Difference Between Implicit And Explicit Costs

Explicit and implicit costs are two simple economic concepts that shed light on the expense of decision-making in any business organisation. True to its name, explicit costs are measurable and visible, also known as out-of-pocket costs. Implicit costs are difficult to measure due to their non-physical nature. To correctly access business profits and make better decisions, you must understand the difference between implicit and explicit costs.

Definition and Purpose

Explicit Costs

If you had to define explicit costs, you can state them as immediate cash expenses from the business. This cost takes place during a company’s usual course of business in the form of rent, salary, electricity, etc. The expense is made to outsiders when production is in process, making it easy to record as and when a transaction takes place. You record explicit costs because it helps you correctly calculate profits, in activities of decision-making and cost control.

Implicit Costs

Implicit costs, being non-monetary costs, are not sustained but exist in a business’s natural course of action. Also known as the economic cost, it is easy to overlook implicit costs because they do not involve any cash flow from the business. It is an opportunity cost that comes from using an asset during production that has already occurred. The purpose of implicit costs, like the interest on a business owner’s capital, salaries, etc., is to assess business profitability and improve decision-making concerning the resources used.

Key Differences Between Implicit and Explicit Costs

Here are some of the most significant differences between explicit and implicit costs -

	Implicit Costs	Explicit Costs
Nature	Implicit costs are estimated because they occur indirectly.	Due to its physical nature, explicit costs are easy to calculate.
Impact on Business	Implicit costs are opportunity costs. As a business owner, investing your capital, time, and resources is calculated as an implicit cost.	You incur explicit costs when you pay for services in the course of business.
Calculation	Implicit costs help you determine only economic profit.	Calculating explicit costs helps you determine account and economic profit.
Financial Standing	Implicit costs are difficult to determine due to their lack of physical exchange.	Explicit costs have a paper trail where each transaction is recorded in your company’s financial statements.
Taxation	Implicit costs offer no tax benefits because they are measured individually.	Explicit costs can be claimed as business expenses to reduce your tax liability.

Amortisation in Detail

A popular accounting technique, amortisation is used to reduce the value of an intangible asset or loan over a period of time. This act of periodically spreading the asset’s cost over its useful life is particularly helpful when determining implicit costs in business. Since these intangible expenses do not change hands, these are implied costs that are done only for accounting purposes in a business.

For instance, you can amortise the cost of a patent bought over the course of its useful life of 10 years. Marking a 10% expense each year, you decrease the patent's value gradually over time.

Depreciation in Detail

Depreciation is calculated for tangible assets and falls under the purview of explicit costs. In the course of business, when you expense a fixed asset like buildings or furniture over its useful life it is known as depreciation. These assets retain a part of their value even when you no longer require them. This resale value is deducted from its original cost and evenly distributed over the expected life of the asset.

For instance, you purchase a new machine for your printing business and use it for 10 years. After 10 years you decide to buy a bigger and better machine. The old machine is a rundown but still holds value. When you deduct its resale value from the original cost and spread it evenly over its estimated life, expensing a portion of depreciation in each accounting year, it is called depreciation.

How Do Explicit and Implicit Cost Influence Decision Making?

As a business owner, estimating both costs will help you create a better business strategy in the short and long run. Here’s how:

• The difference between implicit and explicit costs is their nature. Since explicit costs involve immediate cash flow, exact calculations will help you make better short-term decisions and understand your company’s financial health.
• On the other hand, implicit costs will help you analyse long-term strategies better. Estimating opportunity cost helps in resource allocation that improves business decisions in the future.
• Together, the costs influence business profits for both accounting and economics. With a clear analysis of your profits, you are in a better position to make business decisions.

Examples of Explicit and Implicit Costs

Let’s take some real-world examples of explicit and implicit costs to help you understand their relevance and impact on your business:

• Implicit Costs

As a business owner, if you are involved in the company’s operations, your time that could have earned you an income elsewhere is an implicit cost.

• Explicit Costs

Monthly salaries paid to your employees, or rent paid for a leased office space is a physical expense that implies direct cash flow, and thus an explicit cost.

Tips for Efficient Management

Use these cost management tips to grow profits and ensure ideal resource allocation within your business:

• Keep a separate track of your implicit costs despite their non-physical nature.
• Understand how each cost will help your decision-making process in the long and short run. Use explicit costs to make better short-term finance-related decisions, while implicit costs help decide long-term business strategies.
• Review your costs regularly to assess the highest business efficiency and cut down expenses.
• Both explicit and implicit costs help understand the economic profit of a business. Always consider both for a more accurate estimate of your earnings.
• Get help from financial consultants to manage costs adjusted to your business needs and goals.

Conclusion

In the world of economics, understanding the difference between implicit and explicit costs is important to not just make calculated business decisions, but also shape a successful growth path in the long run. So, whether you are an experienced business owner or a learner starting fresh, use this article as a landscape to tailor a strategy that is best suited for your business goals. For everything else, you have Royal Sundaram Business Insurance that will protect your employees and your business from a wide range of risks always.