4 Important Groups in which the Costs of a Firm are classified
1. History Cost and Future Cost:
Historical costs are book costs which are related to the past. Future costs are estimated costs for the future. In financial decisions future costs are more relevant than the historical costs. However, historical costs act as guide for the estimation of future costs.
2. Specific Cost and Composite Cost:
Specific cost refers to the cost of specific source of capital while composite cost is combined cost of various sources of capital. It is the weighted average cost of capital. In case more than one form of capital is used in the business, it is the composite cost which should be considered for decision-making and not the specific cost.
But where only one type of capital is employed the specific cost of that type of capital may be considered. In capital structure decisions, it is the weighted average cost of capital which should be given consideration.
3. Explicit Cost and Implicit Cost:
An explicit cost is the discount rate which equates the present value of cash inflows with the present: value of cash outflows. In other words, it is the internal rate of return. The explicit cost of specific sources of finance may be determined with the help of the following formula:
Implicit cost also known as the opportunity cost is the cost of the opportunity foregone in order to take up a particular project. For example, the implicitly cost of retained earnings is the rate of return available to shareholders by investing the funds elsewhere.
4. Average Cost and Marginal Cost:
An average cost refers to the combined cost of various sources of capital such as debentures, preference shares and equity shares. It is the weighted average cost of the costs of various sources of finance. Marginal cost of capital refers to the average cost of capital which has to be incurred to obtain additional funds required by a firm.