Explicit vs Implicit Costs: A Guide for Managers SLM Self Learning Material for MBA

Many businesses that appear profitable on paper may actually be losing money when implicit costs are considered. Explicit costs are considered while computing both accounting profit and economic profits, whereas implicit costs are used for determining economic profits only. As per the prudent concept of accounting, all explicit costs should be reported in the books of accounts immediately. On the other hand, implicit costs are not easily and clearly recognizable, they cannot be assigned a monetary value and are therefore imprecise. Hence, implicit costs are not reported or accounted for on the financial records of a company.

• The cost is incurred when any production process is going on, or activity is conducted in the normal course of business.
• Conversely, Implicit Cost are the one that arise from using the asset rather than renting it out.
• Categorize expenses clearly and review them regularly to identify cost reduction opportunities.
• Financial accounting and reporting, being a compulsory task for every business, requires companies to immediately report and account for all business transactions.
• And businesses don’t necessarily record them for accounting purposes as money does not change hands.

An explicit costs are measurable and will be included in profit/loss accounts. For example, if the firm hires a new worker, their salary will be an explicit cost which will be put on the accounting balance sheet. For example, to welcome the new worker and train him to a necessary standard may take the time of the manager, who cannot do other tasks as he trains the new workers. Sarah invested $50,000 of her own savings to start the business instead of putting that money in a savings account earning 4% annually—that’s $2,000 per year in implicit costs.

Both types of costs are crucial for accurate cost analysis and decision-making processes. In this blog, we will explore explicit and implicit costs, their definitions, differences, and their significance in managerial economics. 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 (e.g. cash). For Sarah’s bakery, let’s calculate both types of costs annually. Her explicit costs total $81,600 per year ($6,800 monthly × 12 months). Her implicit costs include $2,000 in foregone interest, $40,000 in foregone salary, and $3,600 in foregone car rental income, totaling $45,600 annually.

These costs are recorded in the books of accounts are vital in cost control, financial efficiency, pricing, and profit calculations. These costs include costs of inputs used in production, office rental, cost of utilities, marketing expense and other monetary transactions. Implicit costs represent the hidden side of business expenses—they’re the opportunity costs of using resources you already own instead of putting them to their next best alternative use. Unlike explicit costs, implicit costs don’t involve direct cash payments, but they’re equally real and important for understanding your true business performance. Implicit costs, also known as imputed costs or opportunity costs, are the alternative benefits or opportunities foregone when a particular decision is made.

What are Explicit Costs?

A company may choose to include implicit costs in its cost of doing business since they represent possible sources of income. These costs represent a loss of potential income, but not of profits. Implicit costs are a type of opportunity cost, which is the benefit that a company passes up by choosing one option versus another. Essentially, implicit cost represents an opportunity cost when a company uses resources for one decision over another. Because it can involve various types of situations, it’s hard to give an implicit cost calculation a standard formula.

What are explicit costs?

Setting the right price and making use of budgets is important for improving business performance. Individuals and firms consider various options of resource allocation and evaluate them in a better way by considering implicit costs. This helps the business firms in improving efficiency in resource allocation.

Differences between Explicit and Implicit Costs

Explicit Costs are the costs which involve an immediate outlay of cash from the business. The cost is incurred when any production process is going on, or activity is conducted in the normal course of business. The cost is a charge for the use of factors of production like land, labour, capital and so on.

Explicit and Implicit Costs, and Accounting and Economic Profit

• On the basis of explanation given above, we can conclude that the implicit costs and explicit costs both substantially differ from each other.
• The entity’s income tax obligation is determined and paid on the basis of accounting profit.
• Emilio works in a plumbing business that he owns, which is organized as a corporation.
• Let’s suppose that you have decided to start own business (own firm) instead of doing a job.

You can plug this amount into other formulas, like the accounting or economic profit formulas, to find out financial information for your business. Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs. We will learn in this chapter that short run costs are different from long run costs. These are all explicit costs because Sarah physically pays money for each of these items.

Explicit and Implicit Costs

Successful businesses develop systems to track and manage both explicit and implicit costs effectively. Start by maintaining detailed records of all explicit costs using accounting software or spreadsheets. Categorize expenses clearly and review them regularly to identify cost reduction opportunities. implicit cost vs explicit cost Implicit costs play a crucial role in evaluating new investment opportunities. Before expanding operations or launching new products, successful managers compare the expected returns against both explicit investment costs and implicit opportunity costs.

Other examples of implicit costs

In this article, we will focus on explaining the concept and use of implicit and explicit costs. Maybe Eryn values her leisure time, and starting her own firm would require her to put in more hours than at the corporate firm. To open her own practice, Eryn would have to quit her current job, where she is earning an annual salary of $125,000. Many managers and business owners make costly errors by focusing solely on explicit costs while ignoring implicit costs. This oversight can lead to poor decision-making and reduced profitability.

Explicit costs and implicit costs are two important concepts in managerial economics that contribute to accurate cost analysis and decision-making. Explicit costs involve tangible monetary payments, while implicit costs represent the opportunity costs and alternative benefits foregone. Understanding both types of costs enables businesses to make informed decisions regarding cost management, pricing strategies, resource allocation, and investment evaluation.

Implicit costs are a little more complicated than explicit costs. Whereas explicit costs are more straightforward, implicit costs deal with intangible costs. As they are not actually incurred they cannot be easily measured, but they can be estimated. They are not recorded in the books of accounts as well as these are not reported. The purpose of ascertaining the implicit cost is that it helps in decision making regarding the replacement of any asset and much more. Explicit costs help business firms in making pricing decisions for their products and budget for their operations.

Implicit costs refer to the opportunity costs of using the resources and are considered important while making economic decisions. These costs are not recorded or mentioned in the financial records of the business, like the income statement and balance sheet. However, these costs suggest the best alternatives that are neglected during decision-making.

By considering explicit and implicit costs, managers can assess the true cost of resources used and enhance the efficiency and profitability of their operations. These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit and economic profit. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit. These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit.

Implicit costs can also be said to be the indirect results of business activities and processes. Usually, they involve indirect expenses from unforeseen events or emergencies. Since implicit costs leave no records, these costs are not easy to account for. Examples of implicit costs include the loss of interest income on funds and the depreciation of machinery for a capital project.

In the fields of accounting, finance and economics, many different approaches are followed to group or categorize business costs. However, on the basis of payments, two major types of costs are explicit costs and implicit costs. In this article, we will clarify the basic difference between these two types of costs and help you identify which type of cost you’re dealing with while operating your business. Implicit cost allows us to make informed decisions by identifying opportunity cost. Individuals and firms can make better decisions in which not only explicit costs are considered but also implicit costs are included for all the available options. There are different types of costs, and in my student life, I remained confused about the true meaning and use of different types of costs in decision-making.