Cost Concepts

Production and cost analysis constitute the supply side of the market. The production analysis deals with the supply side in terms of physical units of inputs and outputs. The cost analysis is concerned with the supply side in terms of physical units of output and the cost of production as expressed in nominal terms.

The significance of cost analysis in decision-making needs no exaggeration. The cost of production provides a floor to product pricing and no firm can afford to ignore its profits, which is the excess of total revenue over total cost. With the emergence of increasing competition over time, both from the domestic and foreign markets, there is a pressure on every firm to reduce its unit cost. A firm which is able to achieve same degree of success on this front is always able to shine in the market enjoying a large market share, high turnover and high profits. Further, production cost, looked from another side, stands for payments made to factors of production, which is of immense significance from the point of view of national planning.

The supply function is derived from cost and objective functions. This function together with the demand function determines products price.

There are several useful cost concepts and a clear understanding of them must precede any discussion on cost analysis.

Economic Cost: The economic cost that a firm incurs in the production of goods refers to the payments it must make to all the resources (factors of production) employed by it in the production of that goods. The resources referred to here includes the ones owned by the firm itself as well as those which it hires from outside for the purpose. To illustrate this, consider a firm which produces 10 tons of wheat by employing the following resources, costing the amounts as indicated against them:

Factors hired from outside

Costs (Rs)

Seed 750
Labor 1900
Tractor for ploughing 2000
Fertilizer 1100
Tube well for irrigation 1250

Self-owned Factors
Employed Opportunity Cost
Family labor 3500
Land 5000
Total in terms of Economic cost 15,500
Costs (Rs)

The economic cost of 10 tons of wheat thus stands at Rs. 15,500. Here it should be noted that while costs of factors hired from outside is known accurately, that of self owned resources has to be imputed on the basis of their opportunity costs. Many small firms ignore their implicit costs and thus they underestimate their cost of production and thereby overestimate their economic profits.

Explicit and Implicit Costs: Economic costs are classified into two parts: explicit and implicit costs. The former, also called the out-of-pocket costs, stands for the payments that must be made on the factors hired from outside the control of the firm. In contrast, implicit costs, also known as book cost or non-cash costs, refers to the payments made to (or opportunity costs of) the self owned resources used in the production. Thus in the above example, explicit cost of wheat production is Rs 7,000 and its implicit cost is Rs. 8,500. The only difference between these two cost concepts is in terms of whether the amount spent is on hired factors or no self owned ones; alternatively, whether it involves cash payment or merely a book cost.

Normal profit is an economic Jargon. It is not profit but an item of economic cost. In particular, it stands for the opportunity cost of entrepreneur’s time. To extend this a little further, the cost of family labor is referred to as implicit wage, the cost of the use of self owned premises in the business as implicit rent the cost of self owned money in the business as implicit interest, and the cost of owner’s time as implicit cost of entrepreneurship or normal profit. Thus, the normal profit is a component of implicit cost. In the above example of wheat, the cost of family labor (implicit wage) is inclusive of normal profit, for family labor in that includes the time spent on entrepreneurial functions.

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