What Are Explicit and Implicit Costs? Comprehensive Guide

Expenses that can’t be easily quantified are called implicit costs. These are costs that can’t be measured directly but contribute to a business’s income. In some cases, owners of a business contribute to these costs. 

For example, a promoter’s time could be better spent elsewhere. Owners may use the ground floor of their home as a retail outlet. Implicit costs allow for the depreciation of necessary items.

Did You Know?

An explicit cost is a rupee amount that appears on the general ledger. An implicit cost, on the other hand, is not reported or shown as an additional cost.

Explicit vs Implicit Cost

Among the many differences between implicit cost and the explicit cost is that the explicit costs are recorded. Implicit costs are unrecorded, but they are still considered indirect costs. Calculating the difference between these two types of costs requires comparison analysis.

Explicit costs are reported separately and are paid in cash to third parties. Examples of these costs are rent and utilities, and compensation. These costs appear in the income statement, but they are not directly linked to an asset. If a note costs ₹7,120, the interest cost is ₹2,880. 

The amount is clearly stated and accounted for in the general ledger for an explicit cost. However, an implicit cost may be accounted for in a separate line item.

Another difference between implicit and explicit costs is that explicit costs are more readily quantifiable. 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.  

Also Read: What Is Cost Estimation – Cost Estimation Types & Examples Explained With Advantages of Cost Estimation

What Are the Explicit Costs?

Explicit costs can also be called opportunity costs. An organisation incurs these costs to produce its goods or services. The business can control these costs to increase its profitability by reducing its advertising or mortgage expenses or cutting staff hours. 

It’s also possible to lower other costs, such as inventory or staff. However, you should be cautious when using this information, as it can be misleading. You may be spending more than you’re making!

The explicit cost is a cash outflow. These costs include wages and salaries, mortgage or rent, materials, inventory, equipment and advertising. Some accountants include depreciation as a cost, but this isn’t a tangible expense. 

The expense itself must result in a cash outflow for it to be included in its books. However, these costs don’t include expenses incurred during a business’ operations, such as taxes.

Also, Based on the weighted average of these costs, the firm’s overall cost of capital is calculated. Take, for example, a company with a capital structure comprising 70% equity and 30% debt; its cost of equity is 10% and its after-tax cost of debt is 7%.

Explicit costs can be identified in two ways. 

1. The first is through the use of money. These costs can be traced through invoices, receipts and quotations. 
2. The second type is called opportunity cost. These costs occur when a company uses resources that could be used to make money, such as human capital. 

While these costs are visible, they are often difficult to measure. This means that companies should be aware of both costs when planning for their businesses.

What Are Implicit Costs?

Unlike direct costs, implicit costs do not appear on a financial statement. Instead, they represent the opportunity cost of the company’s resources. For example, if the company spends ₹1,000 a month to rent a piece of land for a production plant, it does not make money if it doesn’t use it. Moreover, implicit costs help evaluate the efficiency of a resource.

Implicit cost is the cost of the opportunity that a company cannot use because it is not visible to the outside world. These costs are hard to quantify, but it represents the missed income or benefit.

Implicit costs are also known as notional costs or imputed costs. However, their impact is often less visible than their direct counterparts. Therefore, business leaders should recognise and measure them as they are vital to the operation of their organisation.

Implicit cost is an opportunity cost that arises from the allocation of resources. This cost is not reported separately but is not included in the accounting profit. In essence, it is the value of the opportunity created by using internal capital. 

This resource is not explicitly reimbursed for its usage. It is often the case that implicit costs exceed explicit costs by a large amount. The difference between the two is called the accounting profit. In other words, an implicit cost represents the opportunity costs of internal capital.

How to Calculate Explicit vs Implicit Cost Difference?

Calculate Explicit Cost

It is easy to calculate explicit costs if you understand your business costs well. Add up all your business costs to calculate explicit costs. This could also include equipment, supplies, rent, insurance and goods sold.

Remember that expenses can vary from one business to another. There is no single formula to calculate explicit costs. It’s easy to calculate if you’ve narrated the notes of your business costs.

Example of an Explicit Cost:

For example, the business you own has ₹10,000 in goods and supplies, ₹1,000 rent, ₹300 supplies, ₹200 insurance, ₹11,000 employee wages, ₹500 utility costs and ₹450 in rent. Add all your expenses together to calculate your entire explicit cost.

Explicit costs = ₹10,000 + ₹1,000 + ₹300 + ₹2300 + ₹1,000 + ₹500 + ₹450 

For the entire period, your entire explicit costs amount to ₹25,5500. This amount can be used to calculate financial information for your company by plugging it into any other formulas such as the economic or accounting formulas of profit.

How to Calculate Implicit Cost?

Implicit cost is simply an opportunity cost that a company incurs when it uses resources to make a decision. It can be complicated because it involves many different kinds of circumstances. Therefore, it is difficult to provide a standard method for calculating implicit costs.

Identify the opportunity costs to determine your implicit cost. One example is that if you spend a day training a fresh employee, another employee will miss out on sales or commission. This opportunity cost, also known as the commission or other pay, is implicit to the trainer/employee.

Example of an Implicit Cost

Let’s say you are a fresh business owner and just beginning your first business. You determine not to get a salary during the first three years to help with start-up expenses. Your salary might have been ₹3,00,000 annually.

Your decision to make the change is ₹9,00,000 (3,00,000 X 3) because you didn’t receive a salary for three years. It might’ve been an explicit expense if you had received the salary.

Also Read: Overhead Cost – What is Overhead in Cost Accounting, Types & Examples Explained

What is the Opportunity Cost?

The measure of the potential loss in decision-making is called opportunity cost. There are many choices in life. Every choice has an inherent risk of losing out on opportunities. 

There are many consequences to choosing to have children. For example, women can lose their freedom and income. Women may also be less likely to get a job because they are not in the same position. 

Most people who have children feel the benefits outweigh the costs. This thinking is useful for business economics and all other aspects of life. In short, the opportunity cost in business is the value of the highest alternative use of a resource. They typically fall under two types: implicit and explicit costs.

Difference Between Opportunity Cost and Implicit Cost

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.

On the other hand, opportunity cost refers to any potential benefit that a business or individual loses when choosing one option. Example: If someone gives up sweets to lose weight, the opportunity cost will be the price of sweets and the desire for sweets

Conclusion

The economic profit of a firm is calculated by subtracting its total cost (both explicit and implicit) from its total revenue. Explicit costs can be calculated through a complex process that includes explicit and implicit costs.

Once the costs have been determined, the firm’s economic profit will be revealed. However, there are some differences between implicit and explicit costs.

As a general rule, implicit costs are better understood in business because they show the real economic value of a company. Rest, you can check the table.

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