Implicit vs. Explicit Costs: What's the Difference?
By Indeed Editorial Team
Published May 22, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Unlike accountants or other financial and sales professionals, economists define a cost as the value of a resource used to produce a good or service. Implicit and explicit costs are two of these types of microeconomic concepts that affect the operations and accounting of a business. Understanding the meaning and uses of these terms may help you better recognize how private enterprises operate. In this article, we discuss the difference between implicit vs. explicit costs, highlight their definitions, and provide their examples and importance.
Implicit vs. explicit costs
The difference between implicit vs. explicit costs lies in their innate nature and various economic and accounting principles. Some of these areas include:
Explicit costs deal with tangible assets. This means that you can see, touch, hold, and manipulate these items in the physical world. They are items like products or machinery that you might expect a company to buy to furnish a workspace, employ a crew, or use for production and manufacturing. In contrast, implicit costs may not have ties to a physical object or something with traditional value. They may deal more with time, actual labour, or other necessary components of a job that are harder to purchase monetarily or track in expected means.
Discounted cash flow analysis
When a company calculates the present value of an explicit cost or a cost that requires payment to obtain a resource for production, they may use discounted cash flow analysis. This method, which is common among accountants and financial managers, works by converting future benefits into their current-day monetary worth. Conversely, implicit costs do not require any money, and they may be more difficult for accountants to convert into cash.
Taxes and profits
Explicit costs are necessary for calculating taxable income. For example, accountants typically use explicit costs to determine how much of a company's profit is left after tax agents have assessed their due taxes. Explicit costs are taxable income because they directly correspond to a product or service sale. Conversely, implicit costs are not necessary for reporting profits. Furthermore, accountants may avoid attempting to quantify implicit costs to keep taxes to a minimum and ensure high profitability for companies.
With implicit costs, there are no cash exchanges concerning resources. This means that businesses can't continue to earn money off of them elsewhere later after incurring the initial cost. With explicit costs, business owners may use the assets they purchase to create new materials or products or resell them to another buyer later to make an additional profit.
You can consider implicit costs to be opportunity costs. These are situations where a company uses its internal resources without directly stating the compensation rate for using them. This is because someone's time, or another implicit factor, doesn't have the same monetary value as raw materials for manufacturing. You incur opportunity costs when you have various intangible cost options to choose from and make one decision over another.
In contrast, you can consider explicit costs to be out-of-pocket costs. This means you are taking money that you have earned from sales or other revenue generation and are buying and paying for a product or service that exists outside your current organization.
Implicit costs only come into play in evaluating economic profit, whereas explicit costs help calculate both economic and accounting profit. This includes revenues and expenses and intangible costs that may impact return on investment (ROI). For example, when a business owner decides to buy an asset for production or manufacturing, they can consider any implicit costs involved in its use.
In general, it can be easy to measure information about explicit costs. You can link most of these costs to their tangible items and point of sale or transaction. They accompany paper trails such as recipes, invoices or quotes. Implicit costs are more difficult to measure because they come from within the company, and their value and necessity can vary by situation.
What is an implicit cost?
An implicit cost comes from using an asset you already have rather than renting or buying a new one, representing an expenditure of resources. The word implicit means that you imply something without actually saying it. You may incur an implicit cost without listing it as a separate expense in your ledger. They often represent the loss of income, but not the loss of profit. They also help business managers make the most effective decisions based on profit and market conditions. Other names for implicit costs include implied, imputed, or notational costs.
Implicit cost also refers to the benefit you derive from using an asset rather than selling it. For example, if you spend $500 on a bicycle every year but never sell it, that is an implicit cost. It represents the loss of personal income without losing profit for the business.
What is an explicit cost?
Explicit costs are expenses that business owners get on the market, usually by renting or buying an asset, which they use to produce a good or service. Explicit costs represent expenditures of resources, and both accountants and financial managers consider them in their efforts to determine profit for a company. Explicit costs also help business leaders plan budgets and make pricing decisions. This is the only accounting cost necessary to calculate profit, and it has a clear impact on an organization's bottom line. Explicit cost refers to the benefits businesses derive from selling an asset rather than using it.
Consider a business owner who owned a truck for several years and uses it to make deliveries. One day, he decides to sell the truck for $2,000 in cash and uses his car for deliveries instead. The $2,000 received represents the explicit cost of selling the truck.
You can use both implicit and explicit costs to calculate the economic profit. You can use the economic profit of a business for internal company analysis. You can calculate the economic profit by using the formula:
Economic profit = total revenue - (explicit costs + implicit costs)
For example, if you made $567,000 last quarter and had explicit costs of $124,000 and implicit costs of $80,000, your economic profit is $363,000. In addition, you can use explicit costs to calculate the accounting profit or the company's total earnings for a specific period. In the basic accounting profit formula, you subtract the total revenue from the explicit costs. Some accounting profits also factor in operating expenses, depreciation, taxes, and interest.
Examples of implicit costs
Implicit costs can come in various forms depending on the size of a business, the types of employees and the industry. Some examples of implicit costs include:
Bank reserve investments
College courses in place of working a job
Hours allocated to a specific area of a company
Paid time off and sick leave hours for qualifying employees
Prices set below market value for a specific purpose
Machinery for a capital project that has depreciated
Training sessions and hours for new employees
Examples of explicit costs
Most people often consider explicit costs when considering the financial and material resources necessary to start and run a business. Examples of explicit costs include:
Advertising expenses, such as radio ads or television commercials
Cash discounts for product returns
Energy consumption associated with production processes
Factory rent and lease agreements paid in monthly installments
Non-production equipment needed to stay operational
Overhead costs associated with renting a building
Raw materials used for manufacturing a product
Wages paid to employees who work the cash register and answer customer questions
Taxes and fees related to business activity, such as sales tax or workman's compensation
Utilities, such as electricity, gas, and water
Why is it important to calculate the implicit costs?
Calculating implicit costs is important for the following reasons:
Provides a window into company operations and helps businesses make important decisions
Enable more transparency between employees and owners regarding the value of a business
Helps small companies determine costs associated with their products or services, which can help them set more competitive prices on the market
Provides insight into the true costs of owning and running a business are
Why is it important to calculate the explicit costs?
Calculating explicit costs is important for the following reasons:
Demonstrates how much money a company has invested into a particular product or service
Helps small companies determine costs associated with their products or services, which can help them set competitive prices on the market.
Provides insight into how much an owner may charge for purchasing a company
Helps determine what materials, supplies, and equipment are necessary to run a business
Provides an understanding of the level of risk associated with running the business, which owners may consider when making decisions regarding hiring employees or other company expenditures
Provides greater transparency between owners and employees about the day-to-day expenses of owning a business
Enables small companies to determine their production costs, which helps them set competitive prices on the market
Helps companies determine the actual costs associated with running a business
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