Examples of Cost of Production

Examples of cost of production: 1. Sunk Cost and Future Cost 2. Actual Cost 3. Opportunity Cost 4. Explicit Cost 5. Implicit Cost 6. Money Cost and Real Cost 7. Private Cost and Social Cost 8. Selling Cost 9. Overhead Cost.

Example # 1. Sunk Cost and Future Cost:

Expenditure which has been incurred in past and which cannot be recovered is referred to as sunk cost. Sunk costs are unavoidable costs. Suppose a company spends Rs. 70 lakhs to build a plant in a factory which is meant for a very special purpose and has no alternative use. The cost incurred on building the plant is a sunk cost.

Future cost is relevant in managerial decisions as it is based on forecasts.

Example # 2. Actual Cost:

It refers to the actual expenditure incurred by the firm for producing good and service. It involves all the expenditure actually incurred by the firm to procure labour, material, machinery, equipments, energy, transport, etc. Actual wages, rent or interest paid are some examples of absolute cost. Actual costs are generally recorded in the books of accounts.

Example # 3. Opportunity Cost:

Opportunity cost of any input is the next best alternative use that is sacrificed by its current/ present use. In other words, opportunity cost of any resources is the expected returns from the next best alternative use of their best present use.

Opportunity cost indicates what a factor could have earned in the next best use. It reflects the returns that we have given up to select the present (best) use of the factor. Opportunity cost, also referred to as Alternative cost occurs due to the scarcity of resources and the alternative ways that we utilize the resources. A firm, in order to maximize its level of profit will always endeavour to choose the best from the alternative uses available.

When a firm opts for the best of alternatives, it foregoes the returns expected from other alternative uses. The opportunity cost is the next best alternative use foregone.

Example- For a farmer choosing to plant rice, the opportunity cost would be any other crop he may have planted, like wheat.

Example # 4. Explicit Cost:

Explicit cost refers to the contractual cash payments made by the firm for purchasing or hiring the services of various productive factors which are not own by him. This cost has the characteristics of contractual payments and includes the rent, wages, and interest, payment for raw materials, energy, insurance premium, transportation cost, advertisement, and taxes. An accountant takes into account the payments made by a firm to the outside suppliers of various productive factors. An accountant takes into consideration this cost. Therefore, explicit cost is also referred to as accounting cost.

Example # 5. Implicit Cost:

Implicit cost arises in a situation when the factors of production are possessed and supplied by the firm itself or by the entrepreneur in such a case there is no cash outlays. Implicit cost is also known as imputed cost. For instance, Mr. Nitin used to work as a manager in some firm on a salary. If he decides to set up his own business, he foregoes his salary as a manager. This loss of salary is an implicit cost of Mr. Nitin’s own business. It is considered implicit because the income foregone by Mr. Nitin is not charged as the explicit cost of his own business.

Accounting costs are the costs most often associated with the costs of producing. These costs include direct payments to factors like labor and capital to produce output. Accounting costs are the costs that appear on the income statement. Historic cost is an accounting cost measure. The historic cost of an activity is the sum of the costs the firm actually attributes to providing that activity in a given accounting period.

Accounting costs = direct costs + indirect costs

Accounting costs include all explicit costs plus some of the implicit costs.

Economic costs are the costs of production that include not only the accounting costs but also the opportunities forgone by producing a given product. By choosing to produce one commodity, the producers give up the opportunity for producing some other commodity. Sunk cost is an economic cost concept. Sunk costs are historic costs that are irreversibly spent and independent of the fixture quantity of service supplied.

Economic costs = explicit costs + implicit costs

The chief dissimilarity between accounting and economic costs is the inclusion of opportunity costs as a part of economic costs.

Example # 6. Money Cost and Real Cost:

Money cost refers to the cost of production expressed in terms of monetary units. It reflects the aggregate expenditure borne by a firm on the purchase of raw materials and other inputs essential for the process of production. On the other hand, Real cost considers all the physical discomforts, pain, trouble, sacrifice, abstinence involved in the production of a commodity. Different production processes involve different levels of real cost. From the social point of view, the concept of real cost is very important but it involves the problem of subjectivity and value judgment.

Example # 7. Private Cost and Social Cost:

Private cost for a firm’s or an individual of a good, service, or activity include the cost the firm or the individual has to pay to acquire equipment, labor, and buy materials or other inputs.

The private costs of a car include the fuel and oil, maintenance, depreciation. Private costs are paid by the firm or consumer and must be included in production and consumption decisions. In a competitive market, taking into consideration only the private costs will lead to a socially efficient rate of output when there are no external costs.

Now, let us see what is external cost.

External costs are not reflected on firms’ income statements or in consumer’s decisions. But the external costs remain costs to society, regardless of who pays for them. For instance, a firm does not install water pollution control equipment in order to save money. But it will add to the pollution. Because of such activities cities located down a river will have to pay to clean the water before it is fit for drinking. These are the external costs, which must be added to private costs to determine social costs and to make certain that a socially efficient rate of output is achieved.

Social Costs- Social costs include both the private costs and any other external costs to society arising from the production or consumption of a good or service. For instance, in the case of people having cars. The social costs include all the private costs (fuel, oil, maintenance, insurance, depreciation, and operator’s driving time) and also the cost experienced by people other than the operator who are exposed to the congestion and air pollution resulting from the use of the car.

Example # 8. Selling Cost:

Selling Cost refers to the amount of money needed for the advertising, sales representatives’ commissions, and other expenses involved in selling something.

Selling costs include just what you would expect-any expense involved in selling your products or services that tie in directly with sales. For example, sales commissions would count as a selling cost, as would shopping bags and delivery charges (when you deliver something to your customers).

Other types of selling costs, such as advertising and promotions, are not dependent on sales. Rather, the opposite is true- you hope that spending more on advertising and promotion will drive up your sales. Even though the relation is not as clearly defined, it does exist, making these types of expenses are part of selling costs as well.

There is no accounting rule that requires the firm to split out its selling costs. If they are not a large part of the firm’s total expenses, the firm can leave them in with its general expenses. However, if they are high enough for the firm to track them separately, the firm can make a selling costs category within its general expenses.

Selling costs are of two forms, direct (or variable) selling cost and indirect (or fixed) selling cost.

a. Direct Selling Costs:

Direct selling costs come into scene only when a sale takes place. For instance, shopping bags are a common selling expense, but you would not incur this expense unless you sold something to put into that shopping bag. The sale drives the expense.

Examples of direct selling costs include- Shopping bags, Gift boxes and wrapping, Packaging materials, Freight charges, Order fulfillment, Sales commissions

b. Indirect Selling Costs:

Indirect selling costs are those expenses that are necessary to generate sales but are not based on sales. The firm has to pay these expenses even if the firm does not sell a single good. However, it can be very hard to generate sales without them, making them well worth the cost. The most common indirect selling costs include sales salaries, advertising expenses, promotional costs, and travel.

Example # 9. Overhead Cost:

Overhead refers to all non-labor expenses required to operate the business of a firm. These expenses are either fixed or variable. Overhead refers to the ongoing operating expenses necessary to run a business, but are not attributed to a specific business activity. Generally, overhead expenses include expenses that do not directly generate revenues, such as labor and materials, but are needed to maintain the business operations. Overhead expenses include expenses such as accounting, advertising, depreciation, insurance, interest, legal, rent, repairs, office supplies, taxes, information and communications, utilities, research and development, customer relations and service, and travel.

These overhead expenses are listed on the company’s income statement. Overhead costs are considered fixed costs, that is, they do not rise or fall directly with the cost of goods sold.