Accounting Profit Vs. Economic Profit
The major application of the difference between implicit cost vs. explicit cost lies in the determination of economic profit as opposed to accounting profit.
Bookkeeping or accounting considers only the explicit or direct costs when determining the profit and loss of a business, and this forms the basis for tax calculations. The economic costs of production, however, includes both explicit and implicit costs. While the company might show profit in accounting books, economic profit occurs only when the company’s revenue exceeds both explicit and implicit costs.
For instance, a business with gross sales of $1,000,000 annually with 20 percent or $200,000 in profits, and $150,000 in overhead expenses including rent and salaries might apparently seem to make a profit of $50,000. This simple calculation does not consider implicit costs. For instance, the entrepreneur might devote time for the business and thereby forego a salary of $ 70,000 annually. Similarly, the business might have a start up capital of $100,000, which if invested in a fixed deposit yield at a 10 percent interest rate would result in $10,000. The depreciation of capital assets for a year may be another $10,000. The total implicit costs thus come to $70,000 + $10,000 + $10,000 = $90000. Subtracting this implicit cost of $90,000 from the accounting profit of $50,000 means that the company actually makes a loss of $40,000 for the year in this example.
Some entrepreneurs trade-off the opportunity cost of a lost salary for implicit revenue such as psychic income that refers to non-monetary satisfaction gained from operating the business instead of working as an employee.
Considering the implicit costs helps to make effective business decisions. For instance, a company occupying an expensive piece of real estate worth $10,000 a month in rent, but bought for a mere $50 a hundred years ago, needs to make profits above $10,000 a month to cover the implicit costs and justify operating from the plot. Failure to realize $10,000 in profits means that the company should ideally relocate to a lesser expensive premises or shut up shop and rent instead. In this case, the direct cost of $50 for the plot becomes a big distorter.
Explicit costs are easy to find and account. Implicit costs remain hidden, are hard to find, and very often remain overlooked. Companies that do so, and factor implicit costs into their decisions, generally retain the resources they have and attract additional resources such as land, labor, and capital. Companies who ignore implicit costs and consider only direct costs find that despite their accounting books showing a profit, they tend to lose resources and face constraints.