Implicit vs Explicit Costs Differences and How to Calculate
Explicit and implicit costs are included in the economic profit. In the realm of business economics, understanding the various types of costs is essential for making informed decisions. Among the most critical distinctions is that between explicit and implicit costs.
A company can have a positive accounting profit while maintaining a zero economic profit. Implicit costs are a bit more complicated than explicit costs. These costs have already occurred but may not be tracked or reported as separate expenses. These could be opportunity costs, such as when a company uses an asset they already have rather than renting or buying it. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of \(\$125,000\). Accounting costs are generally easy for business owners to identify, track, and record.
Definition of Implicit Cost
The words explicit and implicit also have other senses that are used in particular contexts. For example, the word explicit can mean that something has sexual or inappropriate content, as in explicit lyrics or This interview features explicit language. Let’s say you are a fresh business owner and just beginning your first business. You determine not to get a salary during the first three years to help with start-up expenses.
- You determine not to get a salary during the first three years to help with start-up expenses.
- Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm.
- Business decisions, such as purchasing assets or hiring staff, involve assessing explicit costs.
For example, if a business owner decides to use a building they own to run a business instead of renting it out, the rent they forgo is an implicit cost. Once the costs have been determined, the firm’s economic profit will be revealed. However, there accounting consulting are some differences between implicit and explicit costs. Implicit cost is simply an opportunity cost that a company incurs when it uses resources to make a decision. It can be complicated because it involves many different kinds of circumstances.
Something that’s described as explicit doesn’t leave anything up to interpretation. All these have monetary cost and the transactions will be recorded.
Comparing Implicit Costs and Explicit Costs
Implicit costs are not clearly defined and don’t get reported as expenses. When a company allocates its resources, it forgoes the ability to earn money off the use of those resources elsewhere. Explicit costs are the only accounting costs that are necessary to calculate a profit, as they have a clear impact on a company’s bottom line. The explicit-cost metric is especially helpful for companies’ long-term strategic planning. Now that we have an idea about the different types of costs, let’s look at cost structures.
Understanding Implicit Costs
While these costs are visible, they are often difficult to measure. This means that companies should be aware of both costs when planning for their businesses. Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.
They are in the form of rent, salary, material, wages, and other expenses like electricity, stationery, postage, etc. An organisation incurs these costs to produce its goods or services. The business can control these costs to increase its profitability by reducing its advertising or mortgage expenses or cutting staff hours. When a company hires a new employee, there are implicit costs to train that employee. This is because the hours could have been allocated toward the employee’s current role. So, there is no universal formula for computing explicit costs.
Calculating explicit costs is simple as long as you know your business expenses. To calculate explicit costs, add together your business expenses on the general ledger. Again, this could include insurance, rent, equipment, supplies, cost of goods sold, etc. An example of an implicit cost is having to deal with a fire alarm, which causes a factory to shut down for two hours. There is no observable increase in costs, however by stopping production, it leads to lower output and so there is a loss of sales and income – even if it will not be recorded.