1 Introduction to Cost Concepts

 

1.1 Meaning of Cost

  • Definition: Cost is the amount of expenditure incurred on a particular product or activity. In business, understanding cost is essential for pricing, profitability analysis, and financial planning.
  • Types of Costs:
    • Explicit Costs: Direct, out-of-pocket expenses (e.g., raw material cost).
    • Implicit Costs: Opportunity costs or the cost of foregone alternatives (e.g., interest on capital invested).

1.2 Cost Concepts

  • Fixed Cost: Cost that does not change with the level of output. Examples include rent, insurance, and salaries.
  • Variable Cost: Cost that varies directly with the production level, such as raw materials and direct labor.
  • Semi-variable Cost: Cost that has both fixed and variable components, like electricity bills where there’s a fixed charge plus a usage-based charge.

1.3 Cost Classification

  • By Nature:
    • Direct Costs: Costs directly associated with production (e.g., raw materials).
    • Indirect Costs: Costs not directly traceable to a product but necessary for production (e.g., factory rent).
  • By Function:
    • Production Costs: Costs incurred in the production process.
    • Selling and Distribution Costs: Costs related to promoting and delivering products.
  • By Behavior:
    • Fixed Costs: Remain unchanged with output levels.
    • Variable Costs: Fluctuate with production.
  • Solved Example:
    • Problem: A factory incurs $5,000 fixed monthly rent and $2 per unit in variable costs. Calculate the total cost for 1,000 units.
    • Solution: Fixed cost + (Variable cost * Units produced) = $5,000 + ($2 * 1,000) = $7,000.

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