Recording-2025-03-04T17:42:29.056Z

Cost Concepts

Explicit Cost

• Definition: Costs for resources that are not owned by an individual or business, which must be paid for directly.

• Examples:

  • Grocery shopping at Miles or Kroger: Paying for products purchased.

  • Fast-food purchase, like a Big Mac at McDonald's: A direct payment for food.

  • In a business context:

    • Labor costs: Paying employees for their work (e.g., hiring staff).

    • Material costs: Payments to suppliers for goods necessary to produce products (e.g., ingredients for a pizza).

    • Interest on borrowed money from banks: Required payments based on loans.

    • Rent: Direct payments to landlords for leasing premises (e.g., a building for business).

Implicit Cost

• Definition: Costs associated with resources owned by the individual or business that are used for alternative purposes rather than for running the business.

• Examples:

  • Opportunity cost of a leased building: If a building was leased for $25,000 annually but is now used for the owner’s business instead, that potential income represents an implicit cost.

  • Investment opportunity cost: If $500,000 invested at 10% (resulting in $50,000 annual income) is used for business instead, missing out on that income reflects an implicit cost.

• Comparison with Explicit Cost:

  • Explicit costs involve actual cash payments, while implicit costs are theoretical loss of potential income.

Differentiating Costs

• Accounting Profit vs. Economic Profit:

  • Zero accounting profit may suggest breaking even, but when implicit costs are factored in, true economic losses may persist.

  • Economic profit considers both implicit and explicit costs, which can show a different financial situation than accounting profit alone.

Production Decisions

• Shutting Down vs. Selling Business:

  • Shutting down implies halting production but retaining the business for potential future profit opportunities.

  • Selling the business means it no longer exists, erasing future possibilities of profit.

• Fixed Cost/Overhead Expenses:

  • Represents costs incurred regardless of production levels, such as rent, utilities, and other perpetual expenses (e.g., $50/month cable subscription).

Decision Making Under Loss

• When faced with losses, analyze:

  • Continuing production despite losses versus shutting down.

  • If continuing production results in lower losses than shutting down, keeping the business open is often preferred.

  • Decisions focus on potential for future profitability against current direct costs.

Short Run vs. Long Run

• Short Run:

  • Defined by at least one fixed input (resource).

  • Capital and technology remain constant while variable inputs (labor) change.

  • Fixed and variable costs are recognized, but fixed costs do not exist if all inputs are variable.

• Long Run:

  • No fixed inputs; all inputs are variable.

  • Fixed costs are irrelevant, focusing solely on variable costs and operating costs.

Definitions for Consideration

• Fixed Cost:

  • Costs that must be paid regardless of production quantity.

  • Also known as overhead or startup costs.

• Variable Cost:

  • Costs that fluctuate based on production levels; also referred to as operating costs.

Understanding Costs and Profits

• At zero production, total variable costs remain zero, but fixed costs persist.

• Profit calculations involve total revenue minus total of explicit and implicit costs.

• Insight into how costs interact helps in determining overall business viability and future decisions.