Implicit Cost

Published Oct 25, 2023

Definition of Implicit Cost

Implicit cost refers to the opportunity cost of using a resource for one purpose instead of its next best alternative. It is often associated with using resources that the firm already owns, such as the owner’s time or a building that the firm owns. Implicit costs are not recorded as explicit expenses in a business’s accounting records, but they still have an impact on the firm’s profitability.

Example

Consider a small bakery owned by Sarah. Sarah works full-time in her bakery, but she could have chosen to work for someone else and earn a salary. By deciding to run her own business, Sarah incurs an implicit cost equal to the salary she could have earned elsewhere. This is because Sarah’s time and skills have an opportunity cost associated with them. While she may still enjoy running the bakery, it is important to consider the income she could have earned as an alternative.

Additionally, if Sarah owns the building that houses her bakery, there is an implicit cost associated with using that building. If she were to rent out the space to another business, she could earn rental income. By using the building for her bakery instead, Sarah incurs an implicit cost equal to the potential rental income she could have received.

Why Implicit Costs Matter

Implicit costs are important to consider because they reflect the true cost of utilizing resources. While explicit costs, such as rent or wages paid to employees, are readily visible in a company’s financial records, implicit costs are often overlooked. However, they still affect a firm’s profitability and decision-making. By accounting for implicit costs, business owners and managers can make more informed decisions about resource allocation and assess the true profitability of their operations.