What it means
Accounting records transactions, so it captures explicit costs: wages paid, rent invoiced, materials bought. Implicit costs are the opportunities forgone by using resources you already control, such as your own time, your own premises or your own capital.
The reason to bother with them is that they change the answer to the question of whether an activity is worthwhile. A shop that reports $60,000 of accounting profit is doing badly if the owner could earn $85,000 doing the same work for someone else and has $300,000 of her own money tied up in stock.
The usual components are three. Forgone wages for owner time, forgone rent on property the business occupies rent-free, and forgone interest or investment return on capital the owners have put in.
Subtracting implicit costs from accounting profit gives economic profit. A positive economic profit means the resources are earning more here than in their next best use, and a negative one means they are not, even if the bank balance is growing.
The nuance is that implicit costs are estimates, not facts, because they depend on what the next best alternative really is. Being explicit about that alternative, and reviewing it as circumstances change, is what makes the number useful rather than an academic exercise.
In practice
Real-world examples.
Example
A couple run a guesthouse from a property they inherited. The accounts show $70,000 of profit, but the building would let commercially for $42,000 a year, so the implicit rent means the venture earns far less than it appears to.
Example
A software engineer leaves a $140,000 job to build a product full time. In year one the product earns $30,000, so the implicit cost of forgone salary makes the economic result heavily negative even though the venture is technically profitable.
Example
A manufacturer stores finished goods in a warehouse it owns rather than letting the space to a neighbouring firm for $60,000 a year. That forgone rent is an implicit cost of holding inventory, and including it changes the case for reducing stock levels.
Formula
Calculation
Economic profit = Revenue - Explicit costs - Implicit costs
A designer runs a studio from a flat she owns. In a year the studio bills $400,000 and pays out $250,000 in explicit costs: subcontractors, software, insurance and travel. Accounting profit is $400,000 - $250,000 = $150,000.
Now the implicit costs. She turned down an in-house role paying $95,000, so that is forgone salary. The room she uses as a studio would let for $1,500 a month, which is 12 x $1,500 = $18,000 of forgone rent. She has $200,000 of her own savings in the business, which would otherwise earn 5%, giving 0.05 x $200,000 = $10,000 of forgone interest.
Total implicit costs are $95,000 + $18,000 + $10,000 = $123,000.
Economic profit is $150,000 - $123,000 = $27,000. The studio is worth running, but the true margin over the alternative is $27,000, not the $150,000 the accounts report.Case study
Seen in the real world.
This example is illustrative and fictional. Pellworth Ceramics was founded by two potters who paid themselves nothing for three years and worked from a barn one of them owned. The accounts showed profits rising from $18,000 to $64,000, and the pair concluded the business was doing well.
An adviser rebuilt the numbers on an economic basis. Forgone salaries for two experienced makers came to $110,000 a year, the barn would let for $16,000, and the $90,000 of personal savings in the business would have earned about $4,500 elsewhere, giving implicit costs of $130,500 against accounting profit of $64,000 and an economic loss of $66,500.
The founders did not close the business, but they changed what they did next. They raised prices on the two lines with the longest making time, dropped a wholesale contract that consumed most of one potter's week, and started paying themselves a salary so that future accounts would show the true cost of their labour.
Watch out
Common mistakes.
- Leaving owner time out of the numbers, which flatters small business profits and hides the fact that the owner is working below market rate.
- Treating implicit costs as accounting entries; they are analytical figures used in decisions and never appear in statutory accounts.
- Counting the same sacrifice twice, for example including a forgone salary as an implicit cost while also paying and expensing that salary.
Questions
People also ask.
What is the difference between explicit and implicit costs?
Explicit costs involve an actual payment recorded in the books, while implicit costs are the value of owned resources used up with no payment made.
Is opportunity cost the same as implicit cost?
They are closely linked; opportunity cost is the general idea of what you gave up, and implicit cost is that idea applied to resources the business already owns.
Why does economic profit matter if lenders only look at accounting profit?
Because economic profit tells the owners whether their time and capital are earning more here than anywhere else, which is the decision only they can make.
From the founder's library
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