FormalPara Definition

‘Cost’ is the amount of money that must be expended to achieve specific objectives. Although seemingly a straightforward concept, various notions of ‘cost’ have been developed to serve different purposes.

‘Cost’ is the amount of money that must be expended to achieve specific objectives (in a business context, typically the production or acquisition of goods or services). Although seemingly a straightforward concept, various notions of ‘cost’ have been developed to serve different purposes. Economic concepts of ‘cost’ deviate from standard accounting measures, and economic characterizations can depend on the time frame of analysis. Furthermore, economic concepts such as ‘opportunity costs’ and ‘transaction cost’, intended as guides for managerial decision-making, are distinct from actual monetary expenditures. These conceptual distinctions can have important managerial and strategic implications. Some common notions of ‘cost’ are described briefly below and in greater detail elsewhere in this volume.

Accounting Measures of Cost

Accounting costs capture the recorded value of monetary expenditures made by the firm. There are three basic categories of accounting costs: materials costs, (direct) labour costs and overhead costs. The latter includes subcategories such as indirect labour (including managerial labour), depreciation, rent, utilities and so on. Details of cost accounting can be found in textbooks such as Horngren and colleagues (2011).

A major purpose of cost accounting is to develop measures of fixed and variable cost per unit of output, to provide information for decision-making. Unit cost calculations are often sensitive to how overhead costs are determined and allocated, given that overheads account for the bulk of total costs in many companies today. Moreover, the extent to which overheads are fixed or variable depends on the time frame of analysis. Thus, accounting estimates of unit cost are always arbitrary to some degree.

Accounting measures give little or no information about notions of cost that are not directly linked to the firm’s transactions, such as sunk costs, opportunity costs and transaction costs. Such dimensions of cost often have the most important managerial and strategic implications.

Economic Concepts of Cost

Economists have developed numerous concepts of cost that differ from the accounting measures. The primary economic concept is that of ‘opportunity cost’: the value of a resource in its next best use. Opportunity cost differs from out-of-pocket cost in that it values a resource on the basis of its best alternative application (obtainable by reallocating the resource within the firm, or by selling it outside). This value may be higher or lower than the amount of money originally expended to acquire the resource. Although not directly observable, opportunity cost is the notion that economists consider most relevant for managerial decisions pertaining to resource allocation.

The classical theory of the firm described in economic textbooks is rooted in concepts of fixed, variable and marginal cost. Fixed costs are those that do not vary with the volume of output over the time frame of analysis. (A typical example is the cost of renting equipment and facilities, which is set at the start of each time period and thus does not depend on the volume of output produced.) Variable costs are those that increase with the volume of output (e.g., raw materials, temporary workers). The firm’s total costs are the sum of its fixed and variable costs. Marginal cost is the change in total cost associated with one additional unit of output or, equivalently, the variable cost of producing one more unit. The classical economic theory of the firm implies that decisions relating to output and pricing should be based on marginal cost.

Modern perspectives emphasize the idea that some types of fixed costs are also ‘sunk’. Sunk costs are expenditures that cannot be recouped if the firm exits from the business. Advertising and R&D are important categories of sunk costs, and expenditures on physical facilities often have a sunk cost component. (Note that rent is not sunk, unless a continued stream of rental payment is contractually required. Similarly, the purchase cost of a building or equipment is not sunk if the assets can be sold or used for other purposes without loss. However, if assets take a specialized form that reduces the value that can be obtained in best alternative use or outside sale, the reduction in value from the original purchase price represents a sunk cost.)

Sunk costs are important for several reasons. Investments made by a firm can shift the firm’s cost structure, potentially reducing the firm’s marginal cost. When these investments take the form of sunk costs and are made ahead of competitors, they can serve as a means for strategic commitment and market pre-emption (Ghemawat 1991). Similar logic reveals that industries with high sunk costs tend to have high producer concentration (Sutton 1991).

Sunk costs also have important managerial implications. Economic logic implies that sunk costs, once incurred, should be rationally ignored in making subsequent decisions (which should be based solely on forward-looking marginal or opportunity costs). Nevertheless, sunk costs are often misperceived by managers in ways that distort decision-making. Many managers and individuals treat sunk costs as if they are continuing costs that need to be recouped in the future, a phenomenon known as the ‘sunk cost fallacy’. One explanation for such behaviour is ‘loss aversion’, a common cognitive bias identified by psychologists and behavioural economists (Kahneman 2011).

Transactions cost theory is based on concepts of sunk costs that are specific to a particular business transaction or set of partners. ‘Transactions costs’ arise when firms make relation- or partner-specific investments in order to pursue economic transactions.

In many situations, the costs incurred by a firm do not include all of the economic costs paid by society. For example, production of a product or service may generate air or water pollution; this imposes costs on society that may not be fully charged to the firm. In such cases, the ‘social costs’ of the good or service can exceed the private costs because of external diseconomies or ‘externalities’.

See Also