One of the main objectives of every business entity is to maximize its profit by utilizing its available resources. To be able to do that, entities should have a clear understanding of all elements involved while generating profits. As the costs are one of the major determinants of net earnings for a period, businesses should have a thorough understanding of all types of costs incurred during the period.
In the fields of accounting, finance and economics, many different approaches are followed to group or categorize business costs. However, on the basis of payments, two major types of costs are explicit costs and implicit costs. In this article, we will clarify the basic difference between these two types of costs and help you identify which type of cost you’re dealing with while operating your business.
Definitions and explanations:
Explicit costs are clearly and easily identifiable costs for which a definite and actual payment is disbursed immediately or at some future time. These costs are paid either in cash or in kind whose value can be reliably ascertained in dollar terms. The usual costs incurred by a business organization in its ordinary course of business are explicit costs.
Common examples of explicit costs include the following:
- Cost of goods sold
- Salaries, remunerations and fringe benefits paid to employees,
- Wages paid to workers,
- rent paid for office or factory building,
- Utility bills paid for electricity, gas, telephone and internet,
- Marketing or advertising expenses paid for brand awareness and boosting sales
- Depreciation charged on equipment, machinery and building etc.
Other terms used for explicit costs are accounting cost, outlay cost and out-of-pocket cost
Financial accounting and reporting, being a compulsory task for every business, requires companies to immediately report and account for all business transactions. Hence, all explicit costs incurred are realized during the operations of a business and are reported and accounted for at every stage of business. When calculating the accounting profit, the total explicit costs are deducted from the total revenue realized during the period.
In equation form, the accounting profit can be presented as follows:
Accounting profit = Total revenue – Total explicit costs
Implicit costs (also known as imputed, notional, and implied costs) can be defined as the benefits foregone when the factors of production owned by the entity are used for business operations instead of generating income by other means. In easier words, implicit costs are opportunity costs of using your resources or assets in the course of your own business setup instead of selling or renting them out. Implicit costs get incurred without any exchange of cash. They are not so easily identifiable or recognizable, and therefore cannot be accurately measured. Hence, it is impossible to account for them on the company’s general ledger.
As the implicit costs can’t be objectively measured, they are not made part of the entity’s formal accounting record and are ignored while determining its accounting profit. Implicit costs are, however, important to point out and realize for other purposes. For example, information regarding implicit costs helps measure the economic profit generated by a business entity. Economic profit is a measure used for internal analysis and is helpful to owners and managers in making business decisions. When calculating economic profit, both implicit and explicit costs are deducted from the revenue. The economic profit equation can be shown as follows:
Economic profit = Total revenue – Total explicit costs – Total implicit cost
An example of implicit cost is as follows:
John is a sole proprietor of a local pharmacy and manages it all on his own. However, on the other hand, John could also easily earn $30,000 annually by working as a Medical Assistant at a local clinic. John is giving up the opportunity of earning $30,000 to manage and run his own pharmacy. Hence, the sum of $30,000 is an implicit cost for his sole proprietorship business. If John wants to determine the economic profit generated by his pharmacy, he must deduct this implicit cost of $30,000 (along with all explicit costs) from the revenue realized during the year.
Difference between explicit costs and implicit costs:
The key points of difference between explicit costs and implicit costs are listed below:
Explicit costs are expenses borne directly during production process or daily operations of a business. Implicit costs are not direct expenses incurred, but are potential profits/benefits foregone by firms due to conducting business. Explicit costs are also called out-of-pocket costs, accounting costs and outlay costs whereas implicit costs are also known as imputed costs, notional costs, and implied costs.
2. Involvement of payment and cash outflow:
Explicit costs are subject to an actual current or future payment of a definite amount. It involves an outflow of cash or another asset. Implicit costs, on the other hand, are sacrifices which arise without any outflow of cash or some other asset.
3. Nature of cost incurred:
Explicit costs are objective in nature because they are incurred when the firm uses its factors of production. They have a paper trail and hence are easily ascertainable. On the contrary, the measurement of implicit cost is subjective in nature because they are incurred indirectly and have no track. They are the value of benefits sacrificed to do business and can only be estimated.
4. Ease of recognition and realization cost:
Explicit costs are recognizable due to outflow of cash. As per the prudent concept of accounting, all explicit costs should be reported in the books of accounts immediately. On the other hand, implicit costs are not easily and clearly recognizable, they cannot be assigned a monetary value and are therefore imprecise. Hence, implicit costs are not reported or accounted for on the financial records of a company.
5. Calculation of profits:
Explicit costs are considered while computing both accounting profit and economic profits, whereas implicit costs are used for determining economic profits only.
6. Uses of accounting profit and economic profit figures:
Explicit costs are realized and used by accountants to determine the net accounting profit or net accounting loss figure to be reported in the financial statements. The entity’s income tax obligation is determined and paid on the basis of accounting profit. Implicit costs are usually used by economists to determine the net benefit or net loss of a potential business activity which is helpful to undertake crucial economic decisions. Disclosure of economic profit through financial statements or other means is not required.
Explicit costs vs implicit costs – tabular comparison
A comparison of explicit costs and implicit costs in tabular form is presented below:
|Arise when a cash outflow or payment becomes definite either in current or future period||Arise when resources or assets are used in a particular operation instead of being rented out or used in some other way.|
|Involvement of payment or cash outflow|
|Involve payment||Does not involve payment|
|Nature of cost incurred|
|Objective in nature||Subjective in nature|
|Ease of recognition and realization|
|Easy to recognize and realize||Difficult to recognize and realize|
|Calculation of profit|
|Taken into account for calculating accounting profit only||Taken into account for calculating accounting profit as well as economic profit|
|Use of accounting profit and economic profit figures|
|Accounting profit is measured and used by accountants for reporting and computation of tax obligation||Economic profit is measured and used by economists in critical economic decisions.|
Conclusion – explicit costs vs implicit costs:
On the basis of explanation given above, we can conclude that the implicit costs and explicit costs both substantially differ from each other. Explicit costs are usual business costs that a business need to realize and include in the determination of its net profit or loss for reporting and taxation purposes.
The implicit costs are important for a deep analysis of how a particular economic activity can or cannot be potentially more beneficial than others. However, the measurement of such costs is highly subjective in nature and the accounting standards (like IFRSs and GAAPs) being followed world wide do not permit the use of implicit costs for financial accounting purposes. The idea of implicit cost can be a little hard to grasp for individuals with not much exposure in economics.