Definition of Cost: Different Types and Elements of Cost in Economics Explained

What is Cost

In Economics, Cost is the value of inputs employed to produce an output. It is the aggregate of various cost elements.

It includes the cost of materials, labour charges, rent or depreciation of tools incurred in producing the output, interest paid or foregone by employing the capital, and the value of efforts and sacrifices made by the producer in producing the output.

Cost can be defined as the monetary value of all materials, resources, and efforts involved in producing an output, along with the value of time, the opportunity foregone, and the risks involved in producing the output.

For example, to understand the elements of cost, look at the example of a housewife preparing food.

• The housewife purchases provisions and vegetables, etc. 
• She invests money in utensils, a gas stove, and gas. 
• She labours in the kitchen for hours cutting vegetables, cooking the ingredients, and doing other related tasks. 
• She employs a maid to wash dishes and pays her periodically. 
• She sweats in the kitchen instead of resting in the hall or her bedroom, watching TV or reading books. 
• Further, she risks getting cut or burning her fingers while cooking. 
• So each one of these factors, when taken in their monetary value, constitutes the cost factor of the food she prepared.

This is how the cost of any product is assessed. 

All elements taken together constitute the total cost of the product.

Types and Elements of Cost in Economics

The following are the different types of costs in economics that refer to different aspects of the cost.

• Total cost
• Fixed cost
• Variable cost
• Average cost
• Marginal cost
• Explicit cost
• Implicit cost

Now, let us have a look at the features of each and every aspect of these costs.

Total Cost

Total cost refers to the total amount of expenses incurred in producing the output, which includes the monetary value of each and every aspect mentioned in the above example of a housewife preparing food. It is the cost as a whole of the product. So, total cost constitutes all the expenses incurred in achieving the output.

Fixed Cost

Fixed cost is a more or less lump-sum cost that must be incurred irrespective of the quantity or quality of the product produced. It has no relation to the volume of output. 

For example, in the above illustration of a housewife preparing food, you can see that the stove is needed irrespective of the quantity of food to be cooked. Again, you need the utensils also for cooking. So, these are fixed expenses that are needed as a base for cooking the food. 

The risk factor and the labor are also there, which constitute fixed costs for most part of it. 

In general, fixed costs include all salaries and administrative expenses, including the value of depreciation of assets during that period. 

These are compulsory expenses incurred irrespective of production.

Here, you should note one point. The fixed cost for smaller quantities of production may be high, whereas if the production quantity increases, the fixed cost per unit decreases. 

With the same fixed expenses, you can produce more quantities up to some limits.

Variable Cost

Variable costs are variable in nature. They depend on the quantity and quality of the produce. If food is to be cooked for more people, the expenses increase, and for fewer people, they decrease. If you have to produce high-quality food, you need high-quality ingredients, which are more expensive. So, the cost depends on these factors.

In the above example of a housewife cooking food, the cost of provisions, vegetables, and gas consumption can vary depending on the quantity of food to be prepared. 

If you are cooking for four people, it will be less. But if you cook for 10 people, the total expenses will be much more. This is one variable cost example.

But, on the whole, you should note that the variable cost per unit of food may remain the same. Because the same quantity of provisions and vegetables is required per head.

Average Cost

Average cost refers to the cost per unit of production. It is derived by dividing the total cost by the number of units produced. 

Suppose in the above example of cooking food, if total expenses incurred are Rs.1,000 and the food is served to 10 people, the average cost per meal is 1000 / 10 = Rs.100 per meal. 

Or, if the total monthly expense for cooking comes to Rs.6,000, then the average cost per day is Rs.200 (6,000 / 30 days = 200). 

And if 4 people eat per day, then the average cost per head is 200 / 4 = 50.

Marginal Cost

Marginal cost is the extra amount of expenditure incurred for the addition of one unit of extra product.

Say, for example, a guest visited your home, and you cooked one more plate of meals for him. 

You had to spend on some extra rice, dal, and vegetables for him. Now, the value of these extra items is the additional expenditure incurred in cooking an extra meal. All other expenses remained the same. 

But you had to put in some more effort while cutting extra vegetables, etc. 

So, in this case, the marginal cost incurred is the value of that extra rice, pulses, vegetables, and any other extra ingredients used by you. 

This is the notion or concept of marginal cost.

Explicit Cost

Explicit means clearly and physically visible. You are seeing those expenses clearly without any doubt or misunderstanding. You will be paying the amount, can get bills for them, and enter the amounts in your records as proof of payment. 

In the above example, the cost of provisions, vegetables, utensils, and payment to your maid are all explicit costs.

Implicit Cost

Implicit means implied or understood. They can not be directly experienced. You are not making direct payments to outsiders to prove those expenses. But, you can evaluate such expenses with the aid of the prevailing market value of such expenses.

In the above-cited example of food preparation by the housewife, you can see that the gas stove and utensils are used for cooking. So, it is an element of cost. If you hire the same things from the market to cook food, you might have to pay some rent. So, that much of the rent is an implicit cost of the food. Or, you may calculate the depreciation (if the stove or utensils are too costly) and include that amount as an implicit cost, in place of rent.

So, whatever items get used in production that are not directly and completely identifiable with production, calculate the value of those items through other means of calculation. All such costs are known as implicit costs.

Production Process: Classification of Production Processes

We have learnt that Production is one of the major economic activities that employs land, labour, capital, and entrepreneurship as its factors of production.

Now, what is the production process? Let us understand how production takes place and what processes are involved in production activity.

Production Process Definition and Meaning

The production process can be defined as any activity involved in transforming inputs into outputs. It is the act of manufacturing or producing outputs of economic value to meet the demands and needs of customers and consumers, employing the various processes or techniques available. It involves employing two types of resources.

• The first type involves the employment of tools known as transforming resources. Land, building, labour or manpower, machinery, and managerial skills- all these are examples of transforming resources. They transform the inputs into end products.
• Similarly, production involves employing another kind of resource known as ingredients or inputs in achieving the desired level and quality of production. These ingredients are known as transformed resources. For example, in a cement production process, the ingredients used are limestone, gypsum, and ash, which get transformed into cement.

Classification of Production Processes

Now, coming to different types or classifications of production processes, each process can be identified and classified based on many different sets of features.

I am providing two major types of classification in this article. One classification is based on the volume and the type of market. The other classification is based on the nature of activities involved.

Classification Based on Volume of Production | Type of Market

This classification identifies the following types of production processes to target specific customers and volumes.

1) Mass Production Process/Flow Production Process:

 
In this process, production is carried out on a large scale, employing extensive machinery and automated processes.

Production quantities are not limited to any particular demands or orders but are decided by management through estimates. 

You are able to produce a wide range of output varieties and qualities on a large scale, as most of the work is automated and there is a continuous supply of inputs to achieve the output.

There will be different sections or departments of production staff overseeing and streamlining the activities from one stage of production to another, until the output is complete in all respects and put into the market for sale.

2) Job Production Process: 

Job production involves taking orders from customers and producing the goods according to those orders. 

It may include taking orders from different customers for different items or only for a specific item of production. 

But the quantity produced is equal to the orders placed by the buyer or customer. 

Examples: Hundred Cupcakes for a wedding ceremony; or four kinds of Sweet Dishes, 50 pieces each, for a birthday party.

3) Batch Production Process: 

In this process, goods are produced in batches in sequence according to your own set goals. 

If your target is to produce 4 types of items, each numbering 100 units, then you will produce them one by one. First, you will produce 100 units of item no. 1, then 100 units of item no. 2, and so on. 

Your attention will be concentrated on each item till it is produced completely. So, your machines and workforce are fully employed on each item of good till it is completed.

4) Just-in-Time Production Process: 

Just-in-time process involves producing goods or services as and when they are actually required. It may be similar to the job production process. But not exactly the same. 

Job production is directly linked with your customers, whereas just-in-time is related to demands or orders placed by your agents and retailers.

Production Processes Based on Nature of Functions

Production processes can be classified according to the nature of function or activity involved in the process. So this classification identifies the production process either as a manufacturing process, an administrative process, a selling and distribution process, or a marketing process.

This classification is useful for Cost Accountants. It helps in bifurcating the cost of production stage-wise.

Let us look at these processes:

1) Manufacturing Process

All activities directly related to the production of output are identified as the manufacturing process.

For example, if you are producing bread, the cost of the flour and the activities of making sponge with wheat flour, then fermenting it and mixing the flour to make dough, and baking the bread in an oven to make the final product- all these functions are known as the manufacturing process of the bread. It determines the basic cost of bread.

2) Administrative process

The administrative process involves the administrative expenses involved in the procurement of raw materials and tools for preparing the bread, the planning of resources including finances for running the business and management functions, etc.

3) Selling and Distribution Process

The actual selling functions, including storage in godowns or selling outlets, including the distribution of finished products to selling points and other related selling activities, are all to be cited as features of the selling process.

4) Marketing Process

The marketing process involves locating the market for goods by identifying more profitable markets through surveys and analysis reports; promoting sales through advertising and publicity; promoting the brand image of the product and the company; and promoting the company's shares, etc.