7 1 Explicit and Implicit Costs, and Accounting and Economic Profit Principles of Economics 3e
Explicit costs are accounted for when calculating accounting profit, which is important for financial reporting and tax obligations. However, to gain a true picture of a business’s profitability, one must also consider implicit costs, which are factored into economic profit. By analyzing both, businesses can make more informed decisions about resource allocation, investments, and potential cost-saving measures. This comprehensive understanding can lead to more strategic business planning and improved financial health. Opportunity cost is closely related to implicit cost, but they are not exactly the same.
- While explicit costs affect a company’s accounting profit, implicit costs influence its economic profit.
- Explicit vs implicit cost is a hot topic discussed in the world of accounting.
- In contrast, the adjective implicit describes something that has been implied—meaning it has been suggested or hinted at but not actually directly stated or expressed.
- Accounting profit is the money left over in a business after deducting explicit costs from total revenue.
It’s the costs that include cash outflows because of the production factors. A firm is considering an investment that will earn a 6% rate of return. If it were to borrow the money, it would have to pay 8% interest on the loan, but it currently has the cash, so it will not need to borrow. We will see in the following modules that revenue is a function of the demand for the firm’s products.
Opportunity costs can also include the potential income from explicit costs that were not spent due to choosing a different alternative. Explicit vs implicit cost is a hot topic discussed in the world of accounting. The major difference between these two types of costs lies in the implicit cost being opportunity costs and explicit costs being expenses paid with the business’s tangible assets. Implicit costs are opportunity costs synonymous with imputed costs. These are incredibly subjective costs but can help leadership teams calculate economic profit for the business.
The entity’s income tax obligation is determined and paid on the basis of accounting profit. Implicit costs are usually used by economists to determine the net benefit or net loss of the notion of petty cash and how to work with it a potential business activity which is helpful to undertake crucial economic decisions. Disclosure of economic profit through financial statements or other means is not required.
2: Explicit and Implicit Costs, and Accounting and Economic Profit
However, on the other hand, John could also easily earn $30,000 annually by working as a Medical Assistant at a local clinic. John is giving up the opportunity of earning $30,000 to manage and run his own pharmacy. Hence, the sum of $30,000 is an implicit cost for his sole proprietorship business.
This makes implicit costs synonymous with imputed costs, while explicit costs are considered out-of-pocket expenses. Implicit costs are harder to measure than explicit ones, which makes implicit costs more subjective. Implicit costs help managers calculate overall economic profit, while explicit costs are used to calculate accounting profit and economic profit. The concept of economic profit takes into account both explicit and implicit costs. To calculate economic profit, business owners must deduct both types of costs from total revenues. This profit measurement is less visible but more comprehensive as it provides a clearer picture of the opportunity costs of business decisions.
Some examples of implicit costs are depreciation of equipment, loss of interest income on funds, allocating company time towards maintenance projects instead of other tasks, etc. Explicit and implicit costs are two sides of the same coin, each representing different aspects of business expenditures. While explicit costs are straightforward and easily recorded, implicit costs are subtler but no less important. When comparing explicit and implicit costs, it’s important to recognize that both play a significant role in business decisions. While explicit costs affect a company’s accounting profit, implicit costs influence its economic profit. Another difference between implicit and explicit costs is that explicit costs are more readily quantifiable.
Explicit Costs vs. Implicit Costs
As a general rule, implicit costs are better understood in business because they show the real economic value of a company. Implicit cost refers to an individual or company’s cost but has not been reported separately. An example of an implicit cost is when a business owner who owns a start-up doesn’t take a salary during the first days. The company utilizes internal resources to train its new employee, removing them from the time they might be working on something else. The best way to calculate this implicit cost would be to take the hours of training multiplied by the employee’s hourly wage. As they are not actually incurred they cannot be easily measured, but they can be estimated.
Is opportunity cost the same as implicit cost?
The business can control these costs to increase its profitability by reducing its advertising or mortgage expenses or cutting staff hours. Explicit costs are objective in nature because they are incurred when the firm uses its factors of production. On the contrary, the measurement of implicit cost is subjective in nature because they are incurred indirectly and have no track.
Comparing Explicit and Implicit Costs
Explicit costs are incurred expenses, while implicit costs are costs that are not incurred expenses. Explicit costs (such as wages and rent) are subtracted from the accounting cost. Explicit and implicit costs are included in the economic profit. In the realm of business economics, understanding the various types of costs is essential for making informed decisions. Among the most critical distinctions is that between explicit and implicit costs. These concepts are not just vital for accountants but are also crucial for business owners who aim to gauge the true economic profit of their ventures.
Uses of accounting profit and economic profit figures:
They have clearly defined dollar amounts that flow through to the income statement. Examples of explicit costs include wages, lease payments, utilities, raw materials, and other direct costs. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits. Maybe Eryn values her leisure time, and starting her own firm would require her to put in more hours than at the corporate firm.
Explicit costs
Explicit costs are those which are clearly stated on the firm’s balance sheet, whilst implicit costs are not. Instead, it is the indirect cost of choosing a specific course. When combined together, explicit and implicit costs make up what is known to be the total economic cost. This is because the cost of choosing option A has an explicit cost as well as an implicit cost of what could have been achieved otherwise.
This could also include equipment, supplies, rent, insurance and goods sold. Whilst explicit costs have a specific value, implicit costs are not always so clear cut. For example, spending 5 hours playing video games means those 5 hours cannot be used for studying. The implicit cost is the hours that could have been used for studying instead.