What is an Implicit Cost?

An implicit cost is like living alone in your two-bedroom apartment rather than renting the extra room to a friend…

Suppose you could generate $1,000 per month by letting your buddy crash in your spare room on the ground floor — but maybe you’d rather use it as your home office. By choosing to use the room for yourself rather than hire it out, you’re sacrificing $1,000 in rent. That means the implicit cost of using your second bedroom as a home office is $1,000 per month.

An implicit cost is the amount of money a company misses out on when it decides to use resources internally rather than trying to make money off of selling or renting out those resources.

Implicit costs are a type of opportunity cost, which is the value a company misses out on when making one choice over another. An opportunity cost doesn’t always have a monetary value.

For example, maybe you’ve only got enough money for either a slice of cake or a cup of coffee. If you choose the coffee, you’ll get a nice, warm caffeine boost. But the opportunity cost of that decision will be missing out on cake.

Implicit costs work the same way. For example, if your company hires somebody new, you might ask an existing colleague to devote a week’s worth of time to train the new hire. Because the existing staff member is busy bringing a new colleague up to speed rather than doing his or her normal work, the implicit cost of training that employee would be one week’s worth of the existing worker’s salary.

Implicit costs aren’t normally reported by companies as a direct expense, because they’re generated by using something a company already owns.

Although implicit costs rarely appear as direct expenses, they’re often included when a company measures overall economic profit.

Economic profit is when you take a company’s revenue and subtract all explicit and implicit costs to figure out how much money you’ve made. Economic profit differs from accounting profit, which only subtracts explicit costs from a company’s revenue.

Implicit costs cover a wide range of company assets, resources, and activities.

One example might be company salaries. Start-ups often have low budgets. When money's tight, a small business owner might decide to forgo a formal salary until the business gets up and running. In this case, the time and skills a business owner puts into his or her company without drawing a salary becomes an implicit cost, as he or she could have worked for another business in return for a paycheck.

Although an implicit cost is typically assigned a monetary value, it can be something less quantifiable.

For example, a choice many start-up owners face could be deciding whether to use space inside of their home to run a small business.

Let’s say you decide to empty your garage and use it as a retail store with all your inventory — which means you’ve now got to stick about a dozen boxes of holiday decorations and a bike in your living room, instead.

The implicit cost of using your garage to run your business is going to be less living space inside your house. Although your decision does have a “cost,” that cost isn’t necessarily pegged to a dollar amount.

An implicit cost represents the amount of income or benefit a company is going to miss out on by choosing to use assets rather than trying to rent or sell them. Explicit costs, on the other hand, are out-of-pocket expenses where a company makes payments in exchange for something.

Explicit costs can include expenses such as wages, Internet or electricity bills, rental or mortgage payments, promotional materials, and more. Simply put, just about any tangible expense a company pays to stay operational or make a profit will fall under the category of explicit costs — A tangible expense is any cost where money has changed hands or will change hands.

Because explicit costs represent a real expense in which payment is due, they’re commonly used in business accounting.

To work out a company’s accounting profit, simply take all of your business revenue and then subtract all explicit costs as well as depreciation of assets. The sum you’re left with is how much profit you’ve generated in accounting terms.

Explicit costs can be used alongside implicit costs to work out economic profit. Economic profit is calculated by subtracting both explicit and implicit costs from a company’s total revenue.

Unfortunately, there’s no magical formula to calculate implicit costs. Because there are so many types of costs, some are easier to work out than others. Some implicit costs might not have a quantifiable monetary value.

But let’s focus on how to calculate the implicit costs pegged to a dollar amount. Whenever your company has a resource it could use rather than sell or rent to somebody else, the amount of money you could be making is your implied cost.

For example, let’s say you’ve got two acres of land you could rent to somebody else for $1,000 per month. If you decide to use the land for your company instead of renting it out, the implied cost of using that land yourself is $1,000 per month — the amount you would be making if you chose to rent it.

To figure out the implicit costs of running a company, you’ve got to review all elements of your business on a case-for-case business. Identify all the resources you could be using to generate income but are choosing not to because you’d rather use them internally.

The dollar amount you’ve decided to forgo will be your company’s total implicit cost.

Economists often include implicit costs in calculations to get a more complete picture of a company’s performance — one that goes beyond simple accounting to look at whether a company’s resources are being used efficiently.

When you work out a company’s accounting profit, you simply take all the revenue it’s generated and subtract explicit costs.

But what if the thing you really want to know is whether a company’s overall operations represent an efficient use of resources. You might want to work out the company’s economic profit, which subtracts both implicit and explicit costs from total revenue.

Let’s say a company generates $100,000 a year in accounting profit. But suppose its implicit costs are so great that, in economic terms, it actually represents -$200,000 in economic profit — that is, it’s actually running at a loss in economic terms. That company would want to seriously rethink its operations.

No. Economic depreciation is treated as an explicit cost in accounting.

Depreciation of goods describes the amount of value an asset loses over time, and accountants will typically factor that drop in value as an explicit cost over several years to work out accounting profit.

Let’s say your firm pays $1,000 for a machine, and it decreases in value by $100 per year.

Rather than report $1,000 in explicit costs over one year and call it a day, you may choose to report an explicit cost of $100 per year for 10 years.

This reporting of depreciation factors in the asset’s value over time – accounting for it as an explicit cost over time.