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 cost.
Explanation of Implicit Cost
The implicit costs are expenses that arise when the business utilizes internal resources towards handling the project. There is no explicit declaration or compensation on the resource utilization. The implicit costs come into the picture when it has committed its resources for one project and cannot use those resources for the other projects. It has basically beared 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 dwindles between the choices of buying an asset or renting an asset.
Implicit costs are also classified as the implied costs, notional costs or imputed costs. Such costs are never quantified or are hard to quantify. The implicit costs are never recorded with the perspective of accounting as there is no exchange of cash or cash inflow/outflow for such costs. Such costs do not deteriorate profit levels, but they do signify a loss of any potential income that could have been earned. The business, therefore, keeps such costs in purview while doing business as they do help business understand how they could derive any additional income. Such costs are never classified as real expenses rather classified as notional expenses.
How to Calculate Implicit Cost?
In order 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 current 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 would incur expenses in terms of time and resources that it had invested in the training of the employee to get them trained for the tasks. However, if the employee leaves mid-way then, such costs would result as a potential loss which can’t be reported out 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 that is levied on the tangible asset. Since there are different depreciation matrix 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 purpose.
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. The business if goes with the capital project would tend to earn $10,000 on an annual basis. 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 = Rate of Earning X Lumpsum Investment
- Earnings on Asset = 0.08 x $40,000
- Earnings on Asset = $3,200
Therefore, to earn maximum, the business should invest in the capital project as the business gets the opportunity to earn $10,000, but it has foregone the opportunity to earn from the financial asset and hence the implicit costs would amount to $3,200.
Nature of Implicit Cost
Since there is no mathematical relationship and neither there is any prudent way to establish a mathematical relationship for such costs, the nature of such costs is of intangible nature. Such costs would never appear on the income statement, but everyone knows that such costs exist in the form of opportunity costs.
Importance of Implicit Cost
The implicit costs play a critical role in terms of determining the economic profit earned by the business. The economic profit is determined as the difference in total revenue earned by the business with the sum of explicit costs and the implicit costs. The explicit costs are reported on the income statement of the business. The business, however, has to determine the implicit costs by utilizing scenario and comparative analysis of choices available with them. Therefore, the economists keenly observe the implicit costs pertaining with the business, and they 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 to the economists who are analysing the economy of the nation.
The benefit of determining the implicit costs is that it enables the business to determine the best choice in terms of making a decision towards pursuing a project among the choices of the projects available to them. 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.
The implicit costs can be signified as the costs that the business has to bear or it has already incurred, but it cannot report on the income statement. Such costs are of the notional, imputed or implied type in nature.
This is a guide to Implicit Cost. Here we also discuss the definition and how to calculate implicit cost? Along with example and benefit. You may also have a look at the following articles to learn more –