Cost Concept In Accounting and Economics

The cost concept is a key concept of Economics. It is based on the valuation of materials, resources, time, risks and utilities consumed for purchasing goods and services. The concept of cost refers to the amount of payment made for acquiring goods and services. According to this accounting principle of cost concept, items should be recorded and valued at the price for which they were bought instead of the price at which they can be sold now. It is not a cost management concept as it might sound. Instead, it is a foundational concept of accounting.

Table of Contents

• What is the historical cost concept?
• What is cost concept in economics?
• Why was Cost Concept Introduced in Accounting?
• Difference between cost concept in accounting and economics

What is Cost Concept in Accounting?

• Also known as the historical cost concept, an asset must be recorded at the original purchase price or cost.
• Even during changes in the market value of that asset, the cost does not change over time.
• It must be recorded at its original purchase price or cost.
• The aim is to keep things consistent and straightforward.
• Main goal is to ensure that financial statements are verifiable and objective in nature.
• By following this historical cost concept in accounting, a clear and consistent value of assets and liabilities is available on the balance sheet.

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Example of Historical Cost Concept in Accounting

• Let us understand this principle of accounting with a simple example. Supposedly, you bought a new smartphone for rupees 60,000.
• A year later, its resale value has dropped to 30,000. If you maintain a balance sheet, you will still list that phone for 60,000 rupees even if its market value has dropped.
• As per the cost concept in accounting, items are recorded based on their original purchase price instead of the current market value.

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What is Cost Concept in Economics?

• Cost principle of accounting differs from the cost concept in Economics.
• In Economics, the cost concept considers the value of resources used to produce goods and services.
• Cost concept in Economics covers implicit as well as explicit costs.

The following are the different types of costs that are included in the cost concept of Economics:

Opportunity Cost

• This refers to the amount of your second-best choice.
• Suppose, you had two choices on which you could have spent money.
• The first one was going on a trip to Bali. The second choice was buying a luxurious Louis Vuitton bag.
• Between these two choices, you spent your money on a Bali trip.
• Hence, the opportunity cost, in this case, will be the cost of buying a Louis Vuitton bag.

Explicit Costs

• It is also known as ‘out-of-pocket’ costs.
• These are the cost of monetary payments made by individuals or businesses for using resources.
• Such costs are easily recorded since they measure tangible monetary transactions.
• Explicit costs include wages, salaries, rent, utilities, raw materials, taxes, insurance premiums and interest payments.

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Implicit Costs

• It is also known as imputed costs or opportunity costs.
• These are the costs of using resources that are owned by firms with no burden of making explicit payment.
• Since they have no direct monetary payment, these costs are not recorded in the company's financial books.
• Implicit cost is based on the opportunity cost concept.
• When an owner uses their own resources in their business without receiving explicit compensation.
• Owned property, capital invested in the business and the owner’s labour are examples of implicit costs.

Fixed Costs

• Fixed costs are expenses that don’t change with the level of production or sales.
• They remain consistent regardless of how much is produced or sold.
• These costs are typically consistent over a specific time frame.
• They do not increase with more production or decrease with less.
• They are essential for running a business, even if no products are made or sold.
• Rent, insurance, salaries, and equipment leases are examples of fixed costs.

Variable Costs

• Variable Costs are expenses that change directly with the level of production or sales.
• They fluctuate based on how much is produced or sold. Unlike fixed costs, they can vary over a specific time frame.
• Such costs increase with more production and decrease with less.
• These costs are directly tied to business operations and production levels.
• Cost of purchasing raw materials, hourly wages, and utility bills based on usage.

Total Costs

• Total Costs represent the sum of all the expenses a business incurs.
• This combines both fixed and variable costs.
• It gives a comprehensive view of how much a business spends to produce its goods or services.
• The more you produce, the higher the total costs due to variable costs. Business expenditures, from rent and salaries to raw materials and utility bills are all types of total costs

Marginal Cost

• Marginal Cost is the cost of producing one additional unit of a product.
• It shows the change in total costs when production increases by a single unit.
• This cost helps businesses decide if producing more is financially viable. It helps in determining optimal production levels.
• An example of marginal cost is if the total cost of producing ten items is $100 and for 11 items is $105, the marginal cost of the 11th item is $5.

Average Costs

• Average Cost is the total cost divided by the number of units produced.
• It provides a per-unit cost of production.
• This cost helps businesses set product prices and assess production efficiency.
• It is a way to spread out total costs over the number of items produced.
• For example, if the total cost to produce 100 items is $1500, the average cost per item is $15.

Why was Cost Concept Introduced in Accounting?

The cost concept, also known as the historical cost concept, is a fundamental accounting principle requiring assets to be recorded and reported on the financial statements at their original purchase or acquisition cost. This principle was introduced in accounting for several important reasons:

1. Objectivity and Reliability: The historical cost concept provides a basis for objective and reliable financial reporting. The cost of an asset is typically a verifiable and easily determinable figure, making it less subject to manipulation or bias compared to other valuation methods.
2. Verifiability: Historical cost is based on actual transactions, such as purchase invoices and payment receipts. This makes it easy to verify the accuracy of recorded costs, both internally within an organization and by external auditors.
3. Simplicity: Historical cost is a straightforward method of valuation that is easy to understand and apply. It does not require complex estimates or assumptions, which can be true with other valuation methods like fair value.
4. Consistency: The historical cost concept promotes consistency in financial reporting. Valuing assets at their original cost ensures that similar assets are treated consistently over time, making it easier for users of financial statements to compare performance and financial position across different periods.
5. Stability: Historical cost helps to provide a stable and predictable financial picture of an entity. It avoids frequent fluctuations in asset reported value that can occur with methods like fair value, which can be influenced by market volatility.
6. Matching Principle: The historical cost concept aligns with the matching principle, another fundamental accounting principle. As per this principle, expenses should be recognized in the same period as the revenues they help generate. Historical cost provides a reliable basis for matching the cost of an asset to the periods in which it contributes to earning revenue.
7. Conservatism: Historical cost is considered a conservative valuation method because it understates the value of assets. This conservative approach helps to avoid overstatement of assets and profits, which can be misleading to investors and creditors.
8. Taxation and Regulation: Tax laws and regulatory frameworks are based on the historical cost concept in many jurisdictions. Tax authorities often require businesses to calculate taxes based on the cost of assets. Additionally, regulatory bodies may mandate the use of historical costs in financial reporting for specific industries or asset classes.
9. Prudence: The historical cost concept reflects the principle of prudence, which suggests that financial statements should not overstate an entity's financial position or performance. Recording assets at their original cost is prudent, as it avoids potentially inflated valuations.

Sunk Costs

• Sunk Cost is a cost that has already been incurred and can’t be recovered.
• It refers to the money spent in the past that cannot be refunded or changed.
• These costs should not influence future business decisions.
• They are irrelevant for future operations and decision-making.
• An example of a sunk cost is money spent on an advertising campaign that didn’t yield the expected results.

Difference between Cost concept in Accounting and Economics