In a business, when costs are analyzed from a payment point of view, these are segregated into two types – explicit and implicit costs. An explicit cost is a clearly identifiable cost that a business incurs on production, but implicit costs, though occur, cannot be seen.
Explicit costs are also known as out-of-pocket costs. This is so because such costs involve an immediate payment of cash or require the acquisition of resources for current use. Some examples of these costs involving immediate cash outflow are salaries, wages, interest on advances, raw materials, stores & supplies, printing and stationery, rent, utilities, etc.
Therefore, whenever there is an exchange of money or use of any tangible resources, it gives rise to explicit costs. Such costs are duly recorded in financial statements.
Explicit costs can be either fixed (such as managers’ salaries) or variable (like raw materials or direct wages).
These costs are very frequently used in making important costing decisions. These could be a ‘make or buy’ decision, price fixation, or many other decisions. The importance of explicit costs lies in the fact that these represent expenditures made by a business owner himself to run his business efficiently, and therefore, it is critical to account for these costs.
Implicit cost, on the other hand, is the cost of the opportunity that you forego in order to undertake a particular project. When a business chooses one option over another, the benefit that it misses out on the abandoned option is the implicit cost. That is why an implicit cost is also known as opportunity cost, implied cost, or economic cost.
For example, the implicit cost of retained earnings is the rate of return that a company’s shareholders would have obtained in case they had invested the funds elsewhere.
Simply put, an implicit cost most commonly arises when a business allocates its internal resources towards a certain work. This means that when a company utilizes its internal resources, it always forgoes the opportunity to earn money on such resources had they been invested in any outside investment fund. Thus, an implicit cost exists without any exchange of cash.
Say a firm uses its building for carrying out its manufacturing activities. Although it earns revenue from using the building for its production processes but at the same time, it misses out on the chance to let out its building for rent. The amount of rent foregone by the firm is an example of implicit cost.
Implicit costs do not entail any immediate cash payment. Moreover, they are not separately identified and are not recorded in accounting books. But they are an important consideration and should be weighed by managers before making effective decisions for a company.
More Examples of explicit and implicit cost
Imagine a student in college who is doing higher studies. How much does it cost to go to college for a year? The student could add up costs like tuition fees, college supplies, books, conveyance charges, and so on. These costs are examples of explicit costs since they require monetary payment. However, if compared to the value of the time that it takes for the student to attend his/her class and do homework, etc., explicit costs might appear very small. The implicit cost of attending college is the amount of money that the student could have earned if he or she had done a job rather than attending college. Thus, implicit costs do not require an immediate cash payment but signify the cost of an opportunity that you give up when you make a particular choice.
Another most important implicit cost is associated with the usage of a firm’s capital. Suppose Mr. A invests a capital of $1,00,000 inherited from his father to start a new business venture. The implicit cost of this capital is what Mr. A could have earned if he had taken the money and invested it elsewhere. If we assume that the rate of return on his best alternative investment opportunity is 12%, the implicit cost of capital is $12,000.
When accountants compute costs, implicit costs do not appear in the books of account. A firm’s accounting profit is taken as revenue minus all explicit costs. In the foregoing example, the $12,000 in income that Mr. A is giving up because he chose to use his $100,000 to start his own business rather than investing it elsewhere would not be counted in books. Only the explicit costs of running his new business – like rent, raw materials, salary, wages, etc. will be deducted from revenue to ascertain profit. However, if Mr. A had no amount recovered from his father in inheritance and had to borrow $100,000 from a bank at a 12% annual interest rate, then the interest payment of $12,000 would appear in the books as an explicit cost.
Let’s take another example. Suppose a factory shuts down its operations for a day in order to service its machines. The servicing and repairing cost of machinery comes out to $13,500. This is the explicit cost that the factory incurs on servicing. However, there is another loss to the business which is unseen. Due to the stoppage of operations, the factory has lost its production output for one whole day which comes out to $45,000. This loss of production output is an implicit cost.
Comparison flowchart – Difference Between Explicit Cost and Implicit Cost
|Explicit cost is the cost borne by a business for purchasing inputs.||Implicit cost is a cost related to the usage of self-owned inputs in business.|
|Explicit cost is based on the notion that “cash outflow means cost incurrence”.||Implicit cost is based on the notion that “had the inputs been diverted for some other purpose, they would have rendered some income”.|
3. Cash outflow
|An explicit cost arises when there is an exchange of money between a business and a third party.||There is no cash outflow in case of implicit costs.|
|Explicit costs are easy to quantify as they involve an exchange of cash between two parties.||It is not easy to quantify implicit costs. Since there is no real exchange of money, they are difficult to assess. This also makes them subjective.|
5. Recording in books
|All explicit costs are recorded in the books of account to determine profit.||Though implicit costs are not separately recorded in financial statements, they are often considered by managers in making important cost-related decisions.|
6. Another name
|Another name for explicit cost is ‘out-of-pocket’ cost.||Implicit cost is also known as opportunity cost, implied cost, or economic cost.|
7. Profit ascertainment
|Explicit cost is used for ascertaining both accounting profit and economic profit. Accounting profit = Revenue – Cost of doing business (explicit)||Implicit cost aids in calculating only economic profit. Economic profit = Revenue – Cost of doing business – Opportunity cost (implicit)|
|Explicit costs are clearly identifiable in monetary terms.||It is quite difficult to estimate implicit costs in monetary terms.|
While explicit cost relates to expenditure made by a business owner in cash, implicit cost arrives when a business owner applies his already available resources to a certain job work instead of utilizing them for his own purpose. Although there is no cash payment involved, there is an implied cost of losing a potential income on the resources utilized.
It can also be said that while explicit cost is incurred by a business owner directly, the implicit cost is borne by him indirectly.