What would be an example of an implicit cost of production?

Implicit cost refers to the opportunity cost of the resources of the business organization, also known as notional cost or implied cost, where the organization calculates what the business earned if, instead of using the resource in the business activity, it used the resource for some other purpose say if the business has rented such asset to another party then how much rent they would have earned will be considered as opportunity cost.

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• Implicit and Explicit Costs
• How to Calculate Implicit Costs?
• Implicit Cost Example
• Use and Relevance
• Implicit Cost Video
• Recommended Articles
• Implicit vs. explicit costs
• What are explicit costs?
• What are implicit costs?
• Calculating explicit cost vs. implicit cost
• Calculate explicit cost
• Calculate implicit cost

As the name implies, implicit costs do not represent real expenses. Still, they are considered as a form of the opportunity cost for utilizing a company’s assets or resources in general. For instance, if a company sets up a production plant on its land, by implication, it did not earn any possible rent on the same property it could if it were not to use the resources itself.

It must be borne in mind that implicit costs do not represent real expenses. However, the utility of this measure lies in the fact that it helps to evaluate if a particular resource could have been employed better.

Implicit and Explicit Costs

To better understand implicit costs, it would be necessary to understand explicit costsExplicit costs are the culmination of all direct and indirect expenses recorded in a company’s ledger. read more, which are out-of-the-pocket expenses incurred on business activities and operations. By contrast, it helps to consider probable alternative use of resources and returns thereof. The total costs incurred for a company typically represent both types of costs.

How to Calculate Implicit Costs?

If renting out a fixed asset could result in higher earnings than what a company earns by utilizing that fixed asset for their operations, it means that the company is losing in terms of economic profitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.read more. In simple words, it is no use employing its building to run its operations if a company can’t earn more than the implicit cost of renting it out.

The problem with calculating such costs is that they are often hard to quantify, do not figure on a company’s financial statementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, and are generally more or less intangible. Other typical examples of implicit costs would be the time and resources invested in training an employee, depreciation of the equipmentDepreciation on Equipment refers to the decremented value of an equipment's cost after deducting salvage value over the life of an equipment. It lowers its resale value.read more, etc. However, some could still technically consider depreciation an explicit cost because it represents realistic capital consumption for a resource for which a real expense was made, even if earlier.

Implicit Cost Example

ABC invested $10,000 in certain businesses intending to earn probable profits to the tune of $5000 in a year. First, however, he had to forego the interest he could earn on the sum to make this profit. Let us suppose he had to forego a 12% annual interest, which would have worked out to $1200 in a year. This $1200 represents the implicit cost of investing the sum elsewhere.

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To understand the relevance of these two types of costs, it is important to know that they are widely employed to calculate different types of profit. There are several ways of defining profit, and two of them are accounting profit and economic profit.

Accounting profit

Accounting profit is calculated by deducting explicit costs from total revenues. It represents the calculation of profit-takingProfit-taking is a term used when the investors sell the assets which they possess mainly shares and securities to the market when the price has risen.read more into account real expenses incurred on running business operations.

Economic Profit

It can only be calculated by deducting both explicit and implicit costs from total revenues, which would give a better idea of whether the resources were employed profitably enough or could have been employed better. As a result, economic profit tends to be lower than accounting profitAccounting profit is the net income available after deducting all explicit costs and expenses from total revenue, and it is calculated in accordance with generally accepted accounting principles (GAAP). Operating expenses, labour, transportation, and sales expenses are common examples of these costs.read more most of the time.

Implicit Cost Video

Recommended Articles

This article has guided Implicit Costs, their uses, and their relevance. Here we also calculate Implicit Cost along with an example. You may learn more about Corporate Finance with the following articles –

• Accounting Profit vs Economic Profit
• Buying vs Leasing
• Net Proceeds

When it comes to your business, one of your main goals (if not your biggest goal) is to make a profit. And to find profit, you may need to look at explicit and implicit costs. But, what exactly are these costs? And, what’s the difference between implicit vs. explicit costs? It’s time for your implicit and explicit cost rundown.

Implicit vs. explicit costs

Whether you realize it or not, you deal with both implicit cost and explicit cost while doing business. Implicit and explicit costs help you determine accounting profit and economic profit, opportunity cost, and more. 

So, what is the difference between explicit and implicit cost? Let us walk you through it. 

What are explicit costs?

Explicit costs, also known as accounting costs, are normal business expenses that appear in the general ledger. These costs can directly affect your business’s profitability. 

Accounting costs involve tangible assets and monetary transactions. Explicit cost examples include:

• Employee wages
• Lease payments
• Utilities
• Raw materials
• Advertising
• Supplies
• Rent
• Other direct costs

Accounting costs are generally easy for business owners to identify, track, and record. You can use explicit costs to calculate your company’s profit and see where you need to make changes when it comes to expenses. 

What are implicit costs?

Implicit costs are a little more complicated than explicit costs. Whereas explicit costs are more straightforward, implicit costs deal with intangible costs. 

An implicit cost represents an opportunity cost. Unlike explicit costs, implicit costs are the costs associated if you would do something, like make an investment.

With implicit costs, you do not track them like business expenses in your books. Instead, you can calculate implicit costs to determine economic profit and help make smart business decisions. 

Basically, implicit opportunity cost comes from the use of an asset instead of a purchase or rental of an asset. Check out a few implicit cost examples:

• Annual cash flow from stocks if you sold your business
• Payments you would earn from a rented property
• Time spent on one business activity that could better be spent on a different task
• Business owner passing on taking a salary in the early stages of operations
• Time equipment is offline for maintenance

Calculating explicit cost vs. implicit cost

Now that you have some background information on explicit vs. implicit costs, let’s take a look at how to calculate explicit cost and implicit cost for your business. 

Calculate explicit cost

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.

Keep in mind that expenses vary from business to business. So, there is no universal formula for computing explicit costs. But, it’s pretty easy to compute if you have a list of your business expenses at the tip of your fingers.

Explicit cost example

Say your business has $10,000 in cost of goods sold, $1,000 in rent, $200 in supplies, $300 in insurance, $13,000 in employee wages, and $500 in utility costs for the period. To find your total explicit costs, add together all of your expenses:

Explicit Costs = $10,000 + $1,000 + $200 + $300 + $13,000 + $500

Your total explicit costs add up to $25,000 for the period. You can plug this amount into other formulas, like the accounting or economic profit formulas, to find out financial information for your business. 

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Calculate implicit cost

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.

To find your implicit or opportunity cost of a situation, take a look at the costs associated with an opportunity. For example, a day spent training a new employee means another employee misses out on sales and commission. That opportunity cost (aka the commission and other pay) is an implicit cost for the employee/trainer. 

Implicit cost example

Say you’re a new business owner who just started your first company a few years ago. To help pay for startup expenses, you decide not to take a salary for the first two years. Your salary would have been $60,000 per year. 

Because you did not receive a salary for two years, your implicit cost for your decision is $120,000 ($60,000 X 2). If you would have received said salary, it would have been an explicit cost instead. 

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