Any cost that has already occurred but is not shown or reported as a distinct expense
Any cost that has already occurred but is not shown or reported as a distinct expense is considered an IC. It is an opportunity cost that develops when a corporation devotes internal resources to a project without receiving any clear reward for doing so.
This indicates that when a corporation allocates its resources, it always forgoes the opportunity to gain money from the use of those resources elsewhere, resulting in no financial exchange.
Simply put, an IC is incurred when an asset is used rather than rented or purchased.
Identifying and Dissecting IC
Values imputed, implied, or notional are all terms used to describe IC. It's difficult to put a figure on those expenses. Because money does not change hands, corporations do not often disclose indirect expenses for accounting purposes.
These expenses represent a loss of prospective revenue, not gains. These charges may be included in a company's cost of doing business since they represent prospective revenue sources.
Loss of interest income on funds and equipment depreciation for a construction project are examples of tacit expenses.
Implicit costs are also known as assumed costs, implied costs, and national costs. These expenses are challenging to estimate. Because money does not pass hands, organizations do not have to report implicit expenses for accounting purposes.
These expenses imply a loss of potential revenue, but not profits. ICs are a sort of opportunity cost, which is the benefit that a corporation foregoes by choosing one option over another.
The IC could be the amount of money a corporation loses by opting to use internal resources rather than paying for a third party to use those resources.
For example, a corporation could make money by renting out its facility rather than using it for manufacturing and selling its products. Since IC indicates potential sources of income, a corporation may choose to include them as part of the cost of doing business.
When estimating total economic profit, economists consider both implicit and explicit costs of a running company. To put it another way, economic profit is a company's revenue minus its operating costs and any opportunity costs.
Implicit costs should always be considered when considering how to distribute firm resources in corporate finance decisions.
Implicit Costs vs. Explicit Costs
ICs are not technically incurred and hence cannot be adequately measured for accounting purposes. In the realization of these costs, there are no cash exchanges.
They are, however, significant considerations since they assist managers in making effective business decisions.
Explicit costs, the other main classification of company expenses, are in stark contrast to these expenses. Explicit expenses are any costs associated with a company's cash payment or another tangible resource.
Explicit costs include rent, wages, and other running expenses. All of this is documented in a company's financial statements.
ICs are opportunity costs, whereas explicit costs are expenses paid with a company's actual assets. As a result, these are the same as imputed costs, whereas explicit costs are out-of-pocket expenses.
ICs are more subjective than explicit costs because they are more difficult to quantify. Explicit costs are used to determine accounting profit and economic profit, while these are utilized to calculate overall economic profit.
A better understanding of Accounting Profit and Economic Profit
1. Accounting profit
Explicit costs are subtracted from total revenues to arrive at accounting profit. It is a method of calculating profit that takes into account the actual costs of running a firm.
2. Economic profit
It can only be computed by subtracting both explicit and implicit costs from total revenues, which provides a better indication of whether resources were used profitably or could have been used more profitably.
The economic profit is typically lower than the accounting profit the majority of the time.
Accounting profit, on the other hand, is calculated by subtracting the explicit cost from total revenue - that is, the money brought in minus the money paid out.
The terms "economic profit" and "accounting profit" are not interchangeable. The only difference between the two is that the Economic Profit includes the ICs.
The following is an example of how to calculate Accounting Profit:
Total Revenue ($100,000) – Explicit Expenses ($75,000) = $25,000
Economic profit, on the other hand, can be calculated as follows:
Total Revenue ($100,000) – Explicit Expenses ($75,000) – Implicit Expenses ($30,000) = ($ –5,000)
When implicit expenses are factored in, a negative profit does not always imply that the company is losing money.
It could also indicate that the corporation has incurred an IC of $25,000 rather than an explicit cost of $35,000, which the company should cover with outside resources.
The loss of interest revenue on money and the depreciation of machinery for a capital project are examples of IC.
They could also be intangible expenditures that are difficult to account for, such as when a business owner devotes time to company maintenance rather than employing those hours elsewhere. These costs are rarely documented for accounting purposes.
When a business hires a new employee, there are costs associated with training that individual.
If a manager devotes eight hours of a current employee's day to training this new team member, these costs are equal to the existing employee's hourly compensation times eight.
Because the hours may have been used for the employee's current job, this is the case.
Small business owners that opt not to take a salary in the early phases of operations to save money and generate sales are another example of it. They offer their expertise to the company in exchange for a salary, which constitutes an IC.
There are numerous hidden expenditures that almost every firm faces at some point. For example, hiring a new employee frequently entails both explicit and implicit expenses.
Explicit costs include things like the cost of placing a job advertisement or paying for an applicant's travel to the company's offices for an interview.
Implicit expenses include the time spent interviewing the applicant by the company's president or owner.
Another example of an implicit cost is the usage of a company's own real estate resources. When a corporation uses an office building that it owns as part of its core business operations, it incurs an implicit cost in the form of the opportunity cost, which is the difference between what the firm could earn by renting the office space to other businesses.
Out of a sense of community devotion, a football team may elect to maintain ticket prices below market equilibrium. As a result, there will be hidden revenue costs.
A company may grant a worker 'compassionate leave' to allow them to take time off: this results in an output loss that cannot be readily quantified.
Failure to sell Christmas trees by the deadline of December 25th: If a company has 10 unsold Christmas trees on December 25th, it has lost potential revenue - there may also be a time cost associated with removing the trees.
Everything You Need To Build Your RE Modeling Skills
To Help You Thrive in the Most Rigorous RE Interviews and Jobs.
Explicit Cost Illustrations
A firm's explicit cost is a specific monetary sum. It has a distinct monetary value that may be seen on the company's financial balance sheet. Here are a few examples:
- Costs of advertising and marketing
- Wages, bonuses, commissions, and other forms of employee pay.
- Employee benefits that are not paid directly to the employee, I.e. healthcare, staff restaurant, or staff gym.
- Equipment that firms purchase to make production and output more efficient.
- The firm's use of land necessitates the payment of rent or other mortgage obligations.
- The company requires supplies to supply its output to customers.
- Taxes and legal fees are two of the most costly aspects of running a business.
- Utilities that are essential to keep the firm running such as electricity, water, and internet service.
- Acquisition of new assets, such as machinery and factories
- Recruiting workers – labor expenses
- Acquisition of raw materials
Explicit costs can be measured and are reflected in profit and loss statements. If the company hires a new employee, for example, their wage will be an explicit cost that will be recorded on the accounting balance sheet.
The annual cost of hiring a worker might be £20,000. However, employing a new employee may come with some hidden charges.
For example, welcoming a new employee and training him to the required standard may take the manager's time, as he is unable to perform other responsibilities while training the new employee.
Unlike explicit costs, which have a fixed value, ICs are not always so straightforward.
For example, if you spend 5 hours playing video games, you won't be able to study during that time. The hidden cost is the number of hours that could have been spent learning instead.
Although the value is not always monetarily quantifiable, it is nevertheless considered a cost.
- When a company utilizes its capital, it foregoes the interest it could have earned in interest.
- Training a new employee carries an IC in the fact that those seven hours may have been utilized on another job.
- Going to university has an IC in terms of the money that could have been generated during that time.
- Maintenance requires the company to halt production for a period, which can result in lower output or disgruntled customers.
- If you decide not to sell an asset, its value will depreciate and you will lose out on prospective money.
- Spending bank reserves on a project will result in a loss of interest on previously saved bank funds. The cost of building a new plant is explicit, but interest loss is an implicit one.
- To stay prosperous, a business owner could take a wage decrease. This loss of earnings is an unspoken cost of doing business.
There may be a compelling case for lowering the price of leftover trees during the Christmas season. The sum the firm paid in November is a sunk cost at this point, and it cannot be recovered.
Firms sometimes fall prey to the sunk cost fallacy, wishing to recoup the true explicit cost, yet doing so rigidly can result in the implicit cost of fewer sales.
Implicit Costs and Their Importance
Even though hidden costs are non-monetary charges that do not appear in a company's accounting records or financial statements, they are a significant aspect to consider when calculating bottom-line profitability.
It differentiates between two business earnings types: accounting profits and economic profits.
- Accounting profits are recorded in a company's accounting records and financial statements (such as its income statement).
- On the other hand, accounting profits are defined as total revenues minus total expenses, and only reflect the company's explicit costs - the cash expenses it pays out.
Both explicit and implicit expenses are factored into economic profits.
As a result, while a corporation may exhibit a positive net accounting profit when its hidden expenses are incorporated into the profitability equation, it may be a losing economic enterprise, as demonstrated 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 automatically assume that implicit costs are a negative, profit-draining issue for a company.
Using existing resources, for example, a company may incur an implied cost of $10,000. However, by doing so, it may be able to avoid incurring an explicit cost of $15,000 for the usage of outside resources.
Calculating implicit costs
Let's take a look at an example to see how these costs are calculated.
Fred is currently employed with a law company that specializes in corporate law. He's thinking about starting his law firm, where he expects to make $200,000 a year once he's established.
He'd need an office and a law clerk to manage his practice. He's found the ideal office, which he can rent for $50,000 a year. For $35,000 per year, a law clerk may be recruited. Would Fred's legal practice be profitable if these data are correct?
Step 1: We'll start by calculating the costs. We'll use everything we've learned about explicit costs so far:
Explicit costs = Office rental − Law clerk's salary
Explicit costs =$50,000+$35,000
Explicit costs =$85,000
Step 2: Calculate the accounting profit by subtracting the explicit costs from the revenue.
Accounting profit = Revenues − Explicit costs
Accounting profit =$200,000−$85,000
Accounting profit =$115,000
However, only the explicit expenses are taken into account in these estimates. Fred would have to leave his current position, earning $125,000 a year, to start his practice. This would be an unspoken cost of starting his business.
Step 3: To calculate the genuine economic profit, subtract both the costs:
Economic profit = Total revenues − Explicit costs − Implicit costs
Economic profit =$200,000−$85,000−$125,000
Economic profit =−$10,000
Fred's annual loss would be $10,000. That isn't to say he wouldn't want to start his own business; it just means he'd make $10,000 less than if he worked for a corporation.
Other items can be included in it.
Perhaps Fred enjoys his free time, and starting his own business would require him to work more hours than he did at the corporate firm. The cost of missed leisure in this situation would be an implicit cost that would be deducted from economic profits.
Comparison chart of Implicit and Explicit cost
|Basis of comparison||Explicit cost||Implicit cost|
|Definition||Explicit costs are those that involve a cash outflow as a result of the usage of means of production||They are costs for which there is no financial spending|
|Also referred to as||Explicit cost is also referred as Out-of-pocket Costs||It is also referred as imputed Costs|
|Incidence||Incidence of explicit cost is actual||Incidence of it is Implied|
|Observation and Reporting|
It is observed and reported
|It is neither observed nor reported|
|Cost Calculation||Cost calculation is an objective matter||Cost calculation is a subjective matter|
|Which profit may be determined using cost as a factor?||Accounting and economic profits are determined using explicit costs||Economic profits are determined using it|
|Examples||Some examples are Salaries, rent, ads, wages, payroll, and so forth||Interest in the capital of the owner, Salary to the owner, rent on the owner's building, and other things that don't happen in real life are some examples of it|
Everything You Need To Master Excel Modeling
To Help You Thrive in the Most Prestigious Jobs on Wall Street.
Researched and authored by Deeksha Pachauri | LinkedIn
To continue learning and advancing your career, check out these additional helpful WSO resources:
or Want to Sign up with your social account?