is less than the average cost (AC),
it will pull AC down. If the MC is greater than AC, it will pull AC up. If the MC is
equal to AC, it will neither pull AC up nor down. Hence, MC curve tends to
intersect the AC curve at its lowest point.

Similar is the position about the average variable cost curve. It will not make any
difference whether MC is going up or down. L T is the lowest point of total cost and
LV is the lowest point of variable cost.

The inter-relationships among AVC, ATC, and AFC can be summed up as follows:

 If both AFC and AVC fall, ATC will also fall.

 If AFC falls but AVC rises

(a) ATC will fall where the drop in AFC is more than the rise in AVC.

(b) ATC will not fall where the drop in AFC is equal to the rise in AVC.

(c) ATC will rise where the drop in AFC is less than the rise in AVC.

Cost Output Relationship in Long Run

The long run is a period long enough to make all costs variable including such
costs as are fixed in the short run. In the short run, variations in output are
possible only within the range permitted by the existing fixed plant and equipment.
But in the long run, the entrepreneur has before him a number of alternatives
which includes the construction of various kinds and sizes of plants.

Thus, there are no fixed costs since the firm has sufficient time to fully adapt its
plant. And all costs become variable. In view of this, the long-run costs will refer
to the costs of producing different levels of output by changes in the size of plant
or scale of production. The long-run cost-output relationship is shown graphically
by the long- run cost curve—a curve showing how costs will change when the
scale of production is changed.

The concept of long-run costs can be further explained with the help of an
illustration. Suppose that at a particular time, a firm operates under average total
cost curve U2 and produces OM. Now it is desired to produce ON. If the firm
continues under the old scale, its average cost curve will be NT. If the scale of
firm is altered, the new cost curve will be U 3. The average cost of producing ON
will then be NA.

NA is less than NT. So the new scale is preferable to the old one and should be
adopted. In the long run, the average cost of producing ON output is NA. This may
be called as the long-run cost of producing ON output. It may be noted here that
we shall call NA as the long-run cost only so long as the U 3 scale is in the planning
stage and has not actually been adopted. The moment the scale is installed, the
NA cost will be the short-run cost of producing ON output.
To draw a long-run cost curve, we have to start with a number of short-run average
cost curves (SAC curves), each such curve representing a particular scale or size
of the plant, including the optimum scale. One can now draw the long-run cost
curve which tangential to the entire family of SAC curves, that is, it touches each
SAC curve at one point.

Economics and Diseconomies of Scale

Economies of Scale

Economies of scale are defined as the cost advantages that an organization can achieve by expanding its
production in the long run.
In other words, these are the advantages of large scale production of the organization. The cost advantages are
achieved in the form of lower average costs per unit.

It is a long term concept. Economies of scale are achieved when there is an increase in the sales of an
organization. As a result, the savings of the organization increases, which further enables the organization to
obtain raw materials in bulk. This helps the organization to enjoy discounts. These benefits are called as
economies of scale.

The economies of scale are divided in to internal economies and external economies discussed as follows:

1. Internal Economies

Refer to real economies which arise from the expansion of the plant size of the organization. These economies
arise from the growth of the organization itself.

The examples of internal economies of scale are as follows:

A. Technical economies of scale

Occur when organizations invest in the expensive and advanced technology. This helps in lowering and
controlling the costs of production of organizations. These economies are enjoyed because of the technical
efficiency gained by the organizations. The advanced technology enables an organization to produce a large
number of goods in short time. Thus, production costs per unit falls leading to economies of scale.

B. Marketing economies of scale

Occur when large organizations spread their marketing budget over the large output. The marketing economies of
scale are achieved in case of bulk buying, branding, and advertising. For instance, large organizations enjoy
benefits on advertising costs as they cover larger audience. On the other hand, small organizations pay equal
advertising expenses as large organizations, but do not enjoy such benefits on advertising costs.

C. Financial economies of scale

Take place when large organizations borrow money at lower rate of interest. These organizations have good
credibility in the market. Generally, banks prefer to grant loans to those organizations that have strong foothold
in the market and have good repaying capacity.

D. Managerial economies of scale

Occur when large organizations employ specialized workers for performing different tasks. These workers are
experts in their fields and use their knowledge and experience to maximize the profits of the organization. For
instance, in an organization, accounts and research department are created and managed by experienced
individuals, SO that all costs and profits of the organization can be estimated properly.

E. Commercial economies

Refer to economies in which organizations enjoy benefits of buying raw materials and selling of finished goods
at lower cost. Large organizations buy raw materials in bulk; therefore, enjoy benefits in transportation charges,
easy credit from banks, and prompt delivery of products to customers.

2. External economies
Occur outside the organization. These economies occur within the industries which benefit organizations. When
an industry expands, organizations may benefit from better transportation network, infrastructure, and other
facilities. This helps in decreasing the cost of an organization.

Some of the examples of external economies of scale are discussed as follows:

A. Economies of Concentration

Refer to economies that arise from the availability of skilled labor, better credit, and transportation facilities.

B. Economies of Information

Imply advantages that are derived from publication related to trade and business. The central research institutions
are the source of information for organizations.

C. Economies of Disintegration

Refer to the economies that arise when organizations split their processes into different processes.

Diseconomies of Scale

Diseconomies of scale occur when the long run average costs of the organization increases. It may happen when
an organization grows excessively large. In other words, the diseconomies of scale cause larger organizations to
produce goods and services at increased costs.

1. Internal diseconomies of scale

Refer to diseconomies that raise the cost of production of an organization. The main factors that influence the
cost of production of an organization include the lack of decision, supervision, and technical difficulties.

2. External diseconomies of scale

Refer to diseconomies that limit the expansion of an organization or industry. The factors that act as restraint to
expansion include increased cost of production, scarcity of raw materials, and low supply of skilled laborer.

There are a number of causes for diseconomies of scale

Some of the causes which lead to diseconomies of scale are as follows:

(i) Poor Communication

Act as a major reason for diseconomies of scale. If production goals and objectives of an organization are not
properly communicated to employees within the organization, it may lead to overproduction or production. This
may lead to diseconomies of scale.

Apart from this, if the communication process of the organization is not strong then the employees would not get
adequate feedback. As a result, there would be less face-to-face interaction among employees- thus the
production process would be affected.

(ii) Lack of Motivation

Leads to fall in productivity levels. In case of a large organization, workers may feel isolated and are less
appreciated for their work, thus their motivation diminishes. Due to poor communication network, it is harder for
employers to interact with the employees and build a sense of belongingness. This leads to fall in the productivity
levels of output owing to lack of motivation. This further leads to increase in costs of the organization.

(iii) Loss of Control

Acts as the main problem of large organizations. Monitoring and controlling the work of every employee in a
large organization becomes impossible and costly. It is harder to make out that all the employees of an
organization are working towards the same goal. It becomes difficult for managers to supervise the sub-ordinates
in large organizations.

(iv) Cannibalization

Implies a situation when an organization faces competition from its own product. A small organization faces
competition from products of other organizations, whereas sometimes large organizations find that their own
products are competing with each other.

Cost Control and Cost Reduction

One of the major concern of the enterprise is to maximize the profit, which is possible only through decreasing
the cost of production. For this purpose, two efficient tools are used by the management, i.e. cost control and cost
reduction. Cost Control is a technique which provides the necessary information to the management that actual
costs are aligned with the budgeted costs or not. Conversely, Cost Reduction is a technique used to save the unit
cost of the product without compromising its quality.

While cost control, regulates the action to keep the cost elements within the set limits, cost reduction refers to the
actual permanent reduction in the unit cost. At this juncture, it would be desirable to know the difference between
cost control and cost reduction.

Cost Control

Cost Control is a process which focuses on controlling the total cost through competitive analysis. It is a practice
which works to maintain the actual cost in agreement with the established norms. It ensures that the cost incurred
on an operation should not go beyond the pre-determined cost.

Cost Control involves a chain of functions, which starts from preparation of the budget in relation to the
operation, thereafter evaluating the actual performance, next is to compute the variances between the actual cost
& the budgeted cost and further, to find out the reasons for the same, finally to implement the necessary actions
for correcting discrepancies.

The major techniques used in cost control are standard costing and budgetary control. It is a continuous process
as it helps in analysing the causes for variances which control wastage of material, any embezzlement and so on.

Cost Reduction

Cost Reduction is a process, aims at lowering the unit cost of a product manufactured or service rendered without
affecting its quality by using new and improved methods and techniques. It ascertains substitute ways to reduce
the cost of a unit. It ensures savings in per unit cost and maximization of profits of the organization.

Cost Reduction aims at cutting off the unnecessary expenses which occur during the production, storing, selling
and distribution of the product. To identify cost reduction, the following are the major elements:

 Savings in per unit cost.

 No compromise with the quality of the product.
 Savings are non-volatile in nature.

Tools of cost reduction are Quality operation and research, Improvement in product design, Job Evaluation &
merit rating, variety reduction, etc.

Key Differences between Cost Control and Cost Reduction

The following are the major differences between Cost Control and Cost Reduction:

1. The activity of maintaining cost as per the established norms is known as cost control. The activity of
decreasing per unit cost by applying new methods of production in such a way that it does not affect
the quality of the product is known as cost reduction.
2. Cost Control focuses on decreasing the total cost while cost reduction focuses on decreasing per unit
cost of a product.
3. Cost Control is temporary in nature. Unlike Cost Reduction which is permanent.
4. The process of cost control is completed when the specified target is achieved. Conversely, the process
of cost reduction has no visible end as it is a continuous process that targets for eliminating wasteful
expenses.
5. Cost Control does not guarantee quality maintenance. However, 100% quality maintenance is assured
in case of cost reduction.
6. Cost Control is a preventive function as it ascertains the cost before its occurrence. Cost Reduction is a
corrective action.

The two techniques cost control and cost reduction are used by many manufacturing concerns to diminish the
cost of production. Cost Reduction has a larger scope than cost control as cost reduction is applicable for all the
industries, but cost control is applicable only to the industries where pre- optimisation of the cost which is not yet
incurred is possible. Cost Control works as a road map for the organisation to incur costs as per the set standard.
On the other hand, cost reduction challenges the established standards by decreasing the costs and increasing the
profit.

Indifference Curves
An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction
and utility. Each point on an indifference curve indicates that a consumer is indifferent between the two and all
points give him the same utility.

Indifference Map

An Indifference Map is a set of Indifference Curves. It depicts the complete picture of a consumer’s preferences.
The following diagram showing an indifference map consisting of three curves:
We know that a consumer is indifferent among the combinations lying on the same indifference curve. However,
it is important to note that he prefers the combinations on the higher indifference curves to those on the lower
ones.

This is because a higher indifference curve implies a higher level of satisfaction. Therefore, all combinations on
IC1 offer the same satisfaction, but all combinations on IC2 give greater satisfaction than those on IC1.

Properties of an Indifference Curve or IC

Here are the properties of an indifference curve:

1. An IC slopes downwards to the right

This slope signifies that when the quantity of one commodity in combination is increased, the amount of the
other commodity reduces. This is essential for the level of satisfaction to remain the same on an indifference
curve.

2. An IC is always convex to the origin

From our discussion above, we understand that as Peter substitutes clothing for food, he is willing to part with
less and less of clothing. This is the diminishing marginal rate of substitution. The rate gives a convex shape to
the indifference curve. However, there are two extreme scenarios:

 Two commodities are perfect substitutes for each other – In this case, the indifference curve is a
straight line, where MRS is constant.
 Two goods are perfect complementary goods – An example of such goods would be gasoline and
water in a car. In such cases, the IC will be L-shaped and convex to the origin.
3. Indifference curves never intersect each other

Two ICs will never intersect each other. Also, they need not be parallel to each other either. Look at the
following diagram:

Fig shows tow ICs intersecting each other at point A. Since A and B lie on IC1, the give the same satisfaction
level. Similarly, A and C give the same satisfaction level, as they lie on IC2. Therefore, we can imply that B and
C offer the same level of satisfaction, which is logically absurd. Hence, no tow ICs can touch or intersect each
other.

4. A higher IC indicates a higher level of satisfaction as compared to a lower IC

A higher IC means that a consumer prefers more goods than not.

5. An IC does not touch the axis

This is not possible because of our assumption that a consumer considers different combinations of two
commodities and wants both of them. If the curve touches either of the axes, then it means that he is satisfied
with only one commodity and does not want the other, which is contrary to our assumption.