What is an Implicit Cost?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

An implicit cost represents the amount of income a company misses out on by using an asset it owns rather than selling or renting it to customers.

🤔 Understanding implicit cost

Implicit costs arise when a company decides to use the resources it owns internally rather than use them externally to try to generate income. Implicit costs are also referred to as imputed, implied, or notional costs. These costs are not usually reported by companies as a distinct expense. That’s because they’re an opportunity cost, which represents the benefit a company misses out on by choosing to do one thing instead of another. An implicit cost is essentially the opposite of an explicit cost, which is a tangible payment for something like utilities or employee wages that a company needs to make to cover its expenses.

Example

Let’s say you run a company that prints t-shirts, and the company owns a small warehouse. Your company could choose to rent the warehouse space out to somebody else for $5,000 per month. But instead you choose to use the entire warehouse for your own business to print t-shirts and store inventory.

By using your asset (the warehouse) rather than renting it out to another business, you’re choosing to forgo $5,000 per month in rental income. That lost income is the implicit cost of using your assets internally.

Takeaway

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.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.
Sign up for Robinhood
Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

Tell me more…

What is an implicit cost?

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.

What are some examples of implicit costs?

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.

What is the difference between implicit costs and explicit costs?

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.

How do you calculate implicit cost?

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.

Why do economists include implicit costs in their calculation of profits?

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.

Is economic depreciation an implicit cost?

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.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

1235362

Related Articles

You May Also Like

The 3-minute newsletter with fresh takes on the financial news you need to start your day.
The 3-minute newsletter with fresh takes on the financial news you need to start your day.


© 2021 Robinhood. All rights reserved.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC provides brokerage services. Robinhood Securities, LLC, provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. Robinhood U.K. Ltd (RHUK) provides brokerage services in the United Kingdom. All are subsidiaries of Robinhood Markets, Inc. ('Robinhood').

1476799