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Business Studies

Intelligent people make decisions based on opportunity costs."

- 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, StudySmarter

Figure 1. Fixed Cost, StudySmarter

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 StudySmarter

Figure 2. Variable Costs, StudySmarter

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 StudySmarter

Figure 3. Semi-Variable Costs, StudySmarter

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 StudySmarter

Figure 4. Total Cost, StudySmarter

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.

Cost

Cost is the money a company spends to produce and sell its products and to keep the company running. It refers to all the costs related directly and indirectly to the production, such as the material cost and advertising cost respectively. Costs are differentiated into types depending on their relationship with the level of output of the firm. The types 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.

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. They vary from each other, and are measured differently - 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.

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Final Cost Quiz

Question

Which of the following represents semi-variable costs?

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Answer

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Question

Name the type of cost that has already occurred and can not be retrieved in the future.

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Answer

Sunk costs

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Question

Give an example of a semi-variable cost.

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Answer

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


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Question

Define fixed cost and draw the graph.

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Answer

Fixed cost: Costs that do not change with the level of output.

Examples: Rent, insurance, salary.

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How is the direct cost different from the variable cost?

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Answer

Direct costs are only considered when the firm produces more than one product.


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Question

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

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Answer

monetary

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Question

What type of costs does the graph present?


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Answer

Fixed costs

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Question

What type of costs does the graph present?


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Answer

Variable costs

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Question

What type of costs does the graph present?


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Answer

Semi-variable costs

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Question

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


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Answer

False

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Question

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


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Answer

Opportunity cost

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Question

When it comes to electricity, the base is a fixed cost, but later the cost varies as per consumption. That is why electricity is a ___ cost.


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Answer

semi-variable

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Question

Which of these is a fixed cost?

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Answer

Rent

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Which of these is a variable cost?

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Answer

Cost of packaging

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Question

The sum of the fixed, variable, and semi-variable cost for a particular level of output is called...

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Answer

total cost.

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Question

This is a cost that has already occurred and cannot be retrieved in the future.

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Answer

Sunk cost

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Question

When the output is zero, the total cost is equal to the fixed cost.


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Answer

True

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Question

What does TC stand for in the graph below?


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Answer

total cost

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Question

Total cost = Variable cost + ?

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Answer

Fixed cost

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Question

Research and development are...


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Answer

sunk costs.

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