Theory of Cost

Concept of Costs and Cost Function

Objectives
After going through this lesson, you shall be able to understand the following concepts.

• Cost Analysis
• Types of Costs
• Cost Function

Introduction

We know that the process of production of output involves a number of costs. For instance, payments must be made to the factors of production; raw material needs to be purchased, etc. In other words, expenditure is incurred on various factors and non-factors of production. It is of immense importance for the producer to analyse the cost of production with regard to various factors such as output, level of operation, etc.

Cost Analysis

It refers to the systematic process of calculating and comparing cost associated with various production criteria such as size of output, scale of operations etc. In other words, cost analysis involves the study of the financial aspect of production.

Types of Costs

In economics, the following types of costs can be identified with regard to production.

Explicit Cost

Explicit cost refers to the expenditure incurred or payments made by a firm to various factors of production (such as land, labour, etc.) and also non-factors of production (such as raw material). It is also known as outlay cost or accounting cost.

Opportunity Cost

It refers to the cost of enjoying more of one good/activity in terms of sacrificing the benefit of another good/activity. In other words, it includes the cost of the next best alternative forgone. For instance, suppose a business entrepreneur uses his own land to set up office premises. The same land could have been given on rent and would have formed a source of income for the business. In this case, the opportunity cost of using land for the office premises is the rent that is foregone. Similarly, suppose the entrepreneur invested his own capital in the business. He could have used the same capital in buying some interest-earning assets. Thus, the opportunity cost of capital is the foregone interest. Opportunity cost is also known as implicit cost.
As such costs are difficult to measure, they are not recorded in books of accounts.