Updated July 14, 2023
What is Implicit Cost?
The implicit costs are defined as the business’s cost, and the business has not reported or showcased the cost as an expense in the income statement. The implicit costs are primarily regarded as opportunity costs.
Explanation of Implicit Cost
The implicit costs arise when the business utilizes internal resources to handle the project. There is no explicit declaration or compensation for resource utilization. The implicit costs come into the picture when it has committed its resources to one project and cannot use them for the other. It has borne the costs of foregoing the utilization of resources with respect to the available alternatives. Generally, there is no exchange of cash in implicit costs, and implicit costs generally align with the effective usage of the asset and dwindle between the choices of buying or renting an asset.
Implicit costs are also classified as implied, notional, or imputed costs. Such costs are never quantified or are hard to quantify. The implicit costs are never recorded from the accounting perspective, as there is no cash or cash inflow/outflow exchange for such costs. Such costs do not deteriorate profit levels but signify a loss of any potential income that could have been earned. Therefore, the business keeps such costs in purview while doing business as they help businesses understand how they could derive any additional income. Such costs are never classified as real expenses but as notional expenses.
How to Calculate Implicit Cost?
To calculate implicit costs, the business should undertake at least two scenarios. If undertaking one scenario results in more profit and appreciation in earnings than the currently used scenario, the business is losing out on an opportunity to earn economic profits. Therefore, to determine the implicit costs, the business has to perform scenario analysis or comprehensive comparative analysis to ascertain the overall impact of not going among the available scenarios based on the one specific chosen scenario. There is no such fixed mathematical relationship or formula for the computation of the implicit costs as such costs are of intangible nature.
Example of Implicit Cost
There are several examples of the implicit costs. Suppose an organization has hired a new employee. The business incurs expenses regarding time and resources invested in employee training to prepare them for the tasks. However, if the employee leaves mid-way, such costs would result in a potential loss that can’t be reported on the income statement as there had been no financial transaction undertaken by the business with the employee for such cases. Another example would be the depreciation expense levied on the tangible asset. Since there are different depreciation matrices in place, the business always has to decide the best method and matrix to arrive at the depreciation expense that would then be used for financial reporting and taxation purposes.
Let us take a typical scenario wherein a business has to invest a lumpsum in a capital project or a financial asset. The lumpsum amounts to $40,000. If it goes with the capital project, the business would earn $10,000 annually. If the business goes towards a financial asset, it would annually earn 8 percent on an annual basis. Help the business determine the best investment option and the inherent, implicit costs.
Compute the earnings that the business would earn on the financial asset on an annual basis as displayed below: –
- Earnings on Asset = 0.08 x $40,000
- Earnings on Asset = $3,200
Therefore, to earn the maximum, the business should invest in the capital project as the business gets the opportunity to earn $10,000. Still, it has foregone the opportunity to earn from the financial asset. Hence, the implicit costs would amount to $3,200.
Nature of Implicit Cost
Since there is no mathematical relationship and neither is there any prudent way to establish a mathematical relationship for such costs, the nature of such costs is intangible. Such costs would never appear on the income statement, but everyone knows that such costs exist as opportunity costs.
Importance of Implicit Cost
Implicit costs are critical in determining the economic profit the business earns. The business determines economic profit by subtracting explicit and implicit costs from earned revenue. The explicit costs are reported on the income statement of the business. The business, however, has to determine the implicit costs by utilizing scenarios and comparative analysis of choices available to them. Therefore, economists keenly observe the implicit costs pertaining to the business and generally form them as a part of their economic analysis. It could be inferred that the implicit costs are the costs that are of prime importance to both the operational business and the economists who are analyzing the nation’s economy.
Benefits
The benefit of determining the implicit costs is that it enables the business to determine the best choice in pursuing a project among the available choices. It ensures that the business earns maximum profit by undertaking minimum implicit costs. When making business decisions, the business has to bear implicit costs as such costs signify the opportunity of undertaking an alternative available among the better or inferior choices. Such costs can be signified as the business’s costs for not taking up an alternative or for not going with the project.
Conclusion
The implicit costs can be signified as the costs that the business has to bear or has already incurred but cannot report on the income statement. Such costs are of the notional, imputed, or implied type in nature.
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