What is Cost ? Different Types of Cost in Economics Explained

What is Cost

Cost is the value of inputs employed in producing an output. It includes the cost of materials involved in producing an output along with the labour charges, rent or depreciation of tools involved in producing the output, interest paid or foregone by employing capital and the value of efforts and sacrifices made by the producer in producing the output.

So, 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, opportunity foregone and risks involved in producing the output.

For example, you may take the example of a housewife preparing food or any particular recipe.

• The housewife purchases provisions and vegetables, etc. 
• She invests money in utensils and gas stove and gas. 
• She labours in the kitchen for some hours to cut the vegetables, cook food and do other activities. 
• She employs a maid for washing dishes and pays to her periodically. 
• She sweats in kitchen instead of enjoying in the hall or her bedroom watching the TV or reading books. 
• Further, she risks the probabilities of cutting or burning her fingers while working. 
• So all these factors when taken in their monetary value, constitute the cost factor of the food that she prepared.

This is how the cost of any product is assessed. All these elements taken together, constitute the total cost of the product.

Types of Costs in Economics

The following are the different types of costs in economics signifying 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 housewife preparing food. It is the cost as a whole of the produce. So, total cost constitutes all the expenses incurred.

Fixed Cost

Fixed cost is a more or less lumpsum cost that is to be incurred irrespective of the quantity or quality of the product that is produced. It does not have any relation with the volume of output. For example, in the above illustration of housewife preparing the 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 which are needed as a base for cooking the food. Again the risk factor and the the labour factor are also there which also constitute fixed cost for most part of it. So, fixed cost includes all salaries and administrative expenses including 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 gets increased, the fixed cost per unit may become less. With same fixed expenses, you can produce more quantities upto some limits.

Variable Cost

Variable cost is variable in nature. It depends upon the quantities and qualities of the produce. If food is to be cooked for more people, the expenses increase and for lesser people, it decreases. If, you have to produce high quality food, you need high quality ingredients which are more costlier. So, the cost depends upon these factors.

In the above example of housewife cooking food, the cost of provisions and vegetables and gas consumption can change depending upon 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 are required per head.

Average Cost

Average cost refers to the cost per unit of production. It is derived by dividing the total cost with 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 total monthly expense for cooking comes to Rs.6,000, then average cost per day is Rs.200 (6,000 / 30 days = 200). And, if 4 people eat per day, then average cost per head is 200 / 4 = 50.

Marginal Cost

Marginal cost is the amount of  extra expenditure incurred per 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 some extra rice, dal and vegetables for him. Now, the value of this extra items is the extra money spent by you. All other expenses remained the same. Only you had to put some more effort in cutting vegetables, etc. So, in this case, the marginal cost incurred by is the value of those extra rice, pulses, vegetables and any other extra ingredient used by you. So, 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 payments. 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 example of preparing food 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 market to cook food, you might have had to pay some rent. So that much of rent is an implicit cost of the food. Or, you may calculate the depreciation and include that amount as an implicit cost.

So, whatever items you are using in production which are not directly and completely identifiable with production, and you need to calculate the value of those items through other means of calculation; those costs are known as implicit costs.

Production Process and different types of production process

We have learnt that Production is one major economic activity employing land, labour, capital and entrepreneurship as its factors for achieving the production targets.

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

What is Production Process?
Production process can be defined as any kind of activity involved in the transforming of the inputs into outputs. It is the act of manufacturing or producing some output of economical value to meet the demands and needs of customers and consumers employing the various processes or techniques available.

• Production process involves employing different kinds of tools that are known as transforming resources for achieving the production. 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 process involves employing another kind of resource known as ingredients or inputs for achieving the production. These ingredients are known as transformed resources. For example, if it is a cement production process, the ingredients used are limestone, gypsum and ash which get transformed into cement.

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


A. Classification of production process based on the volume of production | type of market
This classification identifies the following types of production processes that can be chosen by you according to your feasibility to target specific customers and volume.

1. Mass production process: In this process, the production is done in large scales employing extensive machinery and automated processes and it is not limited to any particular demands or orders placed by customers. You are able to produce different varieties and qualities of output on large scales, as most of the work is automated and there is continuous supply of inputs to achieve the output with the help of supervisors and technical teams streamlining all activities of production. This is also known as Flow Production Process. There will be different sections or departments of production staff overlooking and streamlining the activities from one stage of production to another stage of production, till 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 job orders. It may include taking orders from different customers for different items or taking orders for a specific item of production. But, you will be producing only so much quantity as is ordered by the buyer or customer. For example, one 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 of production, goods are produced in batches in a sequence according to your own set goals. If your target is to produce 4 kinds 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 job production process. But, not exactly same. Job production is directly linked with your customers, whereas, just-in-time is related with demands or orders placed by your agents and retailers.

B. Another classification of Production processes based on the nature of functions performed

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

Manufacturing process
All activities directly related with the production of output are identified into manufacturing process.
For example, if you are producing bread, the activities of making sponge with wheat flour, then fermenting it and mixing the flour to make dough and baking the bread in oven to make the final product- all these functions are known as the manufacturing process of the bread.

Administrative process
Administrative process includes 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.

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

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

Capital formation - One of the four basic economic activities

The four basic economic activities of any economy are interlinked and each activity leads to the other next activity.

• Production of goods and services leads to and results in distribution of the goods so produced to their consumption points..
• Distribution of goods to all corners of economy results in consumption of those goods and services in an effective way.
• Consumption can be refrained at some point of satiety and then, the extra consumption capacity can be got diverted into investment for future stocks and capital formation.

So, you are able to see how one activity leads to the other activity.and how they can be interlinked.

Now, coming to capital formation, It can be defined as creation of capital- either working capital or fixed capital- by way of purchasing new stocks or plant and machinery or through increasing the present levels of capital. It can be treated as new investments in business or the yearly increases in present stocks or working capital.

The creation of capital or capital formation refers to the net worth of assets after meeting out liabilities. It is the balance value of additions to capital by way of deducting all liabilities from assets.

Decrease in the expenses and in present consumption leads to excess of income and excess of stocks of produced goods and services. So, whenever there is more production and lesser consumption, it leads to capital formation. So, the restraint from present consumption and generation of savings are the major sources of capital formation. The overall production is either consumed or used for creating capital.


Understanding capital formation process

• Whenever you refrain from present consumption and save your money, it gets deposited into banks generally.
• The banks in turn lend that money to producers or invests the money in shares and equity funds. 
• This investment again is used by the producers and businessmen to purchase machinery and equipments and in starting new ventures or to increase the present production levels. Increased production is possible because of this extra income or savings utilised positively by producers. 
• This will again boost the economy and can increase both income of workers and also the consumption levels. 
• Increased consumption is a sign of elevated standard of living and symbolises a developed economy.

Increased consumption should not mean that whatever you are producing is consumed entirely. When the production of goods and services are much more than requirements, and since you are having more money to spend in developed economies, it is possible that you can consume more things at relatively affordable prices and still save sufficient money. So these savings again create capital formation.


Capital formation takes place when these savings are deposited into banks and used for investments in shares or for financing the producers. If the savings are kept idle at home, then no capital formation can occur. So it is important that idle funds are utilised for producing more goods and services to be considered as contributing to capital formation process.

Consumption of Goods and Services and its effects on economy

Consumption is the 3rd basic economic activity of any economy that follows after Production and Distribution of goods. In some cases, consumption may not necessarily require to go through the intermediary process of distribution, as in the case of a roadside eatery, where food is produced and consumed immediately with no intermediary.

Consumption is the act of using up something. Economically, it is the usage or utilisation of goods and services that are being produced. Whatever goods and services get produced, we use them up for satisfying our needs - let it be our immediate need or some future need. Either way, it is the act of consumption. So, whenever we are eating at some eatery or restaurant, or purchasing some provisions, clothes or other household and electronic goods, all these are counted to be acts of consumption. Similarly, consulting a Doctor, availing hospital services, legal services or salon services - all these acts are also adding to the concept of consumption function.


Types of consumption
Every consumption does not lead to immediate satisfaction of needs.

• Some portion of the consumption adds to storage and future utilisation of those goods. For example purchasing a bag of rice and other monthly or weekly purchases. These items are consumed throughout the month or week.
• Some items of consumption are used for longer durations of life like electronic goods, furniture and other equipments which are utilised for years.
• Many items of goods and resources are procured for using them in manufacturing other end products. This consumption can be termed as industrial consumption. Industrial consumption leads to production of many goods and products that are again utilised by end users or intermediaries. So, it is a chain of consumption.

Limitations of Consumption

There can be some limitations to consumption as it is dependent on other circumstances that are inter linked with it. 

• An individual's income determines his consumption. As the income is limited in nature for any one person, he can spend only a certain amount of money to purchase things or services. So, his consumption is limited according to his income.
• Availability of goods also determines or affects consumption function. You may be wanting to buy something, but it is not available in your region or presently not there in stock. So, you are unable to buy it and should look at other options or go without it.
• Ignorance of knowledge also affects consumption, as you are unaware of some goods in market and so do not think of purchasing them.

Bad effects of Consumption
Consumption, if uncontrolled, can lead to many worst situations of economy.

• Consumption makes goods and services out of stock sometimes.
• Consumption can dry up the resources of economy thereby depriving the future generations of their resources.
• Consumption can make governments depend upon other countries for goods and resources thereby tilting the balance of payments position negatively.

From the above facts, we are able to see that our needs and wants require to be controlled and balanced by curtailing unnecessary consumptions of goods and resources. Then only can our economy prosper.

Distribution of Goods and Services as one of the basic economics activities of man

Distribution also is considered as one major economic activity in addition to the three basic economic activities. It is the activity that comes after production and its job is to distribute the goods and services that have been produced during the period to their points of consumption. Goods produced does not get consumed in the local market of your region itself when productions are on large scales. So, the goods need to be transported to all corners of the market depending upon their requirements. First of all, you may need to create awareness in the market about your produce so that people come to know of it and demand it for their requirements. This involves publicity and advertisement. Then, you need the transporting facilities and storage facilities also for the goods till they get consumed.

So, distribution of goods and services involve these following major activities.

Publicity
To get requirement or demand for your goods, the public should be aware that you are producing so and so goods and/ or services. This can be achieved through advertisements in all leading newspapers or broadcasts on Radio and TV. Further, awareness about your products as to their quality and functions also need to be publicised through distribution of pamphlets and TV advertisements. This will make interested people to demand for your products.

Transportation
When you receive requirement for goods, you need to transport them to the required places. This can be done either with your own fleet of vehicles or through public transportation facilities available like carriers, couriers, railway freight services, cargo services, etc.

Storage
Distribution of goods may require storage space and facilities also for storing the goods at destination points or even at intermediary points till actual consumption takes place to protect them from heat and rain. You can't ship each and every requirement separately, since it will be not economical and may delay the supply also. So, storage occupies an important role in the distribution of goods.

So, from above analysis, you can see that distribution of goods is a very complex economic activity involving publicity, transportation and storage of goods also and it needs to be considered as the second major economic activity after production.

There can be exceptions, in which case there may not be the need of this distribution activity taking place. For example, food consumed directly at small roadside eateries, a hair-cut in the saloon, etc. where there is no involvement of distributing activities. It is a case of direct production and consumption.

A study of the basic economic activity - Production and factors of production

Production is one of the basic economic activity. 

• Production can be defined as the conversion of resources or raw materials with the help of other inputs into usable goods and services.
• It is the process of making / producing or developing user friendly goods and services employing or utilising the various means and resources that are available in an economy.

Man can not consume goods in their raw form in most of the cases. The raw materials and resources need to be processed and tamed in order to be consumed. For example, production of cars, buses, trains, etc. require the steel to be first mined in its raw form, then burned, molted and moulded to give shapes. It requires engineering skills, labour force, finance capital for purchasing the steel and machines/ tools, and for payments to labour, etc. Further it requires the skills of efficient management for controlling the various processes as well as efficient usage of inputs.

So, production implies utilisation of resources as well as the other input factors of production. Here one should notice that only those inputs which become a part of the output or those that are consumed and used up during production process are to be treated as the factors of production..

There are four major factors of production without which you can not carry on the production activity. They are-

• Land,
• Labour,
• Capital and
• Entrepreneurship. 

Now, let me give a brief account of these factors of production as to their importance in production.

Land

Land is one important factor of production. Land is used for cultivation to grow all food grains, vegetables and other trees and plants. The fertility of soil gets used up here in production. Again, land contains rivers and lakes which provide the water for our consumption, besides being used for fisheries and internal transportation purposes. 

Land is the base for all our minerals, oils and other resources. We mine them, process and use them in producing various goods and products that are consumed by us or further used in production of many other different varieties of goods.

Labour

Labour is required to do all physical tasks as well as skilled operations in order to produce something.
Purely physical labour includes lifting of weights, ploughing of soil for agriculture and other unskilled jobs like helpers and servants.
Skilled labour requires special talents in the field through education and training like teachers, doctors and engineers.
All of these professionals aid to the production of goods and services as their time and energy are consumed in the process.

Capital
Capital is one more important factor of the 4 factors of production. You can't do any business without capital. Production requires the accumulation of resources which are procured by paying money or equivalent before starting any production. So, you have to invest capital before starting the production or establishing any kind of business.
Even after accumulating the required resources, you have to pay for the services utilised of land, labour and other intermediary activities before you may start earning income or profits from the business. So, capital is one important factor of production.

Entrepreneurship
Even after all your resources and inputs have been procured to start your production, you need some managerial skills and talents to run your production process. You need to organise everything in a systematic manner to enable  production. You need to know what to produce, how much to produce and the inputs required for the output. You should be able to calculate and predict things prudently and efficiently in order to produce maximum output with the available limited resources in order to succeed. So, entrepreneurship plays an important role in production and you can't ignore it. 

About Four basic economic activities

Any economy is a result of and is always engaged in four basic economic activities to sustain, develop and prosper itself. They are:

• Production,
• Distribution,
• Consumption and
• Capital formation.

These are the backbone of any economy. These economic activities create the wealth and purchasing power for economy. They lead to capital formation also. 

We can't consume most of the goods in their raw form. It requires processing, refining, shaping, mixing, tanning, manufacturing, cultivating and many other procedures to make the resources consumable by human beings. All these are done through production. So, production utilises the available resources to produce the required outputs to meet the needs of people. We always need production to satisfy our needs for existence.

Distribution involves in the passage of goods and services from one hand to the other or from producer to consumer through exchange or transfer. It involves intermediary agents also in the process. It may include bequeathing of assets, transfer of charity funds, subsidies and free social welfare services, all that imply economic values.

Consumption is the result of our desires and wants and it requires the goods that are produced to satisfy its urgency levels. So, consumption implies production in most cases. There are very few uneconomic goods that can be satisfied without production activity like free water, free air.

Consumption is an unending activity. We always need something to satisfy most of our recurring wants on daily basis. So, there will be an unending consumption activity in any economy at any given point of time. It is a continuous process which again requires continuous production of goods and services.

Capital formation takes place when large quantities of goods and services are produced which may result in accumulation of stocks and wealth. Further, production uses the factors of land, labour and capital resulting in wealth distribution to these factors in return for their use or services mostly in the form of rent, wages, interest and any other form of income. This income is used for consumption and balance income is again reinvested in assets and stocks to form capital for future usage.

So, you are able to see that there are four basic economic activities in a society which impact the economic position and development of any economy in our world..

Let us have a deeper look into each of these activities in our next chapters.