An implicit cost is any cost already incurred but not explicitly expressed or reported as a separate expense. It reflects the value of opportunity that occurs when an organization uses internal capital for a project without any precise reimbursement for resource use.
What are Implicit Costs?
In economics, an implicit cost also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use a factor of production for which it already owns and thus does not pay rent. It is the opposite of an explicit cost, which is borne directly. In other words, an implicit cost is any cost that results from using an asset instead of renting it out, selling it, or using it differently. The term also applies to foregone income from choosing not to work.
Implicit costs also represent the divergence between economic profit (total revenues minus total costs, where total costs are the sum of implicit and explicit costs) and accounting profit (total revenues minus only explicit costs). Since economic profit includes these extra opportunity costs, it will always be less than or equal to accounting profit.
As they are not actually incurred they cannot be easily measured, but they can be estimated. They are not recorded in the books of accounts as well as these are not reported. The purpose of ascertaining the implicit cost is that it helps in decision-making regarding the replacement of any asset and much more.
Implicit costs have a direct impact on the profitability and performance of the company. Some common examples of implicit costs are Interest in the owner’s capital, salary to the proprietor, etc. which are not actually incurred but exist.
Implicit Costs vs. Explicit Costs
Implicit costs are technically not incurred and cannot be measured accurately for accounting purposes. There are no cash exchanges in the realization of implicit costs. But they are an important consideration because they help managers make effective decisions for the company.
The main difference between the two types of costs is that implicit costs are opportunity costs, while explicit costs are expenses paid with a company’s own tangible assets. 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.
Understanding the nature of implicit costs
Implicit cost can be a key factor in determining a company’s overall economic success. This is because implicit cost not only accounts for underutilized resources but may account for a business’s incurred loss if it chooses not to utilize its resources to gain more revenue.
Implicit costs can also be referred to as implied, notional or imputed costs because these types of costs may be difficult to quantify. This can be because a business may not record implicit costs for the purpose of accounting, as funds are not being directly exchanged. Furthermore, the implicit cost may represent a potential loss of income, but not necessarily profit. An organization may decide to include implicit costs as the price of operating its business because the implicit cost can also represent alternative sources of income.
Breaking Down Implicit Costs
Implicit costs are also called values imputed, implied, or notional. It’s not easy to quantify those costs. That’s because for accounting purposes companies don’t typically report indirect expenses because money doesn’t change hands.
These costs are a loss of potential revenue but not of profits. A company may choose to include these costs as the cost of doing business as they represent potential revenue sources. Definitions of tacit expenses include loss of interest income on funds and equipment depreciation for a construction project.
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 the 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 owners passing on taking a salary in the early stages of operations
- Time equipment is offline for maintenance