Costing Methods

Cost is the value that must be given up to acquire a good or service. In a business where
selling and distribution expenses are quite nominal the cost of an article may be calculated
without considering the selling and distribution overheads. At the same time, in a business
where the nature of a product requires heavy selling and distribution expenses, the
calculation of cost without taking into account the selling and distribution expenses may
prove very costly to a business. The cost may be factory cost, office cost, and cost of sales
and even an item of expense. For example, prime cost includes expenditure on direct
materials, direct labor and direct expenses. Money spent on materials is termed as cost of
materials just like money spent on labor is called cost of labor and so on. Thus, the use of
term cost without understanding the circumstances can be misleading.
Different costs are found for different purposes. The work-in-progress is valued at factory
cost while stock of finished goods is valued at office cost. Numerous other examples can be
given to show that the term cost does not mean the same thing under all circumstances
and for all purposes. Many items of cost of production are handled in an optional manner
which may give different costs for the same product or job without going against the
accepted principles of cost accounting. Depreciation is one of such items. Its amount varies
in accordance with the method of depreciation being used. However, endeavor should be, as
far as possible, to obtain an accurate cost of a product or service.

Cost Concepts
i) Real Cost
The term real cost of production refers to the physical quantities of various factors used in
producing a commodity. For example, real cost of a table is composed of a carpenters
labour, two cubic feet of wood, a dozen of nails, half a bottle of varnish paint, depreciation
of carpenters tools etc., which go into the making of the table. Real cost, thus, signifies the
aggregate of real productive resources absorbed in the production of a commodity or
service.
The real cost of production of a commodity refers to the exertion of labour, sacrifice involved
in the abstinence from present consumption by the savers to supply capital, and social
effects of pollution, congestion, and environmental distortions.
In a much philosophical way, Marshall (1920), describes real cost as follows: The
production of a commodity generally requires many different kinds of labour and the use of
capital in many forms. The exertions of all the different kinds of labour that are directly or
indirectly involved in making it together with the abstinences or rather the waiting required
for saving the capital used in making it all these efforts and sacrifices together will be called
the real cost of production of commodity.
According to Marshall, thus, the real cost of production signifies toils, troubles, sacrifice on
account of loss of consumption for savings, social effects of pollution caused by factory
smoke, automobiles, etc. Evidently, the concept of real cost is an abstract idea. Its exact
measurement is not possible.
ii) Opportunity Cost
The concept of opportunity cost is based on the scarcity and versatility characteristics of
productive resources. It is the most fundamental concept in economics.
It is a known economic fact that our wants are multiple, while our resources are scarce but
capable of alternative uses. So the problem of choice is involved. We have to choose the use
of a given resource for a particular purpose out of its alternative applicability. When we
choose the resource in one use to have one commodity for satisfying a particular want, it is
obvious that its other use as some other commodity that can be produced by it cannot be
available simultaneously. This means, the second alternative use of the resources is to be
sacrificed to have the resource employed in one particular way, i.e., to get a particular

commodity because the same resource cannot be employed in two ways at the same time.
Apparently, the employment of factors in producing a commodity always involves the loss of
opportunity of production of some other commodity. The sacrifice or loss of alternative use
of a given resource is termed as opportunity cost. Thus, the opportunity cost is measured
in terms of the forgone benefits from the next best alternative use of a given resource. In
other words, the opportunity cost of producing a certain commodity is the value of the other
commodity that the resources used in its production could have produced instead. It should
be noted that opportunity cost of anything is just the next best alternative forgone in the
use of productive resources and not all alternative possible uses.
Importance of Opportunity Cost
The concept of opportunity cost has a great economic significance.
a) Helps to determine of relative prices of goods: The concept of opportunity cost is
useful in explaining the determination of relative prices of different goods. For instance, if
the same group of factors can produce either one car or six scooters, then the price of one
car will tend to be at least six times more than that of one scooter.
b) Assists to determine of normal remuneration to a factor: The opportunity cost sets
the value of a productive factor for its best alternative use. It implies that if a productive
factor is to be retained in its next best alternative use, it must be compensated for or paid
at least what it can earn from its next best alternative use. For instance, if a college
Professor can get an alternative employment in a bank as an officer at a salary of Rs.
20,000 per month, the college has to pay at least Rs. 20,000 salary to retain him in the
college.
c) Support for decision making and efficient resource allocation: The concept of
opportunity cost is essential in rational decision making by the producer. This can be
explained with the help of an example. Suppose, a producer in the automobile industry has
to decide as to whether he should produce motor cars or scooters out of his given
resources. He can arrive at a rational decision by measuring the opportunity costs of
producing cars and scooters and making a comparison with the prevailing market prices of
these goods. The concept of opportunity cost serves as a useful economic tool in analyzing
optimum resource allocation and rational decision making.
iii) Incremental cost
Incremental cost is the overall change that a company experiences by producing one
additional unit of goods. Incremental cost is the composition of total cost from the surrogate
of contributions, where any increment is determined by the contribution of the cost. If the
good being produced is infinitely divisible, so the size of a marginal cost will change with
volume, as a non-linear and non-proportional cost function includes the following:
i) Variable terms dependent to volume,
ii) Constant terms independent to volume and occurring with the respective lot size,
iii) Jump fix cost increase or decrease dependent to steps of volume increase.
iv) Money Cost
Cost of production measured in terms of money is called the money cost. Money cost is the
monetary expenditure on inputs of various kinds raw materials, labour, etc., required for the
output. It is the money spent on purchasing the different units of factors of production
needed for producing a commodity. Money cost is, obviously the payment made for the
factors in terms of money. Money cost is the outlay cost, i.e., actual financial expenditure of
the firm.
The following items of a firms expenditure are explicit money costs:
i) Costs of raw materials;
ii) Wages and salaries;

iii) Power charges;

iv) Rent of business or factory premises;
v) Interest payments of capital invested;
vi) Insurance premiums;
vii) Taxes like property tax, duties, license fees etc.
viii) Miscellaneous business expenses like marketing and advertising expenses, transport
cost, etc.
v) Implicit costs
Implicit costs are the opportunity costs of the use of factors which a firm does not buy or
hire but already owns. Implicit costs are not directly incurred by the firm through market
transactions, but nevertheless are to be reckoned in the measurement of total money costs
of production. These are to be imputed or estimated on the bases of the opportunity costs,
i.e., from what the factors owned by the firm itself could earn in their next best alternative
employment.
Implicit money costs are imputed payment which is not directly or actually paid out by the
firm as no contractual disbursement is fixed for them. Such implicit money costs arise when
the firm or entrepreneur supplies certain factors owned by himself. For instance, the
entrepreneur may have his own land in production, for which no rent is to be paid in the
actual sense. But this, however, is to be reckoned as a cost, assuming that if the
entrepreneur had rented this land to somebody, he would have definitely earned some rent.
Hence, such rent is to be imputed and regarded as implicit money cost.
Implicit costs are as follows:
i) Wages of labour rendered by the entrepreneur himself.
ii) Interest on capital supplied by him.
iii) Rent of land and premises belonging to the entrepreneur himself and used in his
production.
iv) Normal returns (profits) of entrepreneur, compensation needed for his management and
organizational activity.