Explicit vs. Implicit Costs: How to Measure Your True Profit

Explicit costs are recorded on your financial statements, but starting a business involves implicit costs that can change the equation on true profitability.

When you look at a business’s finances, it’s easy to focus only on the obvious expenses. But many critical costs aren’t always visible in the traditional accounting books. That’s why understanding explicit costs and implicit costs is so important. Grasping both can help you see your business’s true profitability and make smarter economic choices.

What Are Implicit Costs?

Implicit costs, also known as opportunity costs, represent the value of the best alternative that was passed on when a particular decision was made. Unlike explicit costs, they don’t involve a direct cash outlay and are often not recorded in standard accounting records. However, they are very real economic costs because they reflect the sacrifice of potential income or benefit.

Implicit Costs Represent:

1. The owner’s time and effort. If a business owner works in their own company, the implicit cost is the formal salary they could have earned working elsewhere.
2. Use of owner’s capital. If an owner invests their own money into the business, the implicit cost is the interest or returns they could have earned by investing that money elsewhere.
3. Use of owner’s property. If a business operates out of a building owned by the proprietor, the implicit cost is the rent they could have charged to another tenant.
4. Depreciation of tangible assets. While depreciation can be an accounting entry, the economic implicit cost relates to the lost value or opportunity of not having newer, more efficient assets.

Calculating implicit costs is crucial for making informed economic decisions, even if they don’t appear on a traditional balance sheet.

What Are Explicit Costs?

Explicit costs are direct, out-of-pocket costs that small businesses incur. They are tangible, measurable, and involve dollars paid from the business to an external party. Explicit costs are typically recorded in a company’s financial statements, such as its income statement and balance sheet.

Explicit Costs Include:

• Wages and salaries paid to employees
• Office rental or rental of facilities
• Raw materials and supplies purchased
• Utility bills (electricity, water, internet)
• Interest payments on loans
• Marketing and advertising expenses
• Insurance premiums

Essentially, if money changes hands or a financial obligation is clearly documented, these are explicit costs.

Accounting Profit vs. Economic Profit: What’s the Difference?

The distinction between explicit and implicit costs becomes particularly significant when you differentiate between accounting profit and true economic profit. These two concepts offer different perspectives on a business’s success.

Accounting Profit

Accounting profit is the profit figure that most people are familiar with, and it’s what you typically see on a company’s financial statements. It is calculated by subtracting only the explicit costs from total revenue. It measures the financial gain from business operations as recorded in the books. Here’s the formula:

Accounting Profit = Total Revenue - Explicit Costs

Economic Profit

Economic profit is a broader, and often more realistic, measure of profitability, especially for long-term decision making. Economic profit takes into account both implicit and explicit costs (including opportunity costs). It measures the true profitability of a venture by considering all resources consumed, whether paid for directly or not. A positive economic profit indicates that the business is earning more than it could in its next best alternative use of resources. You can use either of the following formulas to estimate economic profit:

Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)
Economic Profit = Accounting Profit - Implicit Costs

The key difference between accounting profit and economic profit is the inclusion of implicit costs. While accounting profit might show that a business is making money, being economically successful depends on that business being the most efficient use of capital compared to alternative opportunities.

How to Use Explicit Costs to Calculate Accounting Profit

To calculate accounting profit, you’ll need to know the total revenue and all your explicit costs. Here’s how to do so:

1. Identify total revenue. This is the total amount earned from sales of goods or services during a specific time period.
2. Add up all explicit costs. List every direct, out-of-pocket expense incurred during that same period (e.g., wages, office rental, utilities, advertising expenses).
3. Subtract explicit costs from the total revenue. The result is your accounting profit.

How to Use Implicit and Explicit Costs to Calculate Economic Profit

Calculating economic profit allows for a more comprehensive view of profitability by factoring in the total costs, including opportunity costs:

1. Calculate accounting profit: Follow the steps above to determine your accounting profit.
2. Identify and quantify all implicit costs: This requires careful consideration of any missed alternatives. Determine a monetary value for the owner’s time, capital, and any other resources.
3. Subtract total implicit costs from accounting profit: This figure is your economic profit.

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