Implicit Cost

What is an Implicit Cost?

An implicit cost is a non-monetary opportunity cost that is the result of a business – rather than incurring a direct, monetary expense – utilizing an asset or resource that it already owns. The cost is a non-monetary one because there is no actual payment by the business for the use of the existing resource.

Other terms used to denote implicit costs include notional costs, implied costs, or imputed costs. Implicit costs are the counterpart of explicit costs, which are ordinary monetary expenses that a business makes to provide the goods or services that it sells.

Understanding Implicit Costs

The following example provides the easiest way to demonstrate what an implicit cost is. An owner of a small business performs work for the business but doesn’t receive a salary but instead takes a management fee or dividends. The owner’s efforts or cost does not appear in the income statement.

Instead, the work performed is an implicit cost, with the associated opportunity cost equal to what the business owner might’ve earned by devoting their time and effort to some task for which they would receive direct, monetary compensation (for example, working at a regular, salaried job).

In contrast, if the business owner received a regular salary to operate the business, then the salary they received for work they performed would be an explicit cost to the corporation.

Implicit costs, as shown in the example above, are non-monetary and typically difficult to quantify precisely and, therefore, may not be recorded as part of a company’s regular accounting.

Practical Examples

There are many implicit costs that virtually all businesses incur at one time or another. Hiring a new employee, for example, usually involves both explicit and implicit costs. The explicit costs include things such as the cost of placing an advertisement of the job opening or paying for an applicant to travel to company offices for an interview. Implicit costs include the time that the president or owner of the company may spend interviewing the applicant.

The use of real estate resources that a company owns is another example of an implicit cost. If a company uses an office building that it owns as part of its core business operations, an implicit cost exists in the form of the opportunity cost equal to what the company could receive by renting out the office space to other enterprises.

Significance of Implicit Costs

Although implicit costs are non-monetary costs that usually do not appear in a company’s accounting records or financial statements, they are nonetheless an important factor that must be considered in bottom-line profitability. Implicit costs distinguish between two measures of business profits – accounting profits versus economic profits.

• Accounting profits are a company’s profits as shown in its accounting records and financial statements (such as its income statement). However, accounting profits, which are calculated as total revenues minus total expenses, only reflect actual cash expenses that a company pays out – its explicit costs.
• Economic profits take into consideration both explicit and implicit costs. Therefore, while a company may show a positive net accounting profit, it may actually be a losing economic enterprise when its implicit costs are factored into the profitability equation, as shown below:

Accounting Profit = $100,000 (Total Revenue) – $80,000 (Explicit Costs) = $20,000

Economic Profit = $100,000 – $80,000 – $30,000 (Implicit Costs) = (-)$10,000

However, one should not conclude that implicit costs are necessarily a negative, profit-reducing factor for a business. For example, a business may incur an implicit cost of $10,000 by utilizing its own existing resources. However, by doing so, it may avoid incurring an explicit cost of $15,000, the price it will need to pay for the use of outside resources.

Learn More

CFI offers the Financial Modeling & Valuation Analyst (FMVA®) certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Accounting Profit vs Economic Profit
• Explicit Costs
• Projecting Income Statement Line Items
• Direct Cost
• See all accounting resources