-Introduction -Cost Concepts -Opportunity Cost and Actual Cost -Business Cost and Full Cost -Explicit Cost and Implicit Cost -Out-of-pocket Cost and Book Cost -Fixed Cost and Variable Cost -Total Cost -Average Cost -Marginal Cost and Marginal Revenue -Sunk Cost

1. Cost & Cost Concepts
ENGINEERING ECONOMICS & MANAGEMENT
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2. o In production, research, retail, and accounting, a cost is the value of money that has been used up to
produce something, and hence is not available for use anymore.
o More generalized in the field of economics, cost is a metric that is totaling up as a result of a process
or as a differential for the result of a decision.
o Hence cost is the metric used in the standard modeling paradigm applied to economic processes.
o In business, the cost may be one of acquisition, in which case the amount of money expended to
acquire it is counted as cost. In this case, money is the input that is gone in order to acquire the
thing.
o However, business decisions are generally taken on the basis of money values of the inputs and
outputs.
o Inputs multiplied by their respective prices and added together give the money value of the inputs
i.e. the cost of production.
Introduction
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3. o The cost of production is an important factor in almost all business analysis and decisions specially
those pertaining to:-
a) Locating the weak points in production management
b) Minimizing the cost
c) Finding the optimum level of output
d) Determination of price and dealer’s margin
e) Estimating or projecting the cost of business operation
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4. Cost Concepts
o Cost concepts are used for analyzing the cost of a project in short and long run.
o The cost concepts which are relevant to business operations and decisions can be grouped on the
basis of their nature and purpose, under two overlapping categories:
a) Concepts used for accounting purposes
b) Analytical cost concepts used in economic analysis of business activities
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5. 1) Opportunity Cost and Actual Cost
o Opportunity cost refers to a benefit that a person could have received, but gave up, to take another
course of action. Stated differently, an opportunity cost represents an alternative given up when a
decision is made. This cost is, therefore, most relevant for two mutually exclusive events. In investing,
it is the difference in return between a chosen investment and one that is necessarily passed up.
When assessing the potential profitability of various investments, businesses look for the option that
is likely to yield the greatest return.
o No matter which option is chosen, the potential profit that is forfeited by not investing in the other
option is called the opportunity cost.
o In short, opportunity cost is the loss of other alternatives when one alternative is chosen. That is why
opportunity cost is also called as alternative cost. This is often expressed as the difference between
the expected returns of each option:
 Opportunity Cost = Return of Most Lucrative Option - Return of Chosen Option
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6. Examples
o When the government spends ₹15 crore on interest for the national debt, the opportunity cost is the
money that might have been spent on programs like education or healthcare.
o Suppose that a firm has a sum of ₹1,00,000 for which it has only two alternative use. It can buy
either a packaging machine or lathe machine both having life of 10 years. From packaging machine
firms expects annual income of ₹20,000 and from lathe ₹15,000. A profit maximizing firm would
invest in packaging machine and less interested in the expected income from lathe. The opportunity
cost of income from packaging machine is the expected income from the lathe i.e. ₹15,000.
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7. o Actual cost is the amount of money that was paid to acquire a product or asset. It's exactly what it
sounds like—the actual cost. This cost could be either a historical, past, or present day cost of
product.
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8. 2) Business Cost and Full Cost
o Business cost include all the expenses which are incurred to carry out a business. The concept of
business costs is similar to the actual or real costs.
o Business cost include “all the payments and contractual obligations made by the firm together with
the book cost of depreciation on plant and equipment. The concepts used for calculating business
profit and loss.
o The concept of full cost includes business costs, opportunity cost and normal profit.
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3) Explicit Cost and Implicit Cost
o Explicit costs are those which fall under actual or business costs entered in the books of accounts.
An explicit cost is a direct payment made to others in the course of running a business, such as wage,
rent, materials and license fee (which are the examples of explicit costs). They are cash payments
mode and are paid to hired factors of production in cash, out of pocket.
o In contrast, an implicit cost, also called an imputed cost, implied cost, or notional cost, is
the opportunity cost equal to what a firm must give up in order to use a factor of production for
which it already owns and thus does not pay rent. It is the opposite of an explicit cost, which is borne
directly.
o Opportunity cost of entrepreneur is an important example of implicit cost. For example, suppose an
entrepreneur does not utilize his service to his own business, works as a manager in some other firm
on a salary basis. If he sets up his own business, he forgoes his salary. This loss of salary is called
opportunity cost of income from his own business. These are costs to self owned factors of
production, which are not paid in cash.

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o In other words, an implicit cost is any cost that results from using an asset instead of renting it out or
selling it. The term also applies to foregone income from choosing not to work.
o Implicit costs are not taken into account while calculating the loss or gain.
o Explicit cost + Implicit cost = Economic cost

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4) Out-of-pocket Cost and Book Cost
o The items of expenditure which involve cash payments or cash transfers, both recurring and non-
recurring, are known as out-of-pocket costs.
o All the explicit costs (e.g. wages, rent, etc.) are examples out-of-pocket costs.

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o Business costs which do not involve cash payments, but a provision is therefore made in books of
account and taken into account while finalizing profit and loss. Such expense is called book cost.

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5) Fixed Cost and Variable Cost
o Fixed costs are those which are fixed for a certain given output. Fixed cost does not vary with
variation in output between zero and a certain output.
o Fixed costs include:-
I. Cost of managerial and administrative staff
II. Depreciation of machinery, building and other assets
III. Maintenance of land, etc.
o The fixed cost concept is short-run.
o Variable costs are those which vary with variation in total output.
o Variable costs include:-
I. Cost of raw material

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II. Running cost of fixed capital such as fuel, repairs, routine expenditure
and all other inputs that vary with output.
o The variable cost concept is long-run.
o For a simple example, such as a bakery, the monthly rent for the baking facilities, and the monthly
payments for the security system and basic phone line are fixed costs, as they do not change
according to how much bread the bakery produces and sells. On the other hands, the wage costs of
the bakery are variable, as the bakery will have to hire more workers if the production of bread
increases.
o Fixed cost + Variable cost = Total cost

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6) Total Cost
o Total cost (TC) is the total expenditure incurred in the production of goods and service. It refers to
total outlays of money expenditure, both explicit and implicit, on the resources used to produce a
given output.
o Total cost includes both fixed and variable costs. The total cost for a given output is given by the cost
function. Variable cost varies with the volume of production while overhead cost is fixed; irrespective
of the production volume.
o Variable cost can be further classified into direct material cost, direct labor cost and direct expenses.
The overhead cost can be classified into factory overhead, administration overhead, selling overhead
and distribution overhead.
o Overhead costs are fixed costs which have to be incurred in short run, even if production is not
undertaken. Overhead cost is the aggregate of indirect material costs, indirect labor costs and
indirect expenses.

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o Administration overhead includes all the costs that are incurred in administering the business.
o Selling overhead is the total expense that is incurred in the promotional activities and the expenses
relating to the sales force.
o Distribution overhead is the total cost of shipping the items from the factory site to the customer
site.

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7) Average Cost
o Average cost (AC) and/or unit cost is equal to total cost divided by the number of goods
produced (the output quantity, Q). It is also equal to the sum of average variable costs
(total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q).
o Average costs may be dependent on the time period considered (increasing production may
be expensive or impossible in the short term, for example). Average costs affect the supply
curve and are a fundamental component of supply and demand.
o 𝐴𝐶 =
𝑇𝐶
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8) Marginal Cost and Marginal Revenue
o Marginal cost (MC) of a product is the cost of producing an additional unit of that product.
o For example, if the cost of producing 20 units of a product be ₹10,000 and the cost of producing 21
units of the same product be ₹10,045, then the marginal cost of producing 21st unit is ₹45.
o Marginal revenue (MR) of a product is the incremental revenue of selling an additional unit of that
product.
o For example, if the revenue of selling 20 units of a product be ₹15,000 and the revenue of selling 21
units of the same product be ₹15,085, then the marginal revenue of 21st unit is ₹85.

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9) Sunk Cost
o Sunk cost is known as the past cost of an equipment/asset already incurred or agreed to incur.
o For example, an equipment has been purchased for ₹1,00,000 about three years back. If it is
considered for replacement, then its present value is not ₹1,00,000. Instead its present market value
should be taken as the present value of the equipment for further analysis.

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