Introduction to Cost Concepts

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MICROECONOMICS

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SLMinto.png Introduction


Let us understand that economic efficiency of any firm operating in the market is determined by the ability of the firm to minimize its costs and maximize its profits. WE also need to understand that cost is a function of Output. As the output of a firm changes the cost pattern of a firm also undergoes change. Study of cost and its behavior as production pattern changes in the short run and the long run, gives useful insight into issues like:

  • How the cost pattern of a firm changes in case a firm is operating in the short run?
  • How the cost changes along with the change in the scale of production?
  • How the cost of operation can be minimized?
  • What is the optimum level of operation of any firm (at optimum level the cost of the firm is generally reaches its minimum level)?


In this module various cost concepts are being explained in detail.




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After reading this chapter, you are expected to learn about:


  • Understand and Identify various cost concepts that are associated or related to various stages of business operations and market situations.




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Various Cost Concepts


  • Opportunity Cost
  • Money Cost and Real Cost
  • Accounting Cost and Economic Cost
  • Private Cost and Social Cost
  • Fixed Cost, Variable Cost, Average Cost and Marginal Cost


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Opportunity Cost


The resources of any firm operating in the market are limited and investment options are many. The firm therefore has to decide or select only those investment opportunities/options which provide the firm with the best return or best income on investment. This means that if a firm can invest money/ resources only in one investment option then the firm will select that investment option which promises best return on investment to the firm. In other words while doing so the firm gives up/rejects the next best option for investing the funds. The opportunity cost of a company is thus this income/ return which the firm could have earned on the next best investment alternative.

This can also be understood by a simple example - Let us assume that an individual has two job offers in hand. One job offer is promising him a salary of Rs. 30, 000 per month while the other job offer will ensure salary of Rs. 25, 000 per month. If the job profile and other factors related to the job offers are more or less same then it can be easily expected that the individual will select the job offer which will provide him with higher salary that is salary of Rs. 30, 000 per month. Thus, in this case, the opportunity cost is the return involved in the next best alternative i.e; Salary of Rs. 25, 000 in the next best job offer.

Concept of opportunity cost is closely related to the concept of Economic profit or Economic Rent. A firm earns or makes Economic profit only when besides covering various costs of operation, a firm is also able to earn more than its opportunity cost (or its possible earnings under the next best investment alternative). Opportunity Cost is also termed as Implicit Cost.

Economic Profit is thus earned only when following is true for the Firm:

Income of a Firm > Various Costs of Operations + Opportunity Cost

OR Economic Profit = Earnings or Revenue of Firm - Ecomomic Costs. Here Economic Cost is various expenses of the business plus the opportunity cost

Some simple examples of Opportunity Cost and Economic Profit are discussed in following three brief case studies.



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Case Study

Understanding Opportunity Cost and Economic Profit



  • CASE 1: Mr. Subodh has two job opportunities in hand. First job opportunity can help him to earn Rs. 20, 000 per month and the second opportunity can get him Rs. 17, 000 per month. Under normal circumstances Mr. Subodh will opt for the job opportunity which can help him to earn Rs. 20, 000 per month. In the process Subodh rejects the other job opportunity which can help him to earn Rs. 17, 000 per month. In this case Opportunity cost of Mr. Subodh is Rs. 17, 000 per month as this is the income which the can be earn from the next best alternative.

In above case Economic Profit or Economic Rent is Rs. 3, 000. This has been obtained after deducting Rs. 17, 000 (opportunity cost) from Rs. 20, 000


  • CASE 2: Miss. Kanta can invest her money under the following two investment options (a) Investment in Shares. Such Investment (investment made in the shares) is likely to provide Miss Kanta with return of 20% per annum. (b) Investment in Government Bonds which can provide Miss. Kanta with return of 10% per annum on the amount invested in the bonds. If it is assumed that risk involved in investing in the stocks/shares is very moderate then Miss. Kanta will most likely invest in shares (on account of higher return on investment in shares in comparison to the bonds. In this case the opportunity cost is the return of 10% per annum, which can be earned by Miss Kanta in the next best investment alternative


  • CASE 3: A Company 'Venus Automobiles limited', involved in the production of two and three wheeler automobiles, is thinking of diversifying its business operations. There are two diversification options the company can choose between. One option is that the company can open company owned and opearted automobile service stations and the other option is that company can enter into the business of producing automobile spare parts. If it is expected that option of opening the company owned and operated service stations will generate an additional profit (post charging various expenses) of Rs. 9 million for the company while the option of production of spare parts will generate profit of Rs. 10 million for the company. As expected profit after charging various expenses is higher in the automobile spare part business, the company will choose to diversify in the spare part business. Thus, in this case, the opportunity cost will be the profit of Rs. 9 million, which the company is expected to earn in the nest best alternative that is starting company owned and operated service station business

For the above case, let us assume, that the company actually earns accounting profit of Rs. 9.8 million on its business of producing and marketing automobile spare parts. The Economic Profit or Economic Rent then will be the amount of Rs. 0.8 million obtained after deducting Rs. 9 million (opportunity cost) from Rs. 9.8 million (profit earned)


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Money Cost and Real Cost


Money Cost of production is the actual monetary expenditure made by company in the production process. Money cost thus includes all the business expenses which involve outlay of money to support business operations. For example the monetary expenditure on purchase of raw material, payment of wages and salaries, payment of rent and other charges of business etc can be termed as Money Cost.

Real Cost of production or business operation on the other hand includes all such expenses/costs of business which may or may not involve actual monetary expenditure. For example if owner of a business venture uses his personal land and building for running the business venture and he/she does not charge any rent for the same then such head will not be considered/included while computing the Money Cost but this head will be part of Real Cost computation. Here the cost involved is the Opportunity Cost of the land and building. If the promoter of the company had not used the land and building for the business venture then the land and building could have been used elsewhere for some other enture and could have generated some income for the promoter. This income/rent which could have been earned under the next best investment option is the opportunity cost which needs to be considered while calculating the Real Cost for the firm.



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Case Study

Understanding Money Cost and Real Cost



  • A company 'Arizona Textiles limited' is producing cotton textiles. Various business expenses on per annum basis are as follows: Power Charges - Rs. 5, 00, 00, Cost of Yarn - Rs. 10, 00, 000, Salaries and Wages - Rs. 8, 00, 000, Various Direct and Indirect Overhead Expenses - Rs. 10, 00, 000. The company is not paying any rent for the building from where it is operating as the building is owned by the promoter of the company. If this building had been rented out by the promoter in the market then it could have earned a rent of Rs. 2,00, 000 per annum.

In the above case Money Cost is Rs. 33, 00, 000, obtained after adding the following: Power Charges, Cost of Yarn, Salaries and Wages, Various Direct and Indirect Overhead Expenses.

On the other hand Real Cost is Rs. 35, 00, 000, which has been obtained after adding the following: Money Cost plus the rent which the building belonging to the promoter could have earned in outside market


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Accounting Cost and Economic Cost


Accounting Cost includes all such business expenses that are recorded in the book of accounts of a business firm as acceptable business expenses. Such expenses include expenses like Cost of Raw Material, Wages and Salaries, Various Direct and Indirect business Overheads, Depreciation, Taxes etc. When such business expenses or accounting expenses are deducted from the Sales income of any firm the accounting profit is obtained. Such Accounting/Business expenses or costs are also termed as Explicit Costs.

  • Accounting Cost: Various allowed business expenses. Such as Cost of Raw Material, Salaries and Wages, Electricity Bill, Telephone Charges, Various Administrative Expenses, Selling and Distribution Expenses, Production Overhead Expenses, Other Indirect Overhead Expenses etc.
  • Accounting Profit = Sales Income - Accounting Cost

Economic Cost on the other hand includes all the accounting expenses as well as the Opportunity cost of a business firm. Economic Cost and Economic Profit is thus calculated as follows:

  • Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost
  • Economic Profit = Total Revenues - (Accounting Cost + Opportunity Cost)
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Private Cost and Social Cost


The actual expenses of individuals/ firms which are borne or paid out by the individual or a firm can be termed as Private Cost. Thus for a business firm this may include expenses like Cost of Raw Material, Salaries and Wages, Rent, Various Overhead Expenses etc.

On the other hand Private Cost for an individual will be his or her private expenses such as expense on food, rent of house, expenses on clothing, expenses on travel, expenses on entertainment etc.

Social Cost on the other hand includes Private Cost and also such costs which are not borne by the firm but by the society at large. For example the cost of damage or disutility caused by the operations of a firm in an economy may not be borne by the firm in question but it impacts the society at large and thus such cost is added to the Private Cost to find the Social Cost of producing the product. Such Cost (that is cost not borne or paid out by the firm) is also known as External Cost. Another example of external cost can be the cost of providing the basic infrastructure facilities like good roads, sewage system or network, street lights etc. Cost of such facilities is not borne by a business firm even though the firm is benefits from such facilities. Such costs (External Costs) are thus added to the Private Cost to find the Social Cost of producing a product or good.

Above can be understood by following example: If a Tannery firm (A firm processing animal skins) releases its toxic wastes in the river flowing nearby its factory premises then this act of the Tannery firm results in water pollution and environmental damage. The Cost of such damage/loss (also known as External Cost) is added to the private costs of the tannery firm to get fair idea of Social cost involved in the production of the product in question.

Social Cost of an individual will include his private cost and the cost of damage on account of his actions (that has resulted in doing harm/damage to the environment/society at large).



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Case Study

Understanding Private Cost and Social Cost



  • A Company, 'Giga Dyes and Chemicals limited' is producing chemical dyes that are being used in various indudtrial activities. Various production expenses are as follows: Cost of Raw Material - 5, 00, 000, Salaries and Wages - Rs. 9, 00, 000, Various Direct and Indirect Overhead Expenses - Rs. 12, 00, 000, Selling and Distribution Expenses - Rs. 4, 00, 000. The by-product of the production process of chemical dyes produced by Giga Dye are certain toxic chemicals which are being released by 'Giga Dye and Chemicals' directly into a river flowing near the Dye manufacturing plant. This is polluting the river and killing the organic life thriving in as well as near the river. The cost of loss to the environment caused by Giga is estimated to be Rs. 20, 00, 000 per annum.

In the above case, the Private Cost for 'Giga Dye and Chemicals Limited is Rs. 30,00, 000. This is sum total of various business expenses of Giga such as Cost of Raw Material, Salaries and Wages Overhead Expenses and Selling and Distribution Expenses.

On the other hand Social Cost is Rs. 50, 00, 000. This includes the cost of damage to the environment caused by the activities of the firm. Thus Social cost is Private Cost + External cost. In this case this is = 30, 00, 000 + 20, 00, 000

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Fixed Cost, Variable Cost, Average Cost and Marginal Cost


Fixed Cost is that cost which does not change (that is either goes up or goes down) irrespective of whether the firm is operating or not. For example on account of Strike on account of Lockout in Maruti-Suzuki’s Manesar plant the production process stands still. Even when the plant is not operating the Firm still has to bear such expenses which are indirect in nature. For Example Rent of the factory premises, Wages of administrative employees etc. In other Fixed cost is not related direct production/manufacturing expenses.

Variable Cost on the Other hand is directly proportional to the production operations. As the size of production at any business grows, along with that grow the variable expenses. As the name suggests, the variable expenses vary with the business operations. When the firm is not operating on account of Strike/Lockout etc, then the variable cost of the firm is Zero

Average Cost is the cost that is obtained after dividing Total Cost with the number of units produced.

  • Total Cost = Fixed Cost + Variable Cost
  • Average Cost = Total Cost / Units of Good produced

Marginal Cost is the change in the Total cost when an additional unit of good is produced. In other words Marginal Cost is difference between total Cost of producing ‘N + 1’ units of good and ‘N’ units of good.

  • Marginal Cost = TC (n+1) - TC(n)

Following table can help in understanding the cost concepts like Total Cost (TC), Average Cost (AC), Marginal Cost (MC) etc


Understanding Fixed, Variable, Total, Average and Marginal Cost
Number of Units Produced Fixed Cost Variable Cost Total Cost Average Cost Marginal Cost
1 10 5 15 15 15
2 10 10 20 10 5
3 10 17 27 9 7
4 10 30 40 10 13
5 10 45 55 11 15


In the above table, it is clearly visible that Fixed cost (which is 10) remains same irrespective of the number of units of the good being produced. On the other hand the Variable Cost is increasing as the number of units of good being produced is increasing. Thus, Variable Cost is going up from 5 to 10 and from 10 to 17 etc as the number of units of good being produced is increasing. Again it can be seen from the above table that Total Cost is the sum total of Fixed Cost and Variable Cost. Thus Total Cost is 15 for the first unit (where 10 is Fixed Cost and 5 is Variable Cost). Again for producing 2 units, the Total Cost is 20 (where 10 is Fixed Cost and remaining 10 is the Variable Cost). Above Table also clearly indicates that the Average Cost is being obtained by dividing Total Cost with the number of units of good being produced. Thus for the first unit of good being produced it is 15. This value has been obtained by dividing Total Cost (15) with the number of units of good produced (1). Similarly, the Average Cost of producing two units is 10, which is obtained by dividing Total Cost (20) with number of units produced (2). On the other hand Marginal Cost is the change in the total cost when an additional unit of good is being produced. Thus for the first unit of good being produced, it is 15. This value is obtained by deducting from the Total Cost of producing 'One' unit of good (15) the Total Cost of producing 'Zero' units of good. For producing the second unit, the marginal cost is 5. This is obtained by deducting from the Total Cost of producing 'two' units of good (20) the Total Cost of producing 'one' unit of good (15)


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Summary of Cost Concepts

Various cost concepts help in understanding the business operations and cost involved in business operation of the firms better. For example opportunity cost is the return involved in the next best alternative. Social cost is the cost of damage caused by a business firm/individual to society at large. Private cost are the varied business expenses which a firm/individual has to bear on account of its business/personal operations pertaining to the business of the firm.

Points to Remember are as follows:

  • The opportunity cost of a company is thus this income/ return which the firm can earn on the next best investment alternative.
  • Money Cost of production is the actual monetary expenditure made by company in the production process. Money cost thus includes all the business expenses which involve outlay of money to support business operations.
  • Real Cost of production or business operation includes all such expenses/costs of business which may or may not involve actual monetary expenditure. Economic cost includes all the accounting expenses and the Opportunity cost or implicit cost of the business.
  • The actual expenses of individuals/ firms in the market can be termed as private cost. Thus for a business firm this may include expenses like Cost of raw material, salaries and Wages, Rent, Various overhead expenses etc. For an individual his/her private expenses can be expenses on food, rent of house, expenses on clothing, expenses on travel, expenses on entertainment etc can be considered as Private Costs.
  • Social Cost on the other hand includes the private costs of individuals and firms and also the cost of damage/disutility caused by the operations of individuals and the business firms. For example is a Tannery releases its toxic wastes in the river flowing nearby then such act results in water pollution and environmental damage. Such damage/loss/cost is added to the private costs to get fair idea of Social cost.
  • Fixed Cost: Fixed Cost is that cost which does not change (that is either goes up or goes down) irrespective of whether the firm is operating or not.
  • Variable Cost on the Other hand is directly proportional to the production operations. As the size of production at any business grows, along with that grow the variable expenses. As the name suggests, the variable expenses vary with the business operations. When the firm is not operating on account of Strike/Lockout etc, then the variable cost of the firm is Zero
  • Average Cost on the other hand is the cost that is obtained after dividing Total Cost with the number of units produced.
  • Marginal Cost is the change in the Total cost when an additional unit of good is produced. In other words Marginal Cost is difference between total Cost of producing ‘N + 1’ units of good and ‘N’ units of good.

Self Assessment Questions on Cost Concepts



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True or False Quiz

  • Explicit Cost is
    • Cost borne or paid out by a firm
      • True
    • Cost of loss or damage to the environment on account of activities of a firm
      • False
  • External Cost is
    • Cost of loss or damage to the environment on account of activities of a firm or cost of any such facility which a firm is enjoying but is not paying for
      • True
    • It is the Opportunity Cost of a Firm
      • False
  • Real Cost is
    • Monetary cost (that is paid out) of operations of a firm
      • False
    • Actual Paid Out Cost plus Implicit Cost of a Firm
      • True
      • False




SLMact.gif Activity
Attempt doing following:
  • Try to collect details of various household expenses which your family is incurring per month. Try and divide such expenses under Two heads - Fixed Expenses and the Variable Expenses
  • On basis of internet search make an estimation of Social Cost of Union Carbide Firm which was operating in Bhopal
  • Interact with the adults in your family to assess the opportunity cost of employment/work they are engaged in


For Attempting Quiz on Cost Concepts Click Here


SLMref.png Further Readings



  • Micronomics by Robert S. Pindyck, Daniel L. Rubinfeld and Prem L. Mehta, Pearson Publication
  • Modern Microeconomics by A. Koutsoyiannis, ELBS Publication
  • Managerial Economics by D.N. Dwivedi, Vikas Publication
  • Managerial Economics by Petersen and Lewis, Prentice-Hall Publication