An implicit cost is any cost that has already occurred but not necessarily shown or reported as a separate expense. It represents an opportunity cost that arises when a company uses internal resources toward a project without any explicit compensation for the utilization of those resources. This means when a company allocates its resources, it always foregoes the ability to earn money off the use of the resources elsewhere, so there’s no exchange of cash. Put simply, an implicit cost comes from the use of an asset, rather than renting or buying it.
Key Takeaways
- An implicit cost is a cost that exists without the exchange of cash and is not recorded for accounting purposes.
- Implicit costs represent the loss of income but do not equate to a loss of profit.
- These costs contrast with explicit costs, which involve cash exchanges or the use of tangible resources by a company.
- Examples of implicit costs include a small business owner who may forgo a salary in the early stages of operations to increase revenue.
Understanding Implicit Costs
Implicit costs, also known as imputed, implied, or notional costs, aren’t easy to quantify. Businesses don’t necessarily record implicit costs for accounting purposes as money does not change hands.
These costs signify a loss of potential income but not profits. Implicit costs are a type of opportunity cost, which is the benefit a company misses out on by choosing one option over another. For instance, a company could earn income from renting out its building instead of using it for manufacturing and selling its products.
A company may include implicit costs in their overall cost of doing business since they represent potential sources of income. Economists incorporate both implicit and regular costs when calculating total economic profit. Economic profit is the revenue a company generates minus the cost of doing business and any opportunity costs.
In corporate finance, implicit costs are crucial for resource allocation decisions.
Implicit Costs vs. Explicit Costs
Implicit costs aren’t directly incurred and can’t be measured accurately for accounting purposes since there’s no cash exchange. Nevertheless, they are vital in helping managers make effective business decisions.
These costs differ significantly from explicit costs, which represent tangible expenses paid in cash by a company. Rent, salary, and other operating expenses fall under explicit costs and are recorded in a company’s financial statements.
The primary distinction between implicit and explicit costs is that implicit costs are opportunity costs, whereas explicit costs involve tangible out-of-pocket expenses. Implicit costs are more challenging to measure and are subjective, helping calculate overall economic profit. On the contrary, explicit costs are used to determine both accounting and economic profit.
Examples of Implicit Costs
Examples of implicit costs include the loss of interest income on funds and the depreciation of machinery for a capital project. They may also include intangible costs that are not easy to account for, such as an owner’s time spent on company maintenance instead of on other ventures. Generally, implicit costs are not recorded for accounting purposes.
When a company hires a new employee, there are implicit costs involved in training that employee. If a manager devotes eight hours of an existing employee’s day to train the new team member, the implicit costs would be the existing employee’s hourly wage multiplied by eight, considering those hours could’ve been used for the employee’s current role.
Another example is small business owners who forgo a salary in the early stages to reduce costs and boost revenue. Their management and labor provided to the business instead of taking a salary lead to an implicit cost.
Related Terms: Explicit Costs, Economic Profit, Opportunity Cost, Accounting Profit, Capital Project.
