Implicit Costs. What Are They And How Do They Affect Your Business?

Running a small business or operating a budget for a project can mean encountering a variety of cost structures: fixed costs, variable costs, opportunity costs, incremental costs, economic costs, etc. Two types you are also sure to encounter are explicit costs and implicit costs.

What is an implicit cost?

An implicit cost is a non-monetary opportunity cost that is the result of a business utilizing an asset or resource that it already owns. Rather than incurring a direct, monetary expense, an implicit cost is non-monetary, because there is no actual payment made by the business to purchase an existing resource. The cost is implied.

An implicit cost is, by its nature, an opportunity cost (or potential forgone profit from a missed opportunity) that occurs when a business uses internal resources without regaining direct compensation for using this resource. In other words, when a company allocates its own resources to a project, it forgoes the opportunity to earn money with those resources at the moment. No cash is exchanged.

Understanding implicit costs

Let’s look at two standard examples of implicit cost in action.

• If a factory shuts down production for maintenance and uses the in-house staff to run the maintenance, both the value of the worker’s time and the lost revenue from the downtime are implicit costs.

• If a small business owner doesn’t take a salary during the start-up phase, the value of his time invested - let’s say calculated from his previous employment - is an implicit cost.

Also, implicit costs refer to the loss of income but not the loss of profit. That’s a key difference.

As a type of opportunity cost, i.e. a value that is lost by choosing one option instead of another, the company is choosing to sacrifice income for the moment. That may or may not factor into the final calculations of profit down the road.

An implicit cost could also be the income a company misses out on for choosing to use its assets instead of getting paid by a third party to use those assets. For example, a company owns a building. If they could earn more income from renting out the building versus the revenue generated by using the building for manufacturing its products, that foregone income is an implicit cost.

Some other terms that are used to describe implicit costs are notional costs, implied costs, or imputed costs. These costs are difficult to quantify. Quite often, businesses don’t even record implicit costs for accounting purposes. Because no cash transaction occurs, implicit costs often aren’t put on the books.

Implicit Costs vs. Explicit Costs

Explicit costs are what you might immediately think of when you hear the word cost. An asset, good, or service is bought or paid for and cash is exchanged. In business terms, explicit costs are ordinary monetary expenses that a business makes to create the product or service that it sells. Things like raw materials, machinery, rent, transportation, and employee wages are all explicit costs. These operating expenses are all paid for with a company's tangible assets and are all recorded in a company's financial statements.

Implicit costs, on the other hand, are implied opportunity costs. No assets are spent. Instead, they are calculated by the revenue lost by using a resource it already owns. As such, implicit costs are technically not incurred and cannot be precisely calculated for accounting purposes. 

Even though there are no cash exchanges in implicit costs, they are still an important consideration because they help managers make effective decisions for the company.

Why are implicit costs important?

A business might, or might not, include implicit costs in its overall margin calculation as part of the cost of doing business. Implicit costs do represent possible sources of income that are set aside. Economists, however, always include both implicit costs and explicit costs to calculate a business’s overall financial health, also known as total economic profit. What’s known as accounting profit calculates total revenues minus total expenses, meaning actual cash expenses, or explicit costs, are included.

Economic profit is the revenue a company generates minus all the costs of doing business, both explicit and any opportunity costs. This is important, because, even though a company may show a positive net accounting profit, it may actually be a losing enterprise once the implicit costs are figured into overall profit.

Accounting profit = $100k (revenue) – $80k (explicit costs) = $20 (net profit)
Economic profit = $100k – $80k – $30k (implicit costs) =  - $10,000 (net loss)

But don’t assume that implicit costs always mean are always a negative, overall profit-killing factor for business. For example, a company might see an implicit cost by utilizing its own existing resources but doing so allows them to avoid greater explicit costs for outside resources. In most cases, they are simply a factor to be considered in calculating risks and margins in business strategies.

What are some examples of implicit costs?

Now let’s look at some other examples of implicit costs.

• Lost interest from spent capital. Machinery, technology, real estate, and equipment all depreciate over time. Where capital is diverted away from investment and used to upgrade assets, the loss of interest income on funds is an implicit cost.

• Downtime from productivity. Maintenance in manufacturing facilities, software upgrades in offices, personnel transfers, and equipment exchanges are all standard parts of business operations. 

• Whenever they interrupt revenue-driving operations, the lost revenue that would have been generated in this time and the wages paid to the now unproductive employees are implicit costs.

• Training a new hire. When a company hires a new employee, there are implicit costs involved in training the new hire. If a manager, for example, assigns a veteran employee to teach this new team member, the value of that veteran employee’s time away from their regular task is now an implicit cost. 

• Going to college. There are, of course, explicit costs like tuition, housing, etc. But there are also implicit costs. That student could instead join the workforce. Even with minimum wage, that would be making a net profit. That lost income is the implicit cost. So the total economic cost of choosing to go to school is the explicit cost of tuition and expenses plus the implicit cost of not working.

The bottom line

Implicit costs represent the implied costs of making a choice. When a business chooses to utilize an existing asset versus exploiting that asset for immediate revenue, there are implicit costs that come about. Those potential implicit costs, however, are simply information that goes into the broader equations of doing business. A company wouldn’t avoid tech upgrades or maintenance just because of implicit costs, but they would factor them into when and how extensive of an upgrade they can afford. In the same way, they wouldn’t not train a new hire, but they might calculate which veteran employee they could best spare for how long when creating their onboarding process. It’s all just part of the equation.

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