Table of contents
Cost, in economics, business management and accounting, means the expression in currency or other numerical value of the value of goods and services used in the production or purchase of a good or service. It can be determined on the basis of internal evaluations of the economic entity that holds it or in economic transactions with third economies.
The cost of a good expresses the value of the factors used to produce it. There can be a cost of production in the strict sense, as well as a total cost that also includes the costs of sale and distribution, general costs, promotion costs, taxes and other general charges. The cost of the asset is therefore distinct from the price, which instead represents the market value of the asset, that is, the value at which it is sold to third parties. The determination of the cost can take place through numerous modalities and taking into account several variables, depending on the specific purpose of determining said economic value.
In microeconomics the following types of cost are distinguished:
- fixed costs (FC): costs that in the short term do not change when production varies;
- variable costs (VC): costs that in the short period change to vary of the production;
- total costs (TC): sum of the fixed costs and variable costs;
- marginal costs (MC): report the cost of an additional unit of production;
- medium costs (AC, average costs or ATC, average total costs): report the cost of a single unit of production.
The fixed costs are costs that do not vary proportionally to the increase of the volume of the production. The behavior of such costs is therefore, in the short period, independent from the levels of production. The adjective fixed does not indicate therefore the invariability in the time but the lack of relation of cause effect between the variation of the cost and that one of the output levels. Typical examples of costs fixed of the sums due to title of lease, the salary of the dependent workers, the assurances.
The semivariable costs are costs whose behavior is in part influenced from the levels of the production: a quota of the cost is introduced however also in absence of production while the other quota has reason to be and only varies in function of the levels of output. Examples of semivariable costs are the electric energy, some costs of maintenance, costs of logistics.
Variable or incremental costs are costs directly influenced from the levels of the production. This type of costs does not exist in absence of production and varies to vary the levels of the production. Main example of variable costs are the raw materials.
Cost-of-production theory of value
The cost-of-production theory of value states that the price of an object or condition is determined by the sum of the cost of the resources that went into making it. The cost can comprise any of the factors of production (including labor, capital, or land) and taxation. Technology can be viewed either as a form of fixed capital (e.g. an industrial plant) or circulating capital (e.g. intermediate goods).
Production theory and utility theory interact to produce the theory of supply and demand, which determine prices in a competitive market. In a perfectly competitive market, it concludes that the price demanded by consumers is the same supplied by producers. That results in economic equilibrium.
In the mathematical model for the cost of production, the short-run total cost is equal to fixed cost plus total variable cost. The fixed cost refers to the cost that is incurred regardless of how much the firm produces. The variable cost is a function of the quantity of an object being produced. The cost function can be used to characterize production through the duality theory in economics, developed mainly by Ronald Shephard (1953, 1970) and other scholars (Sickles & Zelenyuk, 2019, ch.2).
Accounting cost is the recorded cost of an activity. An accounting cost is recorded in the ledgers of a business, so the cost appears in an entity’s financial statements. If an accounting cost has not yet been consumed and is equal to or greater than the capitalization limit of a business, the cost is recorded in the balance sheet. If an accounting cost has been consumed, the cost is recorded in the income statement. If cash has been expended in association with an accounting cost, the related cash outflow appears in the statement of cash flows. A dividend has no accounting cost, since it is a distribution of earnings to investors.
Cost accounting is helpful because it can identify where a company is spending its money, how much it earns, and where money is being lost. Cost accounting aims to report, analyze, and lead to the improvement of internal cost controls and efficiency. Even though companies cannot use cost accounting figures in their financial statements or for tax purposes, they are crucial for internal controls.
The scope of an accounting cost can change, depending on the situation. For example, a manager wants to know the accounting cost of a product. If this information is needed for a short-term pricing decision, only the variable costs associated with the product need to be included in the accounting cost. However, if the information is needed to set a long-term price that will cover the company’s overhead costs, the scope of the accounting cost will be broadened to include an allocation of fixed costs.
Economists use the term opportunity cost to indicate what one must give up to obtain what he or she desires. In simple terms, opportunity cost is the benefit not received as a result of not selecting the next best option. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. In short, opportunity cost is the value of the next best alternative. In many cases, it is reasonable to refer to the opportunity cost as the price.
Opportunity cost is closely related to the idea of time constraints. One can do only one thing at a time, which means that, inevitably, one is always giving up other things. The opportunity cost of any activity is the value of the next-best alternative thing one may have done instead. Opportunity cost depends only on the value of the next-best alternative.
Opportunity cost measures cost by what we forgo in exchange. Sometimes we can measure opportunity cost in money, but it is often useful to consider time as well, or to measure it in terms of the actual resources that we must forfeit.
Opportunity costs can tell when not to do something as well as when to do something. Opportunity costs are unavoidable constraints on behavior because one has to decide what’s best and give up the next-best alternative.
Identifying opportunity cost
In many cases, it is reasonable to refer to the opportunity cost as the price. If your cousin buys a new bicycle for $300, then $300 measures the amount of “other consumption” that he has forsaken. For practical purposes, there may be no special need to identify the specific alternative product or products that he could have bought with that $300, but sometimes the price as measured in dollars may not accurately capture the true opportunity cost. This problem can loom especially large when costs of time are involved.
For example, consider a boss who decides that all employees will attend a two-day retreat to “build team spirit.” The out-of-pocket monetary cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room and board for all participants. However, an opportunity cost exists as well: during the two days of the retreat, none of the employees are doing any other work.
Attending college is another case where the opportunity cost exceeds the monetary cost. The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses. However, in addition, during the hours that you are attending class and studying, it is impossible to work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.