Implicit costs are economic costs incurred by a business that do not directly involve monetary expenditures. Instead, they represent an opportunity cost associated with a decision or action.
Forgone interest revenue from investments, depreciation of properties and equipment, as well as utilizing an owner’s time instead of hiring extra employees are all common examples of implicit costs.
They are subtracted from a firm’s total economic profit to calculate its actual economic profit. In economics, this cost type is also referred to as an “implicit expense” or “implicit cost of production.”
In simple terms, implicit costs are the amount of money that would have been earned if the owner had chosen to forgo engaging in their own venture and instead invested the same amount of money in some other pursuit.
Definition of Implicit Costs
Implicit costs involve lost opportunities, such as lacking access to markets or capital that could be utilized elsewhere. Moreover, they may include the effort and human resources expended in production without being associated with a financial cost (Rasmussen, 2013).
Implicit costs are economic costs that exist without a direct monetary expenditure. They include the value of resources used to produce goods or services that do not necessarily have an exact cost (Biradar, 2020).
When making a choice, companies can miss out on the financial gains they could have had if they selected an alternative.
Implicit costs are simply the hidden expenses of such missed opportunities and potential returns that would have been obtained with another decision (Sexton, 2020).
In a nutshell, the implicit cost of any investment or decision is the potential benefit that could have been gained if one had chosen to allocate their resources differently.
10 Examples of Implicit Costs
- Employee time: Employee time is a significant implicit cost for any business. In many cases, employees dedicate their time and effort to completing tasks that do not have a directly associated cost. As a result, the opportunity cost of an employee’s time is implicit.
- Access to capital: Limited access to capital is another great example of implicit costs. If a company cannot borrow money or secure investments, then the opportunities that could have been enabled by accessing capital are implicitly lost.
- Loss of interest income on funds: Interest income on funds invested into production activities is another implicit cost (Sexton, 2020). Suppose a company invests money into its production activities and loses out on that interest. In that case, the opportunity to gain interest is an implicit cost.
- Potential income lost when a business owner-manager chooses to work for themselves rather than someone else: A business owner-manager may decide to work for themselves as opposed to someone else. In this case, the implicit cost is any potential income that could have been earned from other job opportunities.
- Possible profit forgone due to lack of efficient production: Poorly managed operations or inefficient production processes can lead to the loss of potential profits. If a company is not able to produce goods or services in an efficient manner, then this can result in the implicit cost of forgone profit.
- Depreciation: Capital goods or assets depreciation is another example of an implicit cost. When an asset depreciates in value, the company is not able to recover the original cost. As a result, this loss in value is an implicit cost.
- The use of a company’s real estate resources: For businesses that operate in an office building they own, there is a hidden cost–the opportunity cost of the income lost from not renting out the space to other companies (Sexton, 2020). Any money saved by using their existing building instead of leasing elsewhere comes with its own expense.
- Time and resources spent on one business instead of other tasks: Companies often invest resources into a single project or mission while neglecting the potential of other opportunities. As a result, this opportunity cost is implicit.
- Loss of goodwill or reputation: In some cases, businesses may lose out on potential sales and profits due to a damaged reputation or a lack of goodwill. It can include the cost of negative press, customer complaints, and other forms of public opinion.
- Annual earnings from stock on selling business assets: For example, if a company were to sell off its assets, the annual earnings from the stock of those assets would be considered an implicit cost. Such a situation arises because the company would not be able to access those annual earnings if the assets were sold.
Implicit Costs vs. Explicit Costs
While similar in concept, implicit costs differ from explicit costs. Explicit costs are those that involve actual money being spent on goods and services, whereas implicit costs are related to the opportunity cost of a decision.
Implicit costs are hard to measure, yet they cannot be overlooked when businesses make decisions. Oftentimes, these hidden expenses are disregarded and challenging to consider while analyzing different options. Nevertheless, their influence on a company’s profitability can be immense (Sexton, 2020).
Conversely, explicit costs are tangible and can be quantified. These expenses involve purchasing goods such as materials, rent, or labor services.
As an example, explicit costs are the tangible expenses of materials used in production. In contrast, implicit costs are those foregone opportunities when resources could have been allocated to a more lucrative investment (Kiran, 2022).
The primary distinction between explicit and implicit costs is the difference between lost potential earnings versus funds paid out from a company’s financial coffers.
Explicit costs include money that has already been paid out of business, while implicit expenses are those which could have potentially been earned but were not realized.
How to Calculate Implicit Costs
Calculating implicit costs can be tricky since these expenses are often difficult to quantify. Nevertheless, it is possible to calculate the potential losses associated with making certain decisions.
If you want to calculate implicit costs, take into account the following points:
- Measure the value of available alternatives: To accurately assess implicit costs, start by evaluating the income you could have earned if other resources were devoted to a different choice. Next, consider potential returns from additional investments, products, and services that might otherwise be pursued.
- Assess the cost of forgone earnings: Once you’ve calculated the potential revenue from an alternative decision, compare it to your current option. By doing this, you can accurately estimate the cost associated with not taking a different pathway and its lost opportunities.
- Consider additional costs: When making a decision, consider additional charges. Any damage to one’s goodwill or reputation, as well as time and resources spent on a single endeavor instead of other activities, should also be considered.
- Calculate the total implicit cost: Now, you can calculate the total implicit cost by summing up all the potential expenses related to a particular decision. In such a way, you can determine the cost of making a decision and make a better-informed choice.
By understanding implicit costs, businesses can make more informed decisions and ensure they make the most of their resources.
Significance of Implicit Costs
Even though implicit costs are not typically recorded in accounting documents or financial statements, they still have a critical impact on the overall profitability of a business. Such non-monetary expenses must be considered when making crucial business decisions (Sexton, 2020).
Implicit costs differentiate accounting profits from economic profits, providing an accurate view of a business’s total earnings.
Accounting profits are the numbers that appear on financial statements, while economic profits consider both implicit and explicit costs. When these are totaled together, a business can accurately measure the actual price of an opportunity (Biradar, 2020).
Moreover, implicit costs help businesses make decisions more efficiently: when all potential costs are considered, companies can better weigh the pros and cons of a decision.
Besides, implicit costs can also be used to gain a competitive advantage. By considering the opportunity cost of potential investments, businesses can make decisions that will give them an edge over their competitors and help them to capture a larger market share.
Other Types of Costs in Economics
- Marginal Costs: the marginal cost reflects the change in total cost that arises when producing one extra unit of a good or service. It is the incremental cost of producing an extra unit, which is usually not fixed.
- Mixed Costs: Mixed costs, also known as semi-variable costs, are business expenses that have both fixed and variable components. In simpler terms, it’s a cost that fluctuates according to the amount of production.
- Sunk Costs: Sunk costs are defined as expenses that have already been incurred and cannot be reversed or recovered.
- Opportunity Costs: Opportunity cost is the cost of giving up one opportunity in order to take another one.
When a business opts for one choice over the other, it comes with implicit costs associated with lost opportunities.
These costs cannot be identified using traditional accounting practices and require critical insight to understand their full impact on overall earnings.
Take the example of a business investing in one project instead of another. Usually, this decision incurs high implicit costs that include lost potential revenue from other options and additional expenses incurred due to choosing one activity over the other.
Incorporating implicit costs into business planning is essential for any company’s financial success. Doing so can help companies make calculated decisions, increase profits, and come out on top against their competition.
Companies can make the most of their resources by understanding and quantifying implicit costs and ensuring long-term success. In addition, with the right approach, they can take advantage of the many opportunities implicit costs provide.
Biradar, J. (2020). Economics for managers. Ashok Yakkaldevi.
Kiran, D. R. (2022). Principles of economics and management for manufacturing engineering. Butterworth-Heinemann.
Rasmussen, S. (2013). Production economics: The basic theory of production optimisation. Springer.
Sexton, R. L. (2020). Exploring microeconomics. Sage Publications, Inc.