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Unit 2: Cost Elements and Classification

line of production. Therefore, when an economist says that a firm is just covering its costs, it is Notes
meant that all explicit and implicit costs are being met, and that, the entrepreneur is receiving
a return just large enough to retain his/her talents in the present line of production. If a firm’s
total receipts exceed all its economic costs, the residual accruing to the entrepreneur is called
an economic profit, or pure profit. Example of Economic Profit and Accounting Profit Mr. Raj
is a small store owner. He has invested ` 2 lakh as equity in the store and inventory. His annual
turnover is ` 8 lakh, from which he must deduct the cost of goods sold, salaries of hired staff, and
depreciation of equipment and building to arrive at annual profit of the store. He asked help of a
friend who is an accountant by profession to prepare annual income statement. The accountant
reported the profit to be ` 1.5 lakh. Mr. Raj could not believe this and asked the help of another
friend who is an economist by profession. The economist told him that the actual profit was only
` 75,000 and not ` 1.5 lakh. The economist found that the accountant had underestimated the
costs by not including the implicit costs of time spent as Manager by Mr. Raj in the business and
interest on owner’s equity.

Controllable and Non-controllable Costs

Controllable costs are those which are capable of being controlled or regulated by executive
vigilance and, therefore, can be used for assessing executive efficiency. Non-controllable costs
are those, which cannot be subjected to administrative control and supervision. Most of the costs
are controllable, except, of course, those due to obsolescence and depreciation. The level at which
such control can be exercised, however, differs: some costs (like, capital costs) are not controllable
at factory’s shop level, but inventory costs can be controlled at the shop level.

Out-of-Pocket Costs and Book Costs

Out of pocket costs are those costs that improve current cash payments to outsiders. For example,
wages and salaries paid to the employees are out-of pocket costs. Other examples of out-of-
pocket costs are payment of rent, interest, transport charges, etc. On the other hand, book costs
are those business costs, which do not involve any cash payments but for them a provision is
made in the books of account to include them in profit and loss accounts and take tax advantages.
For example, salary of owner manager, if not paid, is a book cost. The interest cost of owner’s
own fund and depreciation cost are other examples of book cost. The out-of-pocket costs are
also called explicit costs and correspondingly book costs are called implicit or imputed costs.
Book costs can be converted into out-of-pocket costs by selling assets and leasing them back
from buyer. Thus, the difference between these two categories of cost is in terms of whether the
company owns it or not. If a factor of production is owned, its cost is a book cost while if it is
hired it is an out-of-pocket cost.
Relevant Costs and Irrelevant Costs

The relevant costs for decision-making purposes are those costs, which are incurred as a result of
the decision under consideration. The relevant costs are also referred to as the incremental costs.
Costs that have been incurred already and costs that will be incurred in the future, regardless of
the present decision are irrelevant costs as far as the current decision problem is concerned. There
are three main categories of relevant or incremental costs.

The present-period explicit costs, the opportunity costs implicitly involved in the decision, and
the future cost implications that flow from the decision. For example, direct labour and material
costs, and changes in the variable overhead costs are the natural consequences of a decision to
increase the output level. Also, if there is any expenditure on capital equipments incurred as a
result of such a decision, it should be included in full, not withstanding that the equipment may
have a useful life remaining after the present decision has been carried out. Thus, the incremental
costs of a decision to increase output level will include all present-period explicit costs, which

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