Implicit costs are non-financial expenses arising from a company using a resource or asset it already owns instead of bearing a direct financial expense. Since the business does not pay for using the existing resource, the expense is not monetary. It is a cost that does not receive direct payment for its usage.
Other terminologies that describe implicit costs include notional, implied, and imputed costs. Explicit costs are regular financial outlays made by a company to provide its products or services, which are the opposite of implicit costs.
It is important to note that implicit costs are not equal to opportunity costs. Opportunity costs refer to the value of resources used in a given situation, whereas implicit costs do not. It is very crucial to understand the difference between implicit and explicit costs.
How Do Implicit Costs Work?
The simplest method to illustrate how an implicit cost works are by the example that follows.
The proprietor of a comparatively small firm works for the company but is not paid a salary; instead, they get management fees or dividends. The income statement does not include the owner’s labor or expenses.
Instead, the result carries an implicit cost, and the opportunity cost is equal to the profit the business owner may have gained by investing their time and energy in a project for which they might receive a direct payment (for example, working at a steady, salaried job).
The salary the business owner would receive for the labor they did, however, can be considered an explicit cost to the firm if they were paid a regular wage to run the business.
Implicit costs, like those in the instance mentioned above, are non-financial and frequently challenging to accurately define, therefore, they might not be included in a company’s regular accounting.
Examples of Implicit Cost
One example already given above is when business owners put in their time and effort to work for their company, particularly when they have just established the firm to reduce costs that will be incurred to increase profitability. Owners can be paid their salary after the business starts to generate regular profits, and their time and labour will then be considered explicit costs.
Another example of an implicit cost is the depreciation of equipment that the business purchases for a capital project, sick days or paid time off for eligible employees, or it may be when a business chooses to manufacture a product rather than the alternatives.
Existing employees take the initiative to hire new resources when a company does. The time allotted for training the new resource represents an implicit cost because the employee may be spending that time working for the company instead of teaching the new resource.
Understanding explicit costs, which are out-of-pocket expenses on corporate activities and operations, is required to better comprehend implicit costs. Contrarily, it is useful to take into account potential alternative resource uses and their associated returns. Both kinds of expenses are often included in a company’s overall costs.
Implicit Costs vs. Explicit Costs
An explicit cost is a distinct item in a business’s financial reports. It represents all costs a company incurs to use resources and achieve its goals. The term ‘explicit’ comes from the word ‘explained’. All expenditures related to a particular objective are documented in the firm’s financial reports.
On the other hand, implicit costs cannot be verified since they’re not associated with any distinct item in a business’s accounting records. Implicit costs are typical for companies whose organizational structures or reporting systems do not indicate the number of resources used in an area. As a result, managers can find implicit costs challenging to control. This is because they are not associated with specific items in accounting records, and it’s hard to determine if there’s sufficient detail about these expenses or not.
The primary benefit of using direct costs over implicit costs includes revenue recognition. Financial reports will reflect all economic activities using organizational resources when a business uses them. This benefits companies because they’ll be able to understand their financial situation much better and take necessary steps to control the company’s expenditures.
Importance of Implicit Costs
Implicit costs are non-financial charges typically not included in a company’s financial documents or statements but are still significant issues that are evaluated when calculating the bottom-line profits.
Accounting profits and economic profits are two different metrics of commercial profits that are distinguished by implicit costs.
- Accounting profits are the company’s earnings as reported in its financial statements and accounting records. However, accounting profits are computed as total revenues minus expenses—reflect just the explicit costs—the real cash payments that a company makes.
- Economic profits account for both direct and indirect costs. Thus, even though a business may be on the positive side of net accounting profits, its hidden expenses are taken into account while calculating the profitability, it may be a losing economic enterprise.
However, one shouldn’t automatically assume that implicit expenses are bad for a corporation, lowering its profits. For instance, a company using its resources could incur an implied cost of $10,000. However, by doing so, it might be able to avoid paying a direct cost of $15,000 that would otherwise be incurred by using outside services.
Implicit costs can be a potent tool for corporations to use in their decision-making. They can also be beneficial to a corporation when they are used as a means of improving productivity. By increasing the efficiency of its facilities and equipment, an implicit cost could lead to higher net profits for the company.
When companies use their resources to reduce their explicit costs, it is usually done to reduce expenses—which would reduce their profitability. However, there are some exceptions where using one’s resources might increase profitability by eliminating unnecessary expenses or creating a new product or service that is more profitable than what would have been created using outside resources.
The bottom line here is that implicit costs are important to understand to make better decisions regarding how much money a company should spend on fixed assets or new facilities and equipment.