In order to produce goods, a firm uses raw material and factors of production (land, labour, capital, etc.) called ‘Inputs’. The expenditure incurred on these inputs is called cost of production. The functional relationship between cost and output is called Cost Function. Cost of production depends on the prices of factors of production. Higher level of output implies higher total cost of production, in a situation of constant technology and constant factor-prices. 

Cost can be classified into the following categories:

(a) Social Cost- Social cost implies the cost which a society bears on account of production of a commodity. Social cost includes both private cost and external cost. It includes all those sacrifices and inconvenience that society has to bear in the process of production. For example, Mathura Oil Refinery discharges its waste into the Yamuna river causing water pollution causing danger to the beauty of Taj Mahal. Mills and factories located in a city cause air pollution by emitting smoke, etc.

(b) Monetary Cost- The amount spent in terms of money for the production of a commodity is called monetary cost. Suppose the cost of production of 500 T-Shirts is Rs. 2,00,000, then this amount will be called the monetary cost of producing 500 T- Shirts.

(c) Opportunity Cost- The concept of opportunity cost plays a very important role in modern economic analysis. Opportunity cost is the loss of income due to an opportunity foregone. Opportunity cost is also called as alternative or economic cost. It arises because of scarcity and alternative uses of resources. We know the resources that are available, at any point of time, to a firm or any business organisation, are limited and resources have alternative uses. Therefore, profit maximizing firms have to choose the best from the alternatives available to them. In fact, firms have to forego the gains expected from the second best alternative use of their resources. The foregone benefit is called opportunity cost of the gains from the chosen use of the resources.

(d) Real Cost – Real cost connotes to those payments which are made to the factors of production to compensate for the toil and efforts in rendering their services. According to Marshall, “The exertions of all the different kinds of labour that are directly or indirectly involved in making it, together with the abstinences or rather the waiting required, for saving the capital used in making it; all these sacrifices together will be called the real costs of production of the commodity.”

(e) Short-term Cost- Short-term is a period of time during which some factors are fixed and some are variable. Accordingly, Short period costs are divided into two components,viz.

(a) Fixed Cost – Fixed costs are the sum total of expenditures incurred by the producer on the purchase or hiring of fixed factors of production.
(b) Variable Cost – Variable costs are the expenditures incurred by the producer on the use of variable factors of production.

(f) Long term cost – The long term is defined as a period of time which is sufficient to bring about proper changes in the scale of output through an adjustment of the quantity of the various factors employed. The quantity of all the factors can be increased or decreased according to the requirement of production. Thus, in the long run, all factors are variable.

(g) LAC (Long-term Average Cost or Envelope Curve) – Long-term average cost refers to the minimum possible per unit cost of producing different quantities of output in the long period. According to the Mansfield, “The long-run average cost curve is that curve which shows the minimum cost per unit of producing each output level corresponding to different scales of productivity.”

(i) LMC (Long-term Marginal Cost) – Change in the total cost in the long – term, due to the production of one more or one less unit of commodity is called long-term marginal cost. In the words of Ferguson, “Long-term Marginal Cost is the addition to total cost attributable to an additional unit of output when all inputs are optionally adjusted.”

(h) Explicit Cost – It is the cost which falls under the actual or business costs entered in the books of account. Explicit costs are the costs in terms of money expenditure of the factors of production hired or purchased by an entrepreneur. It would include wages paid to labour hired by the entrepreneur, interest paid on capital or rent paid on land. These costs are also called accounting costs.

(ii) Implicit Cost- Implicit costs are the value of the factors of production put in by the entrepreneur himself. It includes the normal returns on money- Capital invested by the entrepreneur, wages or salary for his services in his own firm, inputed rent if he is using his own land or building.