Cost Concepts:
1. Opportunity Cost and Actual Cost:
Opportunity cost refers to the loss of earnings due to opportunities foregone due to scarcity of
resources. If resources were unlimited, there would be no need to forego any income-yielding
opportunity and, therefore, there would be no opportunity cost. Resources are scarce but have
alternative uses with different returns. Incomes maximizing resource owners put their scarce
resources to their most productive use and forego the income expected from the second best
use of the resources.
Therefore, the opportunity cost may be defined as the expected returns from the second best
use of the resources foregone due to the scarcity of resources. The opportunity cost it is also
called Alternative cost. For example, suppose that a person has a sum of Rs. 1, 00,000 for
which he has only two alternative uses. He can buy either a printing machine or, alternatively,
a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and from
the lathe, Rs. 15,000.
If he is a profit maximizing investor, he would invest his money in printing machine and
forego the expected income from the lathe. The opportunity cost of his income from printing
machine is the expected income from the lathe, i.e., Rs. 15,000.
The opportunity cost arises because of the foregone opportunities. Thus, the opportunity cost
of using resources in printing business, the best alternative is the expected return from the
lathe, the second best alternative. In assessing the alternative cost, both explicit and implicit
costs are taken into account.
Associated with the concept of opportunity cost is the concept of economic rent or economic
profit. For example, economic rent of the printing machine is the excess of its earning over
the income expected from the lathe (i.e., Rs. 20,000 – Rs. 15,000 = Rs. 5,000).
The implication of this concept for business man is that investing in printing machine is
preferable so long as its economic rent is greater than zero. Also, if firms know the economic
rent of the various alternative uses of their resources, it will be helpful in the choice of the
best investment avenue.
On the other hand, actual costs are those which are actually incurred by the firm in payment
for labour, material, plant, building, machinery, equipment, travelling and transport,
advertisement, etc. The total money expenses, recorded in the books of accounts are, for all
practical purposes, the actual costs. Actual cost comes under the accounting concept.
2. Business Costs and Full Costs:
, Business costs include all the expenses which are incurred to carry our business. The concept
of business costs is similar to the actual or real costs. Business costs “include all the
payments and contractual obligations made by the firm together with the book cost of
depreciation on plant and equipment”.
These cost concepts are used for calculating business profits and losses and for filling returns
for income-tax and also for other legal purposes.
Full costs, on the contrary, include business costs, opportunity cost and normal profit. The
opportunity cost includes the expected earnings from the second best use of the resources, or
the market rate of interest on the total money capital, and also the value of entrepreneur’s
own services which are not charged for in the current business.
Normal profit is a necessary minimum earning in addition to the opportunity cost, which a
firm must get to remain in its present occupation.
3. Explicit and Implicit or Imputed Costs:
Explicit costs refer to those which fall under actual or business costs entered in the books of
accounts. The payments for wages and salaries, materials, license fee, insurance premium,
depreciation charges are the examples of explicit costs. These costs involve cash payments
and are recorded in normal accounting practices.
In contrast with these costs, there are not certain other costs which do not take the form of
cash outlays, nor do they appear in the accounting system. Such costs are known as implicit
or imputed costs. Implicit costs may be defined as the earning expected from the second best
alternative use of resources. For instance, suppose an entrepreneur does not utilize his
services in his own business and works as a manager in some other firm on a salary basis.
If he starts his own business, he foregoes his salary as manager. This loss of salary is the
opportunity costs of income from his own business. This is an implicit cost of his own
business; implicit, because the entrepreneur suffers the loss, but does not charge it as the
explicit cost of his own business. Thus, implicit wages, rent and interest are the highest
wages, rents and interest which owner’s labour, building and capital can respectively earn
from their second best use.
Implicit costs are not taken into account while calculating the loss or gains of the business,
but they form an important consideration in whether or not a factor would remain in its
present occupation. The explicit and implicit costs together make the economic cost.
4. Out-of-Pocket and Book Costs:
Out-of-pocket costs means costs that involve current cash payments to outsiders while book
costs such as depreciation do not require current cash payments. In concept, this distinction is
quite different from traceability and also from variability with output. Not all out-of- pocket
costs are variable, e.g., salaries paid to the administrative staff.
1. Opportunity Cost and Actual Cost:
Opportunity cost refers to the loss of earnings due to opportunities foregone due to scarcity of
resources. If resources were unlimited, there would be no need to forego any income-yielding
opportunity and, therefore, there would be no opportunity cost. Resources are scarce but have
alternative uses with different returns. Incomes maximizing resource owners put their scarce
resources to their most productive use and forego the income expected from the second best
use of the resources.
Therefore, the opportunity cost may be defined as the expected returns from the second best
use of the resources foregone due to the scarcity of resources. The opportunity cost it is also
called Alternative cost. For example, suppose that a person has a sum of Rs. 1, 00,000 for
which he has only two alternative uses. He can buy either a printing machine or, alternatively,
a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and from
the lathe, Rs. 15,000.
If he is a profit maximizing investor, he would invest his money in printing machine and
forego the expected income from the lathe. The opportunity cost of his income from printing
machine is the expected income from the lathe, i.e., Rs. 15,000.
The opportunity cost arises because of the foregone opportunities. Thus, the opportunity cost
of using resources in printing business, the best alternative is the expected return from the
lathe, the second best alternative. In assessing the alternative cost, both explicit and implicit
costs are taken into account.
Associated with the concept of opportunity cost is the concept of economic rent or economic
profit. For example, economic rent of the printing machine is the excess of its earning over
the income expected from the lathe (i.e., Rs. 20,000 – Rs. 15,000 = Rs. 5,000).
The implication of this concept for business man is that investing in printing machine is
preferable so long as its economic rent is greater than zero. Also, if firms know the economic
rent of the various alternative uses of their resources, it will be helpful in the choice of the
best investment avenue.
On the other hand, actual costs are those which are actually incurred by the firm in payment
for labour, material, plant, building, machinery, equipment, travelling and transport,
advertisement, etc. The total money expenses, recorded in the books of accounts are, for all
practical purposes, the actual costs. Actual cost comes under the accounting concept.
2. Business Costs and Full Costs:
, Business costs include all the expenses which are incurred to carry our business. The concept
of business costs is similar to the actual or real costs. Business costs “include all the
payments and contractual obligations made by the firm together with the book cost of
depreciation on plant and equipment”.
These cost concepts are used for calculating business profits and losses and for filling returns
for income-tax and also for other legal purposes.
Full costs, on the contrary, include business costs, opportunity cost and normal profit. The
opportunity cost includes the expected earnings from the second best use of the resources, or
the market rate of interest on the total money capital, and also the value of entrepreneur’s
own services which are not charged for in the current business.
Normal profit is a necessary minimum earning in addition to the opportunity cost, which a
firm must get to remain in its present occupation.
3. Explicit and Implicit or Imputed Costs:
Explicit costs refer to those which fall under actual or business costs entered in the books of
accounts. The payments for wages and salaries, materials, license fee, insurance premium,
depreciation charges are the examples of explicit costs. These costs involve cash payments
and are recorded in normal accounting practices.
In contrast with these costs, there are not certain other costs which do not take the form of
cash outlays, nor do they appear in the accounting system. Such costs are known as implicit
or imputed costs. Implicit costs may be defined as the earning expected from the second best
alternative use of resources. For instance, suppose an entrepreneur does not utilize his
services in his own business and works as a manager in some other firm on a salary basis.
If he starts his own business, he foregoes his salary as manager. This loss of salary is the
opportunity costs of income from his own business. This is an implicit cost of his own
business; implicit, because the entrepreneur suffers the loss, but does not charge it as the
explicit cost of his own business. Thus, implicit wages, rent and interest are the highest
wages, rents and interest which owner’s labour, building and capital can respectively earn
from their second best use.
Implicit costs are not taken into account while calculating the loss or gains of the business,
but they form an important consideration in whether or not a factor would remain in its
present occupation. The explicit and implicit costs together make the economic cost.
4. Out-of-Pocket and Book Costs:
Out-of-pocket costs means costs that involve current cash payments to outsiders while book
costs such as depreciation do not require current cash payments. In concept, this distinction is
quite different from traceability and also from variability with output. Not all out-of- pocket
costs are variable, e.g., salaries paid to the administrative staff.
