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).
Fig. 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.
Fig. 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.
Fig. 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).
Fig. 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.
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