The Costs: A Production Manager should know
Followings are the different types of cost, which a Production Manager should know:
Accounting Cost
All these expenses incurred by a producer that enter the accounts
of the accountant in course of production is known as accounting cost.
An entrepreneur pays wages to the labour employed, rent for hiring land
and building, interest on the capital borrowed, prices for raw
material, transport, electricity etc. for doing the business. All these
expenses are placed in the accounts.
Economic Cost
Economic cost takes into account the accounting cost of his
production and the costs arising out of his personal labour and capital
investment. His personal labour and capital invested could have earned
remuneration of otherwise employed somewhere else. But these
remunerations are not received by the entrepreneur himself. When these
remunerations are added in the accounting cost, this constitutes
economic costs.
Historical Cost
In accounting, historical costs is the original monetary value of
an economic item. Historical cost is based on the stable measuring unit
assumption. In some circumstances, assets and liabilities may be shown
at their historical cost, as if there had been no change in value since
the date of acquisition. The balance sheet value of the item may
therefore differ from the "true" value.
A measure of value used in accounting in which the price of an
asset on the balance sheet is based on its nominal or original cost
when acquired by the company. The historical-cost method is used for
assets in the U.S. under Generally Accepted Accounting Principles
(GAAP).
For example, say the main headquarters of a company, which
includes the land and building, was bought for Rs.100,000 in 1925, and
its expected market value today is Rs.20 million. The asset is still
recorded on the balance sheet at Rs.100,000.
Real Cost
The concept of real cost is another view of classical economists.
Real cost is viewed in terms of pains and sacrifices. According to
Marshall the real cost of production of a commodity is expressed not in
money but in efforts and sacrifices undergone in the making of a
commodity. A worker at work derives pain and displeasure and a
capitalist sacrifices his present for the future in laving his money.
While producing a commodity these pain and sacrifice are taken
into consideration and constitute cost of production. The concept of
real cost has little significance in the analysis of price. The main
difficulty with this concept is that effort and sacrifices are purely
subjective and psychological and therefore can not be subjected to
accurate measurement. The doctrine of real cost in words of Prof.
Henderson, "leads us into a quagmire of unreality and dubious
hypothesis."
Opportunity Cost
The concept of opportunity cost is based on scarcity and choice.
The opportunity cost of a commodity is the next best alternative
commodity sacrificed. In other words opportunity cost of a commodity is
forgoing the opportunity to produce alternative goods and services.
This is because resources are scarce. In view of scarcity of resources,
every producer has to make a choice among several alternatives.
If one commodity is produced another commodity is sacrificed. So
opportunity cost of producing a good is equal to the cost of not
producing another commodity. For example the opportunity cost of
producing tomato is the amount of income from the cultivation of
potatoes sacrificed. Suppose the cultivation of potatoes yield Rs.500.
The farmer cultivates tomato instead of potatoes. If he forgoes the
cultivation of potatoes and takes up tomatoes to cultivation he should
get a minimum of Rs.500 which is the amount to be received from the
best alternative potatoes foregone. Thus Rs.500 is the opportunity cost
of tomatoes.
Money Cost
As we have a monetary economy costs are generally expressed in
terms of money. money cost includes various monetary expenditure made
by a producer in the production. These are the Wages and salaries paid
to labour, the expenditure on machinery, the payment for materials,
power, and transportation, advertisement and insurance etc. Therefore
the sum of money spent for producing a particular quantity of commodity
is called its money cost.
Explicit Cost and Implicit Cost
Explicit cost includes these payments which are made by the
employer to those factors of production which do not belong to the
employer himself. These costs are explicitly incurred by the producer
for buying factors from others on contract. For example, the payments
made for raw materials, power, fuel, wages and salaries, the rent on
land and interest on capital are all contractual payments made by the
employer. Explicit cost is also called accounting cost. These costs are
interred in the accountant's list.
The implicit or imputed costs arise in case of those factors which
are owned and supplied by the employer himself. An employer may
contribute his own land, his own capital and even work as the manager
of the firm. He is entitled to receive remuneration for the use of
these personal factors on his own enterprise. All these items would be
included in implicit or imputed costs and are payable to self. Usually
the producers ignore these implicit costs while computing total costs.
Thus total cost should, include both explicit cost and implicit cost.
Social Cost
Social cost is the total cost of the society which includes the
directed and indirect costs that the society pays for the production of
the commodity. The producer always tries to cover his private costs.
But he never takes care of the costs that the society bears consequent
upon his production of commodity. For example a producer counts his
costs of production and never those of people living around the
factory. Production of commodity pollutes air and water which impair
health and property. This is a cost to the society which always exceeds
private cost.
Fixed Cost, Variable Cost and Semi-variable Cost
In the short-run there exist certain factors which are fixed. These
factors can't be changed. And the costs incurred on these factors
constitute fixed cost. Fixed cost does not change with the change in
out-put. Whatever the volume of production fixed cost remains the same.
Fixed cost is to be incurred if there is production or no-production.
Fixed cost includes those costs like interest on capital, salary of the
permanent staff, insurance premium, property taxes etc. Fixed cost is
otherwise known as supplementary cost.
Variable cost is that cost which varies with the volume of output.
Variable cost is to be incurred if there is production only. Variable
cost is more or less depending on the increase and decrease in the
volume of production. Variable cost is otherwise known as, prime cost.
Thus labour, raw materials, chemicals etc. are the factors which can be
readily varied with the change in output.
Semi-Variable Cost - A cost composed of a mixture of fixed and
variable components. Costs are fixed for a set level of production or
consumption, becoming variable after the level is exceeded.
Also known as a "semi-fixed cost."
This type of cost is variable in the sense that greater levels of
production increase total cost. If no production occurs, then a fixed
cost is still incurred.
Labor costs in a factory are semi-variable. The fixed portion is
the wage paid to workers for their regular hours. The variable portion
is the overtime pay they receive when they exceed their regular hours.
Semi-variable cost is an expense which contains both a fixed-cost
component and a variable-cost component. The fixed cost element shall
be a part of the cost that needs to be paid irrespective of the level
of activity achieved by the entity. On the other hand the variable
component of the cost is payable proportionate to the level of activity.
Transaction Costs
Costs incurred when buying or selling securities. These include
brokers' commissions and spreads (the difference between the price the
dealer paid for a security and the price at which it can be sold).
a transaction cost is a cost incurred in making an economic
exchange (restated: the cost of participating in a market).[1] For
example, most people, when buying or selling a stock, must pay a
commission to their broker; that commission is a transaction cost of
doing the stock deal. Or consider buying a spatula from a store; to
purchase the spatula, your costs will be not only the price of the
spatula itself, but also the energy and effort it requires to find out
which of the various spatula products you prefer, where to get them and
at what price, the cost of traveling from your house to the store and
back, the time waiting in line, and the effort of the paying itself;
the costs above and beyond the cost of the spatula are the transaction
costs. When rationally evaluating a potential transaction, it is
important to consider transaction costs that might prove significant.
Sunk Cost
A cost that has already been incurred and thus cannot be recovered.
A sunk cost differs from other, future costs that a business may face,
such as inventory costs or R&D expenses, because it has already
happened. Sunk costs are independent of any event that may occur in the
future.
When making business or investment decisions, individuals and
organizations typically look at the future costs that they may incur,
by following a certain strategy. A company that has spent Rs.5 million
building a factory that is not yet complete, has to consider the Rs.5
million sunk, since it cannot get the money back. It must decide
whether continuing construction to complete the project will help the
company regain the sunk cost, or whether it should walk away from the
incomplete project.
In economics and business decision-making, sunk costs are
retrospective (past) costs that have already been incurred and cannot
be recovered. Sunk costs are sometimes contrasted with prospective
costs, which are future costs that may be incurred or changed if an
action is taken. Both retrospective and prospective costs may be either
fixed (continuous for as long as the business is in operation and
unaffected by output volume) or variable (dependent on volume) costs.
Marginal Cost
In economics and finance, marginal cost is the change in total cost
that arises when the quantity produced changes by one unit. That is, it
is the cost of producing one more unit of a good.
The marginal cost of an additional unit of output is the cost of
the additional inputs needed to produce that output. More formally, the
marginal cost is the derivative of total production costs with respect
to the level of output.
Marginal cost and average cost can differ greatly. For example,
suppose it costs Rs.1000 to produce 100 units and Rs.1020 to produce
101 units. The average cost per unit is Rs.10, but the marginal cost of
the 101st unit is Rs.20
Absorbed Cost / Absorption costing
The indirect costs that are associated with manufacturing. Absorbed
costs include such expenses as insurance, or property taxes for the
building in which the manufacturing process occurs. When the total
manufacturing costs are determined, the implicit absorbed costs are not
considered, but will be included in a separate account.
On a company's income statement, the cost of goods sold entry
does not reflect the absorbed costs; only the actual costs of the
material is included. Incurring insurance and property tax expenses is
a required part of the manufacturing process, but these absorbed costs
are classified as separate expenses.
Absorption costing means that all of the manufacturing costs are
absorbed by the units produced. In other words, the cost of a finished
unit in inventory will include direct materials, direct labor, and both
variable and fixed manufacturing overhead. As a result, absorption
costing is also referred to as full costing or the full absorption
method.
These are all about few costs which a production manager or personnel related to production should know for better operation and facilitating managerial decision making. A general concept is needed because the details and practical portion will be done by cost accountant of the firm.
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About Article Author

Adri Mitra
Asst. Professor
MIT