The concept of cost along with demand and supply sentence three of the basic areas of managerial economics. Analysis of cost is essential when it comes to large-scale production, where the firm is in a position to factorize the economies of scale. For a profit-maximizing firm, the decision to add a new product is done by comparing additional revenues to additional costs associated with that project. Decisions on capital investment are made by comparing rate of return on investment with the opportunity cost of the funds used to make capital acquisition. Costs are equally important in non-profit sector. For example, to obtain funds for a new dam, a government agency has to demonstrate that the value of the benefits of the dam like flood control and water supply, will exceed the cost of the project.
It is necessary that we define the term 'cost' for better understanding. The traditional definition tends to focus on the explicit and historical dimensions of cost. In contrast, the economic approach to cost emphasizes opportunity cost rather than historical and includes both explicit and implicit costs. Opportunity cost of any decision is the value of next best alternative that must be foregone. For example, a manager who hires an additional secretary may have to forego hiring an additional clerk. The management has to make decisions viewing costs from this perspective; say, if the management decides to reallocate the resources from production department to research and development; the organization may be successful in coming out with innovative and better products but at a cost of lower production rate for that period. Obviously, such decisions have to be made only if the management thinks that the potential for future profits outweigh the reduced profits for the current period.
Cost factor is very critical in the area of production. The rate of output depends on the uninterrupted supply of input elements such as raw material, labor and machinery. All these factors add to the total cost, where, in the short run, at least one factor of production is fixed and the cost of that input is called fixed cost. Regardless of the rate of output, this cost does not change; long term lease of a textile mill or a warehouse, employment contracts with executives to name a few. In the long run both fixed and variable costs tend to change with respect to the volume of production and additional capital acquisition.
Cost accounting is an important feature in big production environments where the cost of each element is defined for arriving at the total cost of production. This also helps to decide on and fix the profit percentage desired by the management over and above the production cost on a unit basis. Corporate companies that are into production will have to identify areas where cost can be reduced. Techniques like budgeting and costing aid in monitoring and controlling costs; also help to reassess the overall objectives of the firm in lieu of changing economic conditions.