Implicit Cost

Written By:
Adiste Mae

What is an Implicit Cost?

When people talk about implicit cost, they typically mean the income that a company should have earned as opposed to the loss of profit that people think because of an increase in expense.

For one thing, implicit cost is not an outright expense – it is the cost of an income that would have been earned.

Simply stated, it is a type of opportunity cost.

With implicit costs, companies find them difficult to quantify because they are not recorded in the books of the company for the reason that money does not change hands.

Other terms used to refer to implicit costs are notional costs, imputed costs, or implied costs.

Understanding Implicit Costs

With opportunity costs, a company loses the benefit of earning something for choosing one option instead of its alternative.

For example, a small business owner performs his or her duties for the company but does not receive any salary for the work done.

His or her labor will not be included as an expense of the company in order to boost their net profit.

For the small business owner, his implicit cost would be the income he could have earned if he devoted his efforts somewhere else where he could be paid a salary.

Implicit costs are not included in the income statement in regular accounting.

However, companies will have the option of including the implicit cost when computing for the economic profit, which is computed by deducting the explicit and implicit costs from the total revenue.

Accounting Profit however is computed by reducing the explicit cost from the total revenue – the money that is brought in less the money that is paid out.

Economic Profit should not be confused with Accounting Profit.

The difference between the two simply lies in the inclusion of the implicit costs in the Economic Profit.

A sample of the calculation of Accounting Profit can be shown as:

Total Revenue ($100,000) – Explicit Expenses ($75,000) = $25,000 

On the other hand, Economic Profit can be computed as:

Total Revenue ($100,000)-Explicit Expenses ($75,000) – Implicit Expenses ($30,000) = ($5,000)

The negative profit when adding implicit costs does not necessarily mean that the company is operating at a loss.

It can also mean that the company has incurred an implicit cost of $25,000 instead of incurring an explicit cost of $35,000 which the company should pay for by using or purchasing outside resources.

Implicit Costs vs Explicit Costs

Because of the lack of the actual transfer of cash, an accurate measurement of the cost will be very difficult to determine and it is for this reason that implicit costs do not make it to the income statement.

Though difficult to determine, they are important for the company to evaluate and make sound financial decisions.

It allows the company to look at the true profitability of their business by looking at costs in all forms.

Additionally, it helps companies carefully weigh their options of whether or not to purchase additional resources or utilize what they already have.

In contrast, explicit costs can be easily determined through the payment of cash or other tangible assets of the company for their operational costs.

Examples of such expenses are salaries, rent, and other operating expenses which are all posted in the books of the company and form part of the income statement.

Costs, by definition, refers to the value of company resources that is used to produce goods and services.

Implicit costs are incurred by making use of resources that are already owned by the company rather than buying or renting it.

Explicit costs on the other hand, are incurred through an actual exchange of money and are easily measurable.

To differentiate the two, there are areas to look out for.

That includes the asset type, actual cash exchange and the cost type.

Explicit costs are typically tangible assets – something that can be touched, felt, seen, and held. Implicit costs are non-tangible – it does not specifically refer to a physical object but refers to labor, or time, or something that makes it hard to quantify.

There is an actual cash exchange in explicit costs while implicit costs do not.

Explicit costs are out of pocket expenses – money that is taken out from the money brought in by the business to purchase items or resources that are not yet owned by the company and can be easily traced through receipts, invoices, or quotations.

Implicit costs are opportunity costs – companies make use of internal resources.

One cannot easily identify the cost or the value of using the company’s internal resources and the rate that is incurred for the time and effort done for using such resources which makes it subjective.

Examples of Implicit Costs

An example already provided above is when business owners dedicate their time and effort to work for their company, especially when they have just started the business in order to save the costs that are to be incurred by the business and help them with the profitability.

Once the company starts to become consistently profitable, owners can be paid their salaries and their time and labor will become explicit costs.

Another example of an implicit cost is the depreciation on the machinery purchased by the company for a capital project, sick leave or paid time off for employees that qualify, or it could also be when a company decides to manufacture a product instead of the other alternatives.

When a company hires a new resource, existing employees take the time to hire the new person.

The hours provided to train the new resource is an implicit cost because the employee could be using his or her time in the company doing the work that he is supposed to do instead of training the new person.