Implicit Costs
What is Implicit Costs?
Implicit Costs are non-monetary opportunity costs of using the firm’s own resources.
These include the foregone salary of the owner working in the business or the rent that could have been earned by leasing owned property. Implicit costs are included in economic profit but not in accounting profit.
Implicit Costs: a worked example
Devon quits a job paying $55,000 to open a bicycle repair shop. He puts $80,000 of savings into the business, money that had been earning 5% interest, and he works out of a garage he owns that could rent for $700 a month. The implicit costs are the forgone salary of $55,000, forgone interest of 0.05 × $80,000 = $4,000, and forgone rent of 12 × $700 = $8,400. Those three sacrifices total $67,400, and not one of them generates a receipt. The shop takes in $190,000 and pays $115,000 in explicit costs, so the accountant reports $75,000. Economic profit is $75,000 minus $67,400, or $7,600. Devon is better off repairing bicycles, though by far less than his tax return suggests.
The mistake students make with implicit costs
Nearly every student remembers the forgone salary and stops right there, missing the interest given up on money tied into the firm and the rent given up on property the owner already holds. Owned resources feel free because no check gets written for them. The reliable test is to take each resource the firm uses without paying an outsider and ask what its best alternative use would have paid. Skipping the owned building or the invested savings inflates economic profit and can turn a genuine loss into an apparent gain.
Implicit Costs questions
Why do accountants ignore implicit costs?
Accounting rules require a transaction with documentation behind it, and no money changes hands when an owner works unpaid or uses a building already owned. Nothing exists to record. Economists count those forgone opportunities anyway, because the resource could have earned income elsewhere, and leaving that alternative out of the calculation makes a barely viable firm look successful.
Are implicit costs real costs?
Implicit costs are real in the only sense that matters for decisions, even though no cash moves. An owner giving up a $60,000 salary loses $60,000 of income just as surely as if the firm had paid a $60,000 wage bill. Economics measures cost as the value of the next-best alternative surrendered, so implicit costs belong in any comparison between staying open and doing something else.
How do implicit costs change economic profit?
Implicit costs come off after explicit costs, since economic profit equals revenue minus explicit costs minus implicit costs. A firm posting $60,000 of accounting profit while carrying $70,000 of implicit costs has an economic profit of negative $10,000, meaning the owner would do better taking the next-best option. Economic profit can therefore never exceed accounting profit.
Related terms
Common comparisons
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