Classification of Costs

Introduction
All business activities involve costs of some sort. These costs cannot be ignored. Better-cost management is therefore quite important in order to maximize profits of a firm. A firm that wants to maximize its profits should not focus only on maximizing revenues but also on minimizing costs. Depending on the purpose of study, costs can be classified into various types. Therefore, understanding various types of costs is of prime importance for managers.

Classifications (Types) of Costs

The types of costs that a firm considers relevant for decision making vary from situation to situation. The manner in which costs are classified is largely dependent on the purpose for which the cost data are being collected.

Accurate cost information is therefore very important to business managers.

Fixed Costs (FC)

Fixed costs are those costs, which do not vary with the changes in the output of a product. These are costs which do not vary with the number of items produced in the short term. They are associated with the existence of a firms plant and therefore, must be paid even if the firms level of output is zero.(These costs have to be paid whether the business is making any sales or not.) They are also known as Overhead costs.

Examples (FC)
Costs incurred as a result of payment of interest on borrowed capital Contractual rent for equipment or building Depreciation charges on equipment and buildings The salaries of top level management and key personnel ,etc.

Variable Costs (VC)

Variable costs are those costs that vary (change) with the level of output. They are often called Direct costs as they can be directly identified with a particular product. Examples: Payment for raw materials Charges for fuel and electricity Payment of wages and salaries of temporary staff Payment of sales commission, etc.

Total Costs (TC)

Total costs are fixed and variable costs combined.
TC=FC + VC

Direct Costs
Direct costs are those costs, which can be directly associated /related to the production of a given/particular product. The direct cost of each product those costs that can be directly related to or identified with a particular product or department. For example, the direct costs for making sports shoes will be the raw materials and production labor needed to make them. It is clear that these costs can be related directly to the sports shoes. They are usually,

Variable costs, for example the material used to make a product, but remember sometimes they could be Fixed as well. An example of a Fixed direct cost would be a special machine needed for only one of the computer designs made by a computer company.

Indirect Costs
Indirect costs are those costs which cannot be directly related to a particular product. Examples include : Certain costs like stationery, Office and administrative expenses, depreciation of plant and buildings Other such expenses that cannot be separated and directly attributed to individual units of production.

 They are often termed as OVERHEADS or OVERHEAD COSTS. They are usually Fixed costs, for example the rent of the factory, but sometimes they could be variable as well. An example of variable indirect costs would be the maintenance cost of machinery. This would increase with the number of units produced, but could not directly related to any one unit of output made.

Average cost (AC)

It is the total cost of production divided by total output. For example, If the total cost of producing computers of a particular type by a computer company in one year was $ 350,000 and 700 units were made, then the Average cost per unit would be : Total cost/ Output = $ 350,000/700 = $ 500 per computer.

Marginal Cost (MC)

MC can be defined as the change in the TC of a firm as a result of change in one unit of output. In other words marginal costs are the extra costs a business will incur by producing one more unit of output. These would be the extra direct costs of making an additional unit. For example, the MC of one additional computer would be the cost of the components and the labour cost of assembling it. These costs are important in short-term decision making of the firm to determine the output at which profits can be maximized.

Incremental Costs
It is the total additional cost that a firm has to incur as a result of implementing a major managerial decision. For example ,for a leading truck manufacturer, the marginal cost of making one additional truck in a defined production period would be the labour, components ,and energy costs which are directly associated for making that extra truck. Incremental costs in this case would be adding a new product line or hiring an in-house legal staff. Thus ,it can be said that marginal cost is a subset of incremental cost.

Sunk Costs
Sunk costs are those costs which are incurred in the past or that have to be incurred in the future as a result of a contractual agreement. The cost of inventory and future rent charges for a warehouse that have to be incurred as a part of a lease agreement are good examples of sunk costs. In any case they have to be borne by the firm.

Opportunity Costs
It is the costs of any decision measured in terms of the next best alternative, which has been sacrificed. Hence, it is also called as alternative cost. In simple terms, the opportunity cost is the opportunity lost with respect to making income because of scarcity of resources. For example, at the firm level, a manager planning to hire a personal assistant may have to give up the idea of having an additional junior accountant in the accounts department. In order to maximize the value of the firm ,a manager must view costs from this perspective.

Implicit Costs
In most business decisions, the total opportunity costs cannot be accounted for fully because of our inability to include implicit costs. Implicit costs are the value of forgone opportunities that does not involve a physical cash payment. For example, an entrepreneur who manages his firm has to forgo his salary, which he could have earned if he had worked elsewhere. Though implicit costs are not included in books of accounts, they do play an important role in a decision making process.

Explicit Costs
Explicit costs can be defined as the costs which involves actual payment to other parties. These costs are also equally important while making business decisions.

Economic Costs
Extending the concept of opportunity costs discussed above, total costs for a business should ideally include a normal payment for all the factors of production, including managerial and entrepreneurial skills and capital provided by the owners of the firm. A normal return to management or capital is the minimum payment necessary to keep those resources from shifting to other firms.

 Hence, economic cost refers to the costs involved for all the factors of production including those purchased from outside as well as those owned by the firm. For example, an entrepreneur has $100,000,which is presently invested in a fixed deposit in a bank earning an interest of $10,000 per annum. Hence, the money earned as interest ($10,000) would be treated as Economic cost.

Cost Functions
A cost function determines the behaviour of costs with the change in output. The cost output relationship gains importance when the firm has to allocate resources and determine a price for the output. The cost function can be a schedule, graph or a mathematical relationship showing the minimum achievable cost for producing various quantities of output. It indicates the functional relationship between total cost and total output.

 If C represents total cost and Q represents the level of output, then the cost function is represented as C = f(Q). Cost functions are derived functions. They are derived from the production functions, which identify the efficient methods of production available at any particular point of time. The cost function can be derived from the input cost combinations of the firm.

 The same level of output can be produced with the help of different combinations of inputs and different cost combinations. The cost function determines the least cost combinations for the production of different levels of output.

 As no output is possible without input, increase in the input costs (eg.raw materials) will lead to an increase in the total cost of production. The input costs are also dependent on the demand and supply situation and on the government regulations( if any depending on the nature of the product).

 On the other hand, the output is under the control of the firm and the magnitude of the output determines the total cost of production. The output has a special role to play as a determinant of the cost function. The change in output level determines the rate of change in the total cost of production.

Short run Cost Functions

It helps in determining the relationship between output and costs in the short run. The level of output where the average total cost is minimum is known as the short run capacity of a firm. If the firms output level is below the short run capacity of a firm , it is under-utilizing its plant and machinery. However, if the output is more than its short run capacity, it is due to over-utilization of the firms plant and machinery.

Long run Cost Functions

It can be defined as a sufficiently long period that allows the firm to adjust factors of production to meet market demand.

In the long run ,the firm chooses the combination of inputs that minimizes the cost of production at a desired level of output.

 The firm identifies the plant size, types and sizes of equipment, labour skills and raw materials that on combination give the maximum output at the lowest cost ,considering the technology available and the production methods used. As the inputs are chosen for producing a desired level of output, all the inputs in the long run are variable.