BE/U4 Topic 4 Explicit cost and Implicit cost
An explicit cost is a cost that occurs, is easily identified, and is accounted for in the general ledger or financial statements. It represents clear, obvious cash outflow that reduces a company’s bottom-line profitability. Examples of explicit costs would be items such as wage expenses, rent, or lease payments. It is easy to identify the sources of those cash outflows and the business activities to which the expenses are attributed.
Net income of a business reflects residual income remaining after all explicit costs have been paid. Explicit costs are the only costs necessary to calculate accounting profit. An explicit cost is an expense that occurs during business operations and has a clearly defined dollar amount. They are recorded in a company’s general ledger and flow through to the expenses listed on a company’s income statement.
Explicit and implicit costs are both utilized in the calculation of economic profit. Economic profit is the total return a company receives based on all costs incurred to attain that revenue, and it is utilized for long-term decision-making. Economic profit is used extensively to determine whether a business should enter or exit a market or industry.
An implicit cost is any cost that has already occurred but not necessarily shown or reported as a separate expense. It represents an opportunity cost that arises when a company uses internal resources toward a project without any explicit compensation for the utilization of resources. This means when a company allocates its resources, it always forgoes the ability to earn money off the use of the resources elsewhere, so there’s no exchange of cash. Put simply, an implicit cost comes from the use of an asset, rather than renting or buying it.
Implicit costs are also referred to as imputed, implied, or notional costs. These costs aren’t easy to quantify. That’s because businesses don’t necessarily record implicit costs for accounting purposes as money does not change hands.
These costs represent a loss of potential income, but not of profits. A company may choose to include these costs as the cost of doing business since they represent possible sources of income.
Examples of Implicit Costs
Examples of implicit costs include the loss of interest income on funds and the depreciation of machinery for a capital project. They may also be intangible costs that are not easily accounted for, including when an owner allocates time toward the maintenance of a company, rather than using those hours elsewhere. In most cases, implicit costs are not recorded for accounting purposes.
When a company hires a new employee, there are implicit costs to train that employee. If a manager allocates eight hours of an existing employee’s day to teach this new team member, the implicit costs would be the existing employee’s hourly wage, multiplied by eight. This is because the hours could have been allocated toward the employee’s current role.
Another example of an implicit cost involves small business owners. But some may decide to pass on taking that salary in the early stages of operations in order to increase revenues and to cut down on costs. They give the business its skill in lieu of a salary, which becomes an implicit cost.
In corporate finance decisions, implicit costs should always be considered when coming to a decision on how to allocate company resources.
The Difference between Implicit and Explicit Costs
Implicit costs are technically not incurred and cannot be measured accurately for accounting purposes. There are no cash exchanges in the realization of implicit costs. But they are an important consideration because they help managers make effective decisions for the company.
These expenses are a big contrast to explicit costs, the other broad categorization of business expenses. They represent any costs involved in the payment of cash or another tangible resource by a company. Rent, salary, and other operating expenses are considered explicit costs. They are all recorded within a company’s financial statements.
The main difference between the two types of costs is that implicit costs are opportunity costs, while explicit costs are expenses paid with a company’s own tangible assets. This makes implicit costs synonymous with imputed costs, while explicit costs are considered out-of-pocket expenses. Implicit costs are harder to measure than explicit ones, which makes implicit costs more subjective. Implicit costs help managers calculate overall economic profit, while explicit costs are used to calculate accounting profit and economic profit.