Classification of Costs

There are several types of costs that a firm may

consider relevant under various circumstances. Such costs include:

1. Actual Costs and Opportunity Costs:

Actual costs are the costs which the firm incurs while producing or acquiring a good or a service like the cost on raw materials, labor, rent, interests etc. The actual costs are also called the outlay costs or acquisition cost or absolute cost. On the other hand, opportunity costs or alternative costs are the return from the next best alternative use of the firms resources which the firm forgoes in order to avail of the return from the best use of resources. 1

Example for Opportunity Cost: Machine A: produces 50,000 returns Machine B: produces 70,000 returns Where the firm prefers machine B as it gives more return. So the opportunity cost is 50,000. The difference between the actual cost and the opportunity cost is called economic profit or economic rent. So, Economic profit or rent = Machine B Machine A 70,000 50,000 = 20,000.
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2. Sunk Cost and Outlay Cost: Sunk cost is otherwise known as DEPRICIATION, which are not altered by a change in quantity and can not be recovered. On the other hand, outlay costs means the actual expenditure incurred for producing or acquiring goods or services. These costs are also known as absolute costs. Hence, sunk costs are the part of outlay costs. 3. Explicit (Paid-out) Costs and Implicit (Imputed) Costs: Explicit costs are those costs which are actually paid by the firm, which is also called paid-out costs. Example: Interest payment from borrowed funds, wages, rent etc. On the other hand, implicit costs or Imputed costs are theoretical costs in the sense that they go unrecognized by the accounting system. Example: Wages, rent, etc. which are due to the entrepreneur for employing his own resources in the firm. For profit and loss account, the explicit cost is important but for the economic decision making, both explicit and implicit costs are important. 3

4. Out-of-Pocket Costs and Book Costs: Out-of-pocket costs are those expenses which are current cash payment to the outsiders. All the explicit costs like payment of rent, wages, salaries, interest, transport charges etc. fall in category of out-of-pocket costs. On the other hand, book costs are those business costs which do not involve any cash payment but for them a provision is made in the book of account to include the in profit and loss account and take tax advantages like the provision for depreciation and unpaid amount of the interest on the owners capital employed in the firm.
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5. Accounting Costs and Economic Costs: Accounting costs are also called actual or outlay costs. These cost point out how much expenditure has already been incurred on a particular process or on production as such. Since these costs are related to the past, are also called sunk costs. On the other hand, economic costs related to future. They are in nature of incremental costs both the imputed and the explicit costs as well as the opportunity costs. 6. Private Costs and Social Costs: Private costs are those costs which are actually incurred or provided for by an individual or a firm for its business activity. Social Costs on the other hand, are the total costs to the society on account of production of a good. Economic Costs = Private Cost + Social Costs
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7. Direct Costs and Indirect Costs: The direct, or traceable or assignable costs are the one that have direct relationship with a unit of operation like a product, a process, or a department. The costs, which are directly and definitely identifiable, are called direct costs. On the other hand, the indirect, or non-traceable or common or non-assignable costs are those whose course can not be easily and definitely traced to a plant, a product, a process or a department. 8. Controllable Costs and Non-Controllable Costs: Controllable costs are those which are capable of being controlled or regulated by executive vigilance and, therefore, can be used to assigning executive efficiency. Non-controllable costs are those costs which can not be subjected to administrative control and supervision. Most of the costs are controllable except, of 6 course, those due to obsolescence or depreciation.

9. Original (Historical) Costs and Replacement Costs: Historical costs of an asset states that it is the cost of plant, equipment and materials at the price paid originally for them. The replacement costs states that it is the cost that firm would have to incur if the firm wants to replace or acquire the same asset now. Example: A machine was worth 10,000 in 1996 and the same machine is worth 14,000 now in 2007. So the original cost is 10,000 and the replacement cost is 14,000. The difference of rupees 4,000 between two costs has resulted because of the price change in the machine during this period.
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10. Shut Down Costs and Abandonment Costs: Shut down costs are those costs which the firm incurs if it temporarily stops its operations. These costs could be saved if the operations are allowed to continue. Besides fixed costs, shut down costs include the cost of sheltering plant and equipment, lay-of-expenses, employment and training of workers when the plant is restarted and above all loss of market. Abandonment costs are the cost of retiring all together a fixed asset from use. For example, the plant installed during war time may be so improvised that it may not be required during peace time. Abandonment costs, thus involves the problem of disposal of assets.
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11. Urgent Costs and Post-ponable Costs: Urgent costs are those that must be incurred so that the operation of the firm continues, like the cost of raw materials, labor, fuel etc. On the other hand, post-ponable costs are those costs whose postponement does not affect (at least foe some time) the operation of the firm. For example, the maintenance of building, machines etc. 12. Business Costs and Full Costs: Business costs are relevant for the firms profit and loss account, and for legal and tax purposes. These costs include all the payment and contractual obligations made by the firm together with the cost of depreciation of a plant and equipment. On the other hand, Full Cost is the summation of opportunity costs of the firm and the normal profits made by the firm. So, Full Costs = Opportunity Costs + Normal Profits. 9