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    7.1 Explicit and Implicit Costs, and Accounting and Economic Profit – Principles of Economics

    7.1 EXPLICIT AND IMPLICIT COSTS, AND ACCOUNTING AND ECONOMIC PROFIT

    Learning Objectives

    By the end of this section, you will be able to:

    Explain the difference between explicit costs and implicit costs

    Understand the relationship between cost and revenue

    Private enterprise, the ownership of businesses by private individuals, is a hallmark of the U.S. economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General Motors come to mind. But firms come in all sizes, as shown in Table 1. The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, meaning they employ more than 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Indeed, Table 1 does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn.

    Number of Employees Firms (% of total firms) Number of Paid Employees (% of total employment)

    Total 5,734,538 112.0 million

    0–9 4,543,315 (79.2%) 12.3 million (11.0%)

    10–19 617,089 (10.8%) 8.3 million (7.4%)

    20–99 475,125 (8.3%) 18.6 million (16.6%)

    100–499 81,773 (1.4%) 15.9 million (14.2%)

    500 or more 17,236 (0.30%) 50.9 million (49.8%)

    Table 1. Range in Size of U.S. Firms. (Source: U.S. Census, 2010 www.census.gov)

    Each of these businesses, regardless of size or complexity, tries to earn a profit:

    P r o f i t = T o t a l R e v e n u e − T o t a l C o s t

    Profit=TotalRevenue−TotalCost

    Total revenue is the income brought into the firm from selling its products. It is calculated by multiplying the price of the product times the quantity of output sold:

    T o t a l R e v e n u e = P r i c e × Q u a n t i t y

    TotalRevenue=Price×Quantity

    We will see in the following chapters that revenue is a function of the demand for the firm’s products.

    We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, payments that are actually made. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources already owned by the firm. Often for small businesses, they are resources contributed by the owners; for example, working in the business while not getting a formal salary, or using the ground floor of a home as a retail store. Implicit costs also allow for depreciation of goods, materials, and equipment that are necessary for a company to operate. (See the Work it Out feature for an extended example.)

    These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.

    Calculating Implicit Costs

    Consider the following example. Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he gets established. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. A law clerk could be hired for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?

    Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them:

    O f f i c e r e n t a l : $ 50 , 000 L a w c l e r k ′ s s a l a r y : + $ 35 , 000 T o t a l e x p l i c i t c o s t s : $ 85 , 000

    Officerental:$50,000Lawclerk′ssalary:+$35,000Totalexplicitcosts:$85,000

    Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.

    R e v e n u e s : $

    Source : opentextbc.ca

    Explicit and implicit costs and accounting and economic profit (article)

    There are different ways of thinking about costs and profit. Read about what they are!

    Types of profit

    Explicit and implicit costs and accounting and economic profit

    There are different ways of thinking about costs and profit. Read about what they are!

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    Key points

    Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs.

    Private enterprise is the ownership of businesses by private individuals.Production is the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs.Revenue is income from selling a firm’s product; defined as price times quantity sold.Accounting profit is the total revenues minus explicit costs, including depreciation.Economic profit is total revenues minus total costs—explicit plus implicit costs.Explicit costs are out-of-pocket costs for a firm—for example, payments for wages and salaries, rent, or materials.Implicit costs are a specific type of opportunity cost: the cost of resources already owned by the firm that could have been put to some other use. For example, an entrepreneur who owns a business could use her labor to earn income at a job.

    Explicit and implicit costs and accounting and economic Profit

    Private enterprise—the ownership of businesses by private individuals—is a hallmark of the US economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General Motors come to mind. But firms come in all sizes, as you can see in the table below.

    The vast majority of US firms have fewer than 20 employees. As of 2010, the US Census Bureau counted 5.7 million firms with employees in the US economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, firms that employ more than 500 workers. Another 35% of workers in the US economy are at firms with fewer than 100 workers.

    These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. There are also millions of small, non-employer businesses where a single owner or a few partners are not officially paid wages or a salary but simply receive whatever they can earn—there is not a separate category in the table for these businesses.

    Range in size of US firms

    Number of employees Firms, % of total firms Number of paid employees, % of total employment

    Total 5,734,538 112.0 million

    0–9 4,543,315, 79.2% 12.3 million, 11.0%

    10–19 617,089, 10.8% 8.3 million, 7.4%

    20–99 475,125, 8.3% 18.6 million, 16.6%

    100–499 81,773, 1.4% 15.9 million, 14.2%

    500 or more 17,236, 0.30% 50.9 million, 49.8%

    Source: 2010 US Census, www.census.gov

    Each of these businesses, regardless of size or complexity, tries to earn a profit.

    \text{Profit}=\text{Total revenue} - \text{Total cost}

    Profit=Total revenue−Total cost

    start text, P, r, o, f, i, t, end text, equals, start text, T, o, t, a, l, space, r, e, v, e, n, u, e, end text, minus, start text, T, o, t, a, l, space, c, o, s, t, end text

    Total revenue is the income brought into a firm from selling its products. It is calculated by multiplying the price of the product times the quantity of output sold:

    \text{Total revenue}=\text{Price} \times \text{Quantity}

    Total revenue=Price×Quantity

    start text, T, o, t, a, l, space, r, e, v, e, n, u, e, end text, equals, start text, P, r, i, c, e, end text, times, start text, Q, u, a, n, t, i, t, y, end text

    We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs—payments that are actually made. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs.

    Implicit costs are more subtle but just as important. They represent the opportunity cost of using resources already owned by the firm. Often for small businesses, they are resources contributed by the owners—for example, working in the business while not getting a formal salary or using the ground floor of a home as a retail store. Implicit costs also allow for depreciation of goods, materials, and equipment that are necessary for a company to operate.

    These two definitions of cost are important for distinguishing between two conceptions of profit—accounting profit and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, which includes both explicit and implicit costs.

    The difference is important. Even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.

    Calculating implicit costs

    Let's take a look at an example in order to understand better how to calculate implicit costs.

    Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he gets established. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. A law clerk could be hired for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?

    Step 1. First we'll calculate the costs. We'll use what we know about explicit costs:

    Source : www.khanacademy.org

    Explicit and Implicit Costs (Definition and Examples)

    An explicit cost is the clearly stated costs that a business incurs, whilst implicit costs are those which occur, but are not seen.

    What are Explicit and Implicit Costs

    How to Calculate Implicit Costs

    Explicit Cost Examples

    Implicit Cost Examples

    Explicit and Implicit Costs Definition

    WRITTEN BY PAUL BOYCE | Updated 17 December 2020

    What are Explicit and Implicit Costs

    An explicit cost is the clearly stated costs that a business incurs. For example, employee wages, inputs, utility bills, and rent, among others. These are the costs which are stated on the businesses balance sheet.

    By contrast, implicit costs are those which occur, but are not seen. In other words, these are the costs that are not directly linked to an expenditure. For example, a factory may close down for the day in order for its machines to be serviced. The explicit cost to repair the machines is $10,000. However, the factory has lost a whole days output which has cost it $50,000 in lost production. This indirect cost is known as the implicit cost.

    Key Points

    An explicit cost is that which is clear and identifiable in monetary terms.

    An implicit cost is the cost of choosing one option over another.

    Accounting profit is revenue minus explicit costs, whilst economic profit is revenue minus explicit AND implicit costs.

    Explicit costs are those which are clearly stated on the firm’s balance sheet, whilst implicit costs are not. Instead, it is the indirect cost of choosing a specific course. When combined together, explicit and implicit costs make up what is known to be the total economic cost. This is because the cost of choosing option A has an explicit cost as well as an implicit cost of what could have been achieved otherwise.

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    How to Calculate Implicit Cost  

    Implicit costs are costs that occur due to a specific path or option being chosen. It represents an opportunity cost when the firm uses resources for one use over another. The implicit cost is the cost of the action that is foregone. For example, a manager may need to train their staff, which requires 8 hours of their time. The implicit cost is the cost of their time which could have been employed doing their other daily tasks. In turn, this costs the firm however much output that manager would have created had they not needed to train the employees.

    Another example of an implicit cost is that of going to college. The explicit cost may be $30,000 per year. However, there is also an implicit cost. A student going to college could be working instead. Even in a minimum wage job, that would be approximately $12,000 per year – which is the implicit cost. They could be earning $12,000 a year if they didn’t go to college. So the total economic cost is the explicit cost of tuition at $30,000 and the implicit cost of not working which is over $12,000 – meaning a total economic cost of $42,000.

    Explicit Cost Examples 

    An explicit cost is one that is a clear and obvious monetary amount made by the firm. It has a clear monetary amount which can be seen in the firm’s financial balance sheet. Such examples include:

    Advertising and marketing costs.

    Employee wages, bonuses, commissions, and any other compensation to employees.

    Employee benefits that are not paid directly to the employee, I.e. healthcare, staff restaurant, or staff gym.

    Equipment that businesses purchase to make production and output more efficient.

    Rent or other mortgage payments required for the land the firm is using.

    Supplies that the firm requires in order to supply its output to consumers.

    Taxes and legal fees.

    Utilities that are required to keep the firm running such as electricity, water, and internet service.

    Implicit Cost Examples 

    Whilst explicit costs have a specific value, implicit costs are not always so clear cut. For example, spending 5 hours playing video games means those 5 hours cannot be used for studying. The implicit cost is the hours that could have been used for studying instead. The value by which is not necessary monetarily quantifiable, but is still considered as a cost.

    Lost interest on funds occurs when the firm employs its capital, which means it foregoes the interest it could have earnt in interest.

    Training a new employee presents an implicit cost in the fact that those seven hours could have been used doing other work.

    Going to University means that there is an implicit cost which is the money which could have been earned during that period.

    Maintenance means the firm has to stop production for a time which can lead to a lower level of output or dissatisfied customers.

    Accounting and Economic Profit

    In economics, there are two main types of costs for a firm. First are explicit costs. When looking at a firm’s financial statements, these costs are subtracted from the firm’s revenue to obtain its accounting profit. These explicit costs include employees’ wages, materials, utility bills, and rent.

    Second of all, there are implicit costs, which is a factor in calculating the firm’s economic profit. This is simply the same as accounting profits, but also subtract the implicit costs. So the economic profit is calculated by obtaining the firm’s revenue and subtracting BOTH explicit and implicit costs.

    General FAQs on Explicit and Implicit Costs

    What Is Explicit And Implicit Cost?

    An explicit cost is an absolute cost which is monetarily definable. In other words, it is clear that the firm has spend $x on Y. For example, employees wages, utility costs, and rent, are all examples of explicit costs. By contrast, an implicit cost is the cost of choose one option over another. For example, choosing not to work overtime means $x as an implicit cost as that income is foregone.

    Source : boycewire.com

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