Elements of Costs
Cost can be broadly classified into variable cost and overhead cost. Variable cost varies with the volume of production while overhead cost is fixed, irrespective of the production volume.
Variable cost can be further classified into direct material cost, direct labour cost, and direct expenses. The overhead cost can be classified into factory overhead, administration overhead, selling overhead, and distribution overhead.
Direct material costs are those costs of materials that are used to produce the product. Direct labour cost is the amount of wages paid to the direct labour involved in the production activities.
Direct expenses are those expenses that vary in relation to the production volume, other than the direct material costs and direct labour costs.
Overhead cost is the aggregate of indirect material costs, indirect labour costs and indirect expenses. Administration overhead includes all the costs that are incurred in administering the business.
Selling overhead is the total expense that is incurred in the promotional activities and the expenses relating to sales force. Distribution overhead is the total cost of shipping the items from the factory site to the customer sites.
The selling price of a product is derived as shown below:
(a) Direct material costs + Direct labour costs + Direct expenses = Prime cost
(b) Prime cost + Factory overhead = Factory cost
(c) Factory cost + Office and administrative overhead
= Costs of production
(d) Cost of production + Opening finished stock – Closing finished stock = Cost of goods sold
(e) Cost of goods sold + Selling and distribution overhead = Cost of sales
(f) Cost of sales + Profit = Sales
(g) Sales/Quantity sold = Selling price per unit
In the above calculations, if the opening finished stock is equal to the closing finished stock, then the cost of production is equal to the cost of goods sold.
The following are the costs/revenues other than the costs which are presented in the previous section:
ü Marginal cost
ü Marginal revenue
ü Sunk cost
ü Opportunity cost
1. Marginal Cost
Marginal cost of a product is the cost of producing an additional unit of that product. Let the cost of producing 20 units of a product be Rs. 10,000, and the cost of producing 21 units of the same product be Rs. 10,045. Then the marginal cost of producing the 21st unit is Rs. 45.
2. Marginal Revenue
Marginal revenue of a product is the incremental revenue of selling an additional unit of that product. Let, the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of selling 21 units of the same product be Rs. 15,085. Then, the marginal revenue of selling the 21st unit is Rs. 85.
3. Sunk Cost
This is known as the past cost of an equipment/asset. Let us assume that an equipment has been purchased for Rs. 1,00,000 about three years back. If it is considered for replacement, then its present value is not Rs. 1,00,000. Instead, its present market value should be taken as the present value of the equipment for further analysis.
So, the purchase value of the equipment in the past is known as its sunk cost. The sunk cost should not be considered for any analysis done from now onwards.
4. Opportunity Cost
In practice, if an alternative (X ) is selected from a set of competing alternatives (X,Y ), then the corresponding investment in the selected alternative is not available for any other purpose. If the same money is invested in some other alternative (Y ), it may fetch some return. Since the money is invested in the selected alternative (X ), one has to forego the return from the other alternative (Y ).
The amount that is foregone by not investing in the other alternative (Y ) is known as the opportunity cost of the selected alternative (X ). So the opportunity cost of an alternative is the return that will be foregone by not investing the same money in another alternative.