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1.2. Different Cost Definitions

Cost case based on the costs of driving a car.

Different cost related problems are treated later in this chapter in relation to a simple car case (My Uncle's Car, case 1.6). Why the description of cost functions, cost types, and other costs are relevant to decision-making is based on the determination of the costs of owning and driving a car.

The case is simple but contains many of the issues that appear in when determining the costs of a specific activity.

Expenses, payment, and costs

When determining costs, one has to differentiate between the following terms:

o Expenses, which are implicit in the making of a deal, purchasing factors, and production.

o Payments, which are the cash flow resulting from expenses.

o Costs, which appear when the specific factors of production are utilized in relation to a given activity.

Based on the car case:

o Fuelling up is an expense

o If cash is the method of payment, then the expense generation and payment occurs simultaneously. Whereas when a creditcard/membership card is the means payment, then the actual payment experiences a time delay, i.e. when the debt to the creditcard or membership card is cleared.

o The cost of a given trip appears as the fuel is consumed.

Generally speaking:

o An expense and a payment are separated when buying on credit.

o Costs usually have to be spread over many usage periods, i.e. if the factor of production endures in many years: e.g. the buying of the car (the depreciation is spread over several years).

In certain circumstances:

o The opportunity costs can exist even though there is no matching expense or payment, which is the case when your own factors of production are used; e.g. a farmer who himself is working on the farm, or a grocer who has tied his own money up in the inventory. When using own factors of production the opportunity costs are of great significance (see below).

o An expense can exist without any payment, which is the case if the supplier accidentally does not send the bill, or if the firm goes bankrupt and is not able to pay the bill.

o An expense can exist without a matching cost; i.e. if the expense does not concern the specific activity; e.g. the purchase of inoperative software or the hiring of a person that does not show up at work.

Different cost definitions

It is important to understand there are many differences and similarities concerning costs, which is why different definitions and examples of cost types are listed below.

Costs of consumption/ usage

In terms of the consumption/usage definition, costs are defined as: "The, in money, assessed consumption/usage of production assets, included in the completion of a given product and sales procedure!"4

In other words, it is about costs that are paid or realized through loss in value.

Based on car case 1.6 the costs of consumption/usage are the, in money, assessed consumption/usage of factors of production concerning the owning and driving of a car. Examples of costs of consumption/usage are:

o Fuel, tires, maintenance, wear and tear etc. All of which are consumed/used during the driving of the car, i.e. mileage-dependent costs.

o Insurance, vehicle excise duty, interest etc. All of which are consumed/used by letting the car stand still, i.e. time dependent costs.

o And then some costs that are difficult to manage: e.g. the risk of damaging the car while driving (damage typically results in the payment of own risk and in some cases a higher premium), or a flat tire, an act of vandalism on the car, a deficiency in the alarm system etc.

Depending on what the decision-making situation demands, consumption/usage costs can be stated in terms of mileage, trip, period of time, driver, or as situation-dependent.

Opportunity costs

Opportunity costs are defined as the indirect loss in income, occurring if the factors of production have alternative uses that are excluded by the activity.

In this situation, we see an expansion of the consumption perspective as the use of own factors of production, such as workforce and equity, are embraced. Here the exclusion of alternative activity is also embraced.

If carrying out activity X inhibits the possibility of carrying out activity Y, then the value of carrying out activity Y is the opportunity cost of activity X. Opportunity costs are also called implicit costs.

To an owner of a car the opportunity costs are equal to the value of the best alternative, in the case that having the car rules out other activities. Some examples:

o Alternate rate of return possibilities on the capital that is tied up in the car. This example is determined by the fact that if the car were sold or not bought in the first place, yield could be obtained by buying stocks or bonds.

o Alternate leasing of the car, which means that if driving in the car excludes the possibility of leasing it, the lost income is an opportunity cost.

Grocer case 1.2:

A minor grocery store is owned by a 35 year-old man and has an annual turnover of 2,100,000 DKK and annual costs of 1,750,000 DKK which, without taking opportunity costs into consideration, makes a profit of 350,000 DKK a year. He has tied up 500,000 DKK in the inventory and he has, if he is willing to sell, been offered 500,000 DKK in goodwill for the business, money that could produce a 4% yield on the bond market. Moreover he has been offered a job at a major retailer offering a yearly salary of 320,000 DKK -and possibly better working conditions.

The profit of the grocer is presented with and without opportunity costs in table 1.2:

Profit excluding opportunity costs:

Profit including opportunity costs:

Turnover 2,100,000 kr.

Turnover 2,100,000 kr.

- Costs of usage

- Costs of usage

1,750,000 kr.

1,750,000 kr.

- Opportunity costs (yield)

40,000 kr.

- Opportunity costs (alternative salary)

320,000 kr.

Profit

Profit

350,000 kr.

- 10,000 kr.

Table 1.2: The profit of the grocer, excluding and including opportunity costs.

According to table 1.2 the grocer achieves a profit of 350,000 DKK but it excludes other alternative activities (yield and salary if employed), which results in a direct loss of income of 360,000 DKK. According to this, the grocer would achieve an additional income of 10,000 DKK a year by closing down business, taking the job at the retailer, and investing the released capital from the inventory in bonds.

 
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