What Is Implicit Cost And Explicit Cost? (With Examples)

By Indeed Editorial Team

Published 18 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

When a company or organisation engages in business operations, such as opening new office headquarters or taking a loss on earnable wages, it experiences the effects of implicit cost. The implicit costs of a business operation or process, also known as implied costs, relate to underutilised resources in profit generation mechanisms. Companies consider both implicit and explicit costs when determining total economic profitability of an operation. In this article, we examine what it means for a business to incur implicit and explicit costs, the major differences between the two types of costs and how companies apply them when calculating profits.

What is implicit cost?

The answer to the question, "What is implicit cost?" is that it is any cost that a company incurs but does not document as a separate expense in its books. The implicit cost of a company is the opportunity cost of the company using the existing resources they own. Implicit costs are essentially intangible costs. Payments that you can earn from a rented property and annual cash flow from stock sales are examples of implicit costs.

Implicit costs are usually resources that a company's owners supply. They may be out-of-pocket costs, such as the costs you incur while maintaining a property for business operations rather than for generating rental profit. These costs can allow for the depreciation of assets such as goods, materials and equipment necessary for business operations. Implicit costs can contain costs that would otherwise be absent if a company uses these resources to generate income.

Understanding the nature of implicit costs

Implicit costs can play a significant role in a company's overall financial success. This is because implicit cost not only accounts for underutilised resources, but it can also account for a company's loss if it decides not to employ its resources to increase revenue. You can also refer to implicit costs as implied, notional or imputed costs.

Typically, these types of costs can be challenging to define. The implicit cost may represent a potential loss of income, but not necessarily profit. As implicit costs might also represent alternative sources of income, an organisation may choose to include them as part of the operational cost of doing business.

Related: What Is A Cost Accountant? (With Duties, Salary And Skills)

What is explicit cost?

An explicit cost, also known as an explicit expense, is a tangible expense that results in a cash outflow. A company usually documents it in its book of accounts. Explicit costs include employee salaries, wages and office space rental charges. To assess a business's revenue and its economic and accounting profit, you can account for both explicit and implicit costs.

Costs and company expenditure typically include both explicit and implicit elements. If a printer at a printing shop breaks down, the cost of the repair expert and parts are explicit costs. The lost production time as a result of the breakdown is an implicit cost.

What are the key differences between implicit and explicit cost?

The fundamental difference between implicit and explicit costs lies in the profit concepts. To calculate a company's accounting profit, you can deduct explicit costs from a company's overall revenue. The difference between money brought in and money paid as expenses such as salary, rent or other overhead costs is accounting profit. Accounting profit does not account for implicit costs and it might be a rudimentary representation of a company's profitability rather than its entire economic success in the market or industry.

To find out the economic profit of a company, you can deduct total costs, both implicit and explicit, from total revenue. Considering economic profitability can help a company determine its true profitability. Although you can use a business's accounting profit to calculate its total income taxes, the economic profit is what ultimately determines the success of its operations.

Related: How To Calculate Variable Cost In 3 Steps (With Examples)

What is economic profit?

The difference between a company's entire revenue and its total implicit and explicit costs is called economic profit. It is usually the remaining profit after examining the next best alternative investment and it might be positive or negative in value. Companies usually employ economic profits for internal analysis and these figures may not be subject to transparent disclosure.

Calculating total economic profit

Companies calculate economic profit using economic principles and information on market activities. To calculate total economic profit, you can follow these steps:

  1. Calculate explicit costs. Explicit costs can include things like salaries, rent, utilities and other expenses. To calculate the total explicit costs for your firm, add all of such costs together.

  2. Calculate revenue. Determine the overall revenue for your company using your general ledger. This figure represents the amount of revenue that the company makes and it usually appears as net sales or net revenue on the first line of the income statement.

  3. Calculate implicit costs. Identify and calculate potential expenses that you may have missed. For example, if you are establishing a new business and it requires you to leave your current job, losing prospective revenue is an implicit cost.

  4. Subtract costs from profits. Subtract the total of your implicit and explicit costs from the company's total revenue. The remaining figure is the total economic profit of the company.

Related: Gross Income: What It Is And How To Calculate It Per Month

Examples for implicit and explicit costs

Because of the relationship between implicit and explicit costs, both calculations are important for computing accounting profit and economic profit of a company. When determining overall accounting profit, companies usually consider explicit costs first, followed by implied costs of business operations such as a reduction in salary, an increase in working hours or other resources that they can potentially employ to create revenue. These examples show how to compute a business's accounting profit using explicit costs, and then calculate the economic profit by integrating both the explicit and implicit costs of operation:

Example of explicit cost

A lawyer who is currently working at a corporate law firm is thinking about starting their own legal practice. After establishing their private law practice, the lawyer expects to earn around ₹8,00,000 per year. This lawyer may require office space and an assistant to function. According to the lawyer, the cost of renting an office space may be ₹3,00,000 per year, while the cost of hiring an assistant could be around ₹2,40,000 per year.

The lawyer would begin by calculating the overall costs. To accomplish this, they start with explicit costs.

Explicit costs = office rental + assistant's salary

Explicit costs = ₹3,00,000 + ₹2,40,000 = ₹5,40,000.

Example for accounting profit

The lawyer can then calculate how much accounting profit he may receive after computing the explicit costs. To find the amount, the lawyer uses the ₹5,40,000 in explicit costs to compute the estimated accounting profit. The lawyer can calculate the accounting profit by deducting the explicit costs from the expected revenue, which is ₹8,00,000

Accounting profit = expected revenue - explicit cost

Accounting profit = ₹8,00,000 - ₹5,40,000 = ₹2,60,000

Accounting profit solely considers the costs that are present in the company's books of accounts. The lawyer has quit from their position at the corporate firm to create their private practice. This has resulted in a salary loss. If a lawyer earns ₹6,00,000 a year, we can consider this amount as an implicit cost of starting their own firm.

Example for implicit cost

As the lawyer already makes ₹6,00,000 per year, we can regard this as an implicit cost to them starting their law firm. The accounting profit may not account for other implicit costs, such as the time the professional spends establishing a private practice. By calculating the total economic profit of the new firm using both implicit and explicit costs, the lawyer can estimate the possibility of economic success. The lawyer accomplishes this by deducting the total costs from their expected revenue.

Economic profit = total revenue - explicit costs - implicit costs

Economic profit = ₹8,00,000 - ₹5,40,000 - ₹6,00,000

Economic profit = ₹8,00,000 - ₹11,40,000 = -₹3,40,000

Opening a private law office would cause a loss of ₹3,40,000 for the lawyer. This does not imply that the private firm would not make a profit. The lawyer may want to consider the hidden costs to assure their new firm's success. The economic loss indicates that the lawyer may be earning ₹3,40,000 less than at the corporate firm, when they start their new venture.

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