Cost

Intelligent people make decisions based on opportunity costs."

Cost Cost

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Table of contents

    - Charlie Munger

    When we think of costs in business terms, we often think of the costs associated with producing a product or service; but what about the costs associated with making a decision to choose an alternative? This is known as opportunity cost. Let's examine the different types of costs incurred when making business decisions.

    What is the meaning of cost?

    Cost is defined as the monetary value spent by a company for the production of products and operating the business.

    Cost essentially means the total amount of money a company has to spend to keep it up and running. Every business incurs a cost for the production of its products and can vary from one another - the fixed costs of a firm are valued in terms of depreciation, and the cost of capital used is measured in terms of interest expense for raising the capital.

    Classification of cost

    Costs are classified into types depending on their relationship with the level of output of the firm. Types of costs are as follows:

    Fixed cost

    These are costs that do not change with the level of output.

    Rent, insurance, salaries paid.

    Fixed costs are steady and can be visualised as a horizontal line on a graph (see figure 1 below).

    Cost, Fixed cost graph, StudySmarterFig. 1 - Fixed cost

    Variable cost

    These are costs that depend on the volume of output. Variable costs are doubled when output is doubled and are halved when production reduces to half.

    Packaging costs, or raw material costs.

    Figure 2 shows how variable costs increase when the output quantity increases.

    Cost Variable cost graph StudySmarterFig. 2 - Variable costs

    Semi-variable cost

    These are costs that are both fixed and variable at some point.

    Electricity - the base is a fixed cost, but later the cost varies as per consumption.

    Cost Semi-variable cost StudySmarterFig. 3 - Semi-variable costs

    Direct cost

    Any cost directly associated with the production of a particular product. They are similar to variable costs but are only considered when the firm produces more than one product.

    Direct material costs or direct labour costs (hourly wages).

    Indirect cost

    Also known as indirect overheads, these are costs related to the firm’s output, but are not directly linked to the cost of any produced object.

    Administration cost, or the cost of electricity in the office.

    Opportunity cost

    This represents the cost given up by the firm for choosing an alternate option.

    Purchasing a new expensive machine rather than a cheaper older version. The opportunity cost would be the difference between better and improved productivity vs. the money that could have been saved in terms of interest expense if the cheaper machine was purchased, but with lower performance.

    Sunk cost

    Refers to the cost that has already occurred. These can not be retrieved in the future.

    Research and development costs, or marketing costs.

    Total cost

    This is the sum of the fixed, variable, and semi-variable cost for a particular level of output. When the output is zero, the total cost is equal to the fixed cost (see below).

    Cost Total Cost graph StudySmarterFig. 4 - Total cost

    As a result, there are multiple different costs a business needs to consider. There are not only costs associated with production and operation, but also the costs of making decisions, and costs that can no longer be recovered in the future.

    Cost - Key takeaways

    • Types of costs are fixed costs, variable costs, semi-variable costs, direct and indirect costs, opportunity costs, and sunk costs.

    • Cost is defined as the monetary value spent by a company for the production of products and operating the business.

    Frequently Asked Questions about Cost

    What is cost?


    Cost is defined as the monetary value spent by a company for the production of products and operating the business. Every business incurs a cost for the production of its products. 


    Fixed, variable, semi-variable, direct, indirect, opportunity and sunk costs are the different types of costs.

    What is the definition of cost?

    Cost is defined as the monetary value spent by a company for the production of products and operating the business. 

    Test your knowledge with multiple choice flashcards

    Administration cost and the cost of electricity in the office are direct costs.

    This represents the cost given up by the firm for choosing an alternate option. What type of cost is it?

    Which of these is a fixed cost?

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