Accounting Costs and Economic costs: An entrepreneur has to pay price for the factors of production
which he employs for production. He thus pays wages to workers employed, prices for the raw materials,
fuel and power used, rent for the building he hires and interest on the money borrowed for doing business.
All these are included in his cost of production and are termed as accounting costs. Accounting costs relate
to those costs which involve cash payments by the entrepreneur of the Firm. Thus, accounting costs are
explicit costs and includes all the payments and charges made by the entrepreneur to the suppliers of
various productive factors. Accounting costs are expenses already incurred by the Firm. Accountants record
these in the financial statements of the Firm
However, it generally happens that an entrepreneur invests a certain amount of capital in his business. If the
capital invested by the entrepreneur in his business had been invested elsewhere, it would have earned a
certain amount of interest or dividend. Moreover, an entrepreneur may devote his time to his own work of
production and contributes his entrepreneurial and managerial ability to do business. Had he not set up his
own business, he would have sold his services to others for some positive amount of money. Accounting
costs do not include these costs. These costs form part of economic cost. Thus, economic costs include:
(1) the normal return on money capital invested by the entrepreneur himself in his own business; (2)
the wages or salary not paid to the entrepreneur, but could have been earned if the services had been
sold somewhere else. Likewise, the monetary rewards for all factors owned by the entrepreneur himself
and employed by him in his own business are also considered a part of economic costs. Economic costs
take into account these accounting costs; in addition, they also take into account the amount of money
the entrepreneur could have earned if he had invested his money and sold his own services and other
factors in the next best alternative uses. Accounting costs are also called explicit costs whereas the cost of
factors owned by the entrepreneur himself and employed in his own business is called implicit costs. Thus,
economic costs include both accounting costs and implicit costs. Therefore, economic costs are useful for
businessmen while making decisions. The concept of economic cost is important because an entrepreneur must cover his economic cost if he
wants to earn normal profits. Normal profit is part of implicit costs. If the total revenue received by an
entrepreneur just covers both implicit and explicit costs, then he has zero economic profits. Super normal
profits or positive economic profits (abnormal profits) are over and above these normal profits. In other
words, an entrepreneur is said to be earning positive economic profits (abnormal profits) only when his
revenues are greater than the sum of his explicit costs and implicit costs.
Outlay costs and Opportunity costs: Outlay costs involve actual expenditure of funds on, say, wages,
materials, rent, interest, etc. Opportunity cost, on the other hand, is concerned with the cost of the next
best alternative opportunity which was foregone in order to pursue a certain action. It is the cost of the
missed opportunity and involves a comparison between the policy that was chosen and the policy that was
rejected. For example, the opportunity cost of using capital is the interest that it can earn in the next best
use with equal risk.
A distinction between outlay costs and opportunity costs can be drawn on the basis of the nature of the
sacrifice. Outlay costs involve financial expenditure at some point of time and hence are recorded in the
books of account. Opportunity cost is the amount or subjective value that is foregone in choosing one
activity over the next best alternative. It relates to sacrificed alternatives; it is, in general not recorded in the
books of account. The opportunity cost concept is generally very useful for business managers and therefore it has to be
considered whenever resources are scarce and a decision involving choice of one option over other(s) is
involved. e.g., in a cloth mill which spins its own yarn, the opportunity cost of yarn to the weaving department
is the price at which the yarn could be sold. This has to be considered while measuring profitability of the
weaving operations.
In long-term cost calculations also opportunity cost is a useful concept e.g., while calculating the cost of
higher education, it is not the tuition fee and cost of books alone that are relevant. One should also take into
account the earnings foregone, other foregone uses of money which is paid as tuition fees and the value of
missed activities etc. as the cost of attending classes.
Wednesday, March 17, 2021