If you run a business, you need to know how to measure your profits and costs. But not all costs are obvious or easy to calculate. In this article, you will learn about the difference between explicit and implicit costs, and how they affect your profits. You will also see some examples of how to apply these concepts to your own business decisions.
Explicit costs are the payments you make to others for the resources you use in your business. These include wages, rent, utilities, taxes, interest, raw materials, and any other out-of-pocket expenses. Explicit costs are easy to track and record, and they reduce your accounting profit, which is the difference between your total revenue and your total explicit costs.
These costs can be categorized as Direct and Indirect costs, directly impacting Gross Profit and Operating Profit, respectively. These costs hit the Income Statement.
Implicit costs are the opportunity costs of using your own resources in your business. These include the value of your time, your own capital, your own skills, and any other forgone alternatives. Implicit costs are not recorded in your books, but they affect your economic profit, which is the difference between your total revenue and your total explicit and implicit costs.
These can also be considered Profits or Opportunities lost, while pursuing regular business activities. A % description of these elements, is used as Discounting factor while calculating valuation of the business.
You might wonder why you should care about implicit costs if they are not reflected in your financial statements. The reason is that implicit costs represent the true cost of running your business, and they affect your decision making. If you ignore implicit costs, you might overestimate your profits and invest in projects that are not worth it. On the other hand, if you account for implicit costs, you might find new ways to increase your profits by using your resources more efficiently or finding better alternatives.
Calculating implicit costs can be tricky, because you need to estimate the value of your own resources and the next best use of them. One way to do this is to compare your current situation with a hypothetical scenario where you do not run your business. For example, if you own a building that you use for your business, you could ask yourself how much rent you could earn if you leased it to someone else. This would be your implicit cost of using your own building. Similarly, if you work in your business, you could ask yourself how much salary you could earn if you worked for someone else. This would be your implicit cost of using your own labor.
To illustrate how explicit and implicit costs affect your profits, let's look at some examples. Suppose you run a bakery that generates $100,000 in revenue per year. You pay $40,000 in explicit costs, such as wages, rent, ingredients, and so on. Your accounting profit is $60,000 ($100,000 - $40,000). But you also have implicit costs. You own the building where the bakery is located, and you could rent it for $20,000 per year. You also work in the bakery full-time, and you could earn $30,000 per year as a manager in another bakery. Your implicit costs are $50,000 ($20,000 + $30,000). Your economic profit is $10,000 ($100,000 - $40,000 - $50,000). This means that your bakery is only marginally profitable, and you might want to consider other options.
Now suppose you run a software company that generates $500,000 in revenue per year. You pay $200,000 in explicit costs, such as salaries, office space, software licenses, and so on. Your accounting profit is $300,000 ($500,000 - $200,000). But you also have implicit costs. You invested $1 million of your own money in the company, and you could earn 10% interest per year if you invested it elsewhere. You also work in the company as the CEO, and you could earn $150,000 per year as a consultant for other companies. Your implicit costs are $250,000 ($100,000 + $150,000). Your economic profit is $50,000 ($500,000 - $200,000 - $250,000). This means that your software company is moderately profitable, and you might want to keep running it or look for ways to improve it.
Knowing your explicit and implicit costs can help you optimize your profits by making better decisions about how to use your resources. To do this, compare your economic profit with your opportunity cost. If it is negative, aim to minimize your economic loss. Additionally, evaluate the trade-offs between explicit and implicit costs for each decision you make. For example, hiring more workers will increase explicit costs but reduce implicit costs of using your own time. Finally, look for new opportunities to increase revenue or reduce costs, such as finding new markets or products, new suppliers or partners, or new technologies that could boost your business performance. You could also find new uses for your own resources, such as renting out spare space or teaching skills.