External costs are The concept and classification of costs

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Doing any business involves certain costs. One of the basic laws of the market is that you have to invest something in order to get something. Even if an organization or an entrepreneur sells the result of his own intellectual activity, he still bears certain costs. This article discusses what costs are, what they are, the differences between external and internal costs, as well as the formulas for calculating them.

What are costs?

This concept is applicable in all areas of business. Costs are the organization's expenses for its needs, maintenance of production activities, utility bills, salaries to employees, advertising costs and much more. External and internal costs, their correct calculation and analysis are the key to stable operation and financial security of enterprises. In the process of doingcommercial affairs, it is necessary to take a sober look at the capabilities and needs of the organization, optimally select the set of purchased services and products, trying to minimize costs and maintain their level below the level of profit.

Terminology, or What are costs called?

Economics is a science with a very large number of branches, each of which studies its own separate phenomena. Each direction has its own ways of collecting and processing information, as well as methods for documenting the results. Due to the large number of various reports used by different specialists, but carrying essentially identical information, there is some uncertainty in the terminology. So, the same phenomena can have completely different names. So, in different types of documents, internal and external costs can be found under different names. These items are listed below:

• accounting and economic;
• explicit and implicit;
• explicit and imputed;
• external and internal.

By their nature, all these names are identical to each other. Familiarity with this fact will allow you not to get confused in the future when processing various documents in which these names occur.

External costs are…

Organizations in the course of their work purchase raw materials, materials, machinery and equipment, pay for the labor of service personnel and staff of specialists, pay utility bills for consumed water, energy, use of a land plot or areaoffice buildings. All these payments are external costs. It is a part of the money transferred by an organization in favor of the supplier of the required product or service. In this case, the supplier is a third-party organization that is not related to this company. Also, these payments may be referred to in various documents and reports as accounting or explicit costs. All this has one characteristic feature - such payments are always reflected in the accounting records with the exact date, amount and destination.

Internal costs

Above, what are external costs. Economic costs, they are also internal, implicit or imputed - the second type of expenses taken into account in reporting and analysis. With them, everything is a little more complicated. Unlike explicit costs, this is a waste of your own resources, and not acquiring them from a third party. And the amount that is considered in this case as expenses is the amount that could be received by the organization if it used the same resources in the most optimal and profitable way. The use of this type of expense is not used in accurate and documented accounting. On the other hand, implicit costs are actively operated by economists, whose tasks include assessing the effectiveness of the organization's work over past periods, planning and compiling business models for future production processes, as well as optimizing all areas of a commercial company.

Subtypes of external costs

Productionthe process requires investments in its various components, without which the mechanism for the production of products or the provision of services simply will not function. The external costs of the firm are classified depending on how their price will fall on the final cost of the product or service provided. The identified types of external costs are:

• Fixed costs - expenses, the amount of which is included in equal shares in the cost of a product or service over a certain period of time. They do not change with the increase or decrease in production volumes. Examples of such costs include salaries of employees holding administrative positions, or payments for renting an office, warehouse and production facilities.
• Average fixed costs are costs that also do not change over a short period of time. However, in the case of average fixed costs, the dependence on the volume of products produced or services performed can be traced. With a larger volume, the cost of production decreases.
• Variable costs - costs that directly depend on the volume of output produced. So, the more goods were produced, the more it is necessary to pay for raw materials and materials, the labor of workers receiving piecework wages, the supply of energy resources.
• Average variable costs - the amount of money spent on paying the variable costs of producing a unit of output.
• Total costs - the result of adding fixed and variable costs, reflecting the overall picture of spendingon the functioning of the organization and production activities for a certain period of time.
• Average total costs - an indicator of how much money from the total cost falls on one unit of output.

Features of variable costs

What costs are called external variables? The volume of which varies with the volume of production. Only fluctuations in the amounts of variable costs are not always linear. Depending on the cause and mode of change in output, costs can change in three predictable ways:

• Proportional. With this type of change, the amount of costs changes in the same proportion with the volume of production. That is, if a company produced 10% more products in a given period, costs also increased by 10%.
• Regressive. The amount of costs spent on production is growing more slowly than the volume of production. For example, a company produces 10% more goods, but costs have only increased by 5%.
• Progressive. Production costs are rising faster than production volumes themselves. That is, the company produced 20% more products, and costs increased by 25%.

The concept and meaning of the period in the calculation of costs

Any calculations, analytical and reporting activities, as well as planning are impossible without the concept of a period. Each organization develops and functions at its own pace, so a clear time frameThere is no gap that is the same for all firms. The decision on which period of time to use as the reporting period is made in each individual organization. However, these figures are not taken from the void. They are calculated depending on many external and internal factors.

Time is a factor of great importance when calculating profits and expenses. An analysis of the growth of production activity or its deterioration, profitability or unprofitability can be carried out only on the basis of its final indicators for several reporting periods. Usually, data is considered separately for short-term and long-term periods.

Costs in the long and short run

Short-term period may be different in duration for organizations of different industries. General rules for its establishment - in the short term, one group of production factors is stable, the other may change. Land, production areas, the number of machines and pieces of equipment remain constant. The number of workers and their wages, purchased materials and raw materials, and so on can change.

Long-term planning is characterized by the acceptance of all factors of production and their costs as variables. During this time, the organization can grow or, conversely, decrease, change the number and composition of employees in the staffing table, change the actual and legal address, purchase equipment, and so on. Long-term planning is always more complex and deeper. Need to be as accurate as possiblepredict the dynamics of development in order to stabilize the company's position in the market.

Cost formula

In order to find out how much money an organization spends to maintain production activities, there is a formula for external costs. It is depicted like this:

• TC=TFC+TVC, where:

  • TC - an abbreviation from the English language - Total Costs - the total amount of costs for the production of products and the functioning of the organization;
  • TFC - Total Fixed Costs - total amount of fixed costs;
  • TVC - Total Variable Costs - total variable costs.

In order to find out the amount of external costs per unit of goods, an example of a formula can be given as follows:

• ATC=TC/Q, where:

  • TC - total spending;
  • Q - volume of goods released.