Page 32 - DCOM202_COST_ACCOUNTING_I

Cost Accounting – I

Notes own business is 0, the opportunity cost is ` 5 lakh per year. Therefore, the opportunity cost is the
earnings he foregoes by working for his own firm. One may ask you that whether this opportunity
cost is really meaningful in the decision making process. As we see that the opportunity cost is
important simply because, if Mr. Ram cannot recover this cost from his new business, then he
will probably return to his old job. Opportunity cost can be similarly defined for other factors of
production. For example, consider a firm that owns a building and therefore do not pay rent for
office space. If the building was rented to others, the firm could have earned rent. The foregone
rent is an opportunity cost of utilizing the office space and should be included as part of the cost
of doing business. Sometimes these opportunity costs are called as alternative costs.

Explicit and Implicit Cost

Explicit costs are those costs that involve an actual payment to other parties. Therefore, an explicit
cost is the monitory payment made by a firm for use of an input owned or controlled by others.
Explicit costs are also referred to as accounting costs. For example, a firm pays ` 100 per day to a
worker and engages 15 workers for 10 days, the explicit cost will be ` 15,000 incurred by the firm.
Other types of explicit costs include purchase of raw materials, renting a building, amount spent
on advertising etc. On the other hand, implicit costs represent the value of foregone opportunities
but do not involve an actual cash payment. Implicit costs are just as important as explicit costs
but are sometimes neglected because they are not as obvious. For example, a manager who runs
his own business foregoes the salary that could have been earned working for someone else as
we have seen in our earlier example. This implicit cost generally is not reflected in accounting
statements, but rational decision-making requires that it be considered. Therefore, an implicit
cost is the opportunity cost of using resources that are owned or controlled by the owners of the
firm. The implicit cost is the foregone return, the owner of the firm could have received had they
used their own resources in their best alternative use rather than using the resources for their
own firm’s production.

Accounting and Economic Cost

For a long time, there has been a considerable disagreement among economists and accountants
on how costs should be treated. The reason for the difference of opinion is that the two groups
want to use the cost data for dissimilar purposes. Accountants always have been concerned
with firms’ financial statements. Accountants tend to take a retrospective look at firms finances
because they keep trace of assets and liabilities and evaluate past performance. The accounting
costs are useful for managing taxation needs as well as to calculate profit or loss of the firm. On
the other hand, economists take forward-looking view of the firm. They are concerned with what
cost is expected to be in the future and how the firm might be able to rearrange its resources to
lower its costs and improve its profitability. They must therefore be concerned with opportunity
cost. Since the only cost that matters for business decisions are the future costs, it is the economic
costs that are used for decision-making. Accountants and economists both include explicit costs
in their calculations. For accountants, explicit costs are important because they involve direct
payments made by a firm. These explicit costs are also important for economists as well because
the cost of wages and materials represent money that could be useful elsewhere. We have already
seen, while discussing actual costs and opportunity costs, how economic cost can differ from
accounting cost. In that example we have seen how a person who owns business chooses not to
consider his/her own salary. Although, no monitory transaction has occurred (and thus would
not appear as an accounting cost), the business nonetheless incurs an opportunity cost because
the owner could have earned a competitive salary by working elsewhere. Accountants and
economists use the term ‘profits’ differently. Accounting profits are the firm’s total revenue less
its explicit costs. But economists define profits differently. Economic profits are total revenue
less all costs (explicit and implicit costs). The economist takes into account the implicit costs
(including a normal profit) in addition to explicit costs in order to retain resources in a given

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