Implicit cost is the returns from the best alternative investment for the resource committed to a project. Failure to consider implicit costs can cause severe distortions in financial analysis, be it for companies or for individuals. Read on for examples of implicit cost.
Implicit Costs Definition
What is implicit cost?
Implicit costs, or notional cost, is opportunity cost, or the cost of opportunities lost, when utilizing the finite resources available at one’s disposal for a particular purpose. Such costs are notional, and do not entail any actual cash outflow.
Opportunity Cost of Assets
Implicit costs result when a person or business uses an available asset rather than rent or sell such assets. One example of implicit cost is a business firm owning a building and using the same for its operations. The implicit cost is the rent the building would attract if leased out to another firm. The viability of using the building for the firms business depends on the net returns generated from the operations from the building less the implicit costs of renting out the same building. If the result is negative, the business operations from the building is unviable even if it generates positive cash flows and the accounts show a profit, or indicate that the asset is underutilized.
To illustrate, assume the net profit of the business is $10000 per month and the possible rent that the building can earn is $7000, the actual or economic profits from operations is $10000 - $7000 (notional rent that the firm would get even if it does not carry out any operations) = $3000. If the rent that the building can earn is $12000 and the profits out of business operations are $10000, actual loss is $10000- $12000 = $ -2000, meaning that the asset is underutilized and that carrying out the business from the premises does not make business sense.
In a similar way, assuming $100000 invested in a business fetches a return of $5000 annually, and the bank interest is 10 percent, the business even when making profit is unviable. This is because the implicit cost of $10000 (10 percent interest for $100000) is more than the returns from the investment.
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Among the best examples of implicit cost is the value of entrepreneur’s labor. The entrepreneur of any small business commits time and effort to run the business, but rarely pays himself or herself, considering the profits of the business as the fruits of his or her toil. The implicit cost of the entrepreneur is the salary that the entrepreneur could have drawn when working elsewhere. The net profits of the business is the profit less the notional salary for the entrepreneur.
If for instance, the business makes an annual profit of $50,000 (without considering notional entrepreneur's salary) but the entrepreneur could have got $60000 salary by taking up employment elsewhere, the business is actually running at a loss, and the entrepreneur is underachieving, or selling himself or herself short.
Use of Personal Assets or Privileges
Examples of implicit costs extend to the personal sphere as well, and include instances such as the cost of commuting to work having an implicit cost of wear and tear of personal vehicle.
In another example, a person going on a vacation might calculate the cost of his or her vacation as the cost of the travel expenses, hotel accommodation, dining out, and sightseeing costs. If the individual did not take the vacation, he or she could have cashed the earned leave from the company, and as such, the implicit cost of the vacation is the value of leave when sold to the company. The true cost of the vacation is therefore the actual expenses incurred plus the notional leave cashing. Thus if the cost of the vacation was $5000, and the leave sale value foregone was $1000, the true cost of the vacation is $5000+$1000 = $6000.
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How People Approach Implicit Costs
Implicit cost acts as a major distorter of the balance sheet or financial calculations, and very often failure to consider implicit costs mean that the business actually runs in an economic loss even when cash flows remains positive and the balance sheet shows a profit.
People very often however willingly forego the implicit cost owing to some special considerations or self-interest. For instance, entrepreneurs may not consider the implicit cost of their own salary as a trade-off for the satisfaction of operating the business instead of working as an employee. Similarly, a firm might stay in their own premises instead of renting it out to maintain the prestige of operating from a prime location, and an individual might willingly forego the leave encashment for the pleasure of the vacation.
- Byrns, Ralph. “Profit." http://www.unc.edu/depts/econ/byrns_web/Economicae/Essays/Profit.htm Retrieved 05 November 2010
- East Tennessee State University. "Explicit and Implicit Cost" http://faculty.etsu.edu/hipples/EXIMCOST.htm. Retrieved 5 November 2010
- Lipsey, Richard G. (1975). "An Introduction to Positive Economics." (fourth ed.). Weidenfeld & Nicolson