What are Explicit and Implicit Costs?
The entire idea of the cost of production or production cost is applied corresponding or we can say that it is related to money cost. Money cost refers to any money expenditure which the firm or supplier or producer undertakes in purchasing or hiring factors of production or factor services.
Let us understand this with the help of an example:
For producing any commodity, the firm requires various factors of production like land, labor, capital, etc. Therefore, to employ all these factors of production, the producer needs to bear some costs. For hiring labor, he/she needs to pay wages, for getting the land to set up a plant he/she needs to pay rent. Therefore, all these costs come under money costs.
All these money costs are included in the accounting books of a firm as costs of production.
Money costs made by the firms to the owners of various factor services (i.e., the household) in hiring and purchasing them as per what is required in the production process of goods, is known as explicit cost.
Although we should always keep in mind that, money expenditure only constitutes a part of the cost. There are certain factor services owned by the entrepreneur himself for which no money payment is made. Since no payment is made for such factor services, they are not included in the cost of production in the normal accounting practice.
What are Economic Costs?
Economists take the cost of production in a wider sense; economic cost consists of three components. They are:
- Money Cost or Explicit Cost
- Implicit Cost
- Normal Cost
Implicit Cost refers to the estimated value of inputs owned by the firm and used by it in its production unit.
- Besides, purchasing or hiring resources from others, a producer may also use his/her factor services in the process of production.
- The owner or the entrepreneur may own certain factor services which he/she may use in his/her own business.
- For example, the entrepreneur may use his/her land, or capital and may provide entrepreneurial and managerial services.
- As such he/she is entitled to receive rent on his/her land, interest on the capital contributed by him/her, and payment for such services.
Thus, in the case of such factors of production that the firm neither purchases nor hires, the cost must also be calculated. Such costs need to be imputed from what they could earn in their best alternative use. Such cost is known as implicit cost.
Normal Profit: Normal profit is regarded as the minimum payment which a producer must get to induce him to undertake the risk of production. Normal profit is the minimum supply price of the entrepreneurial services. It is, in a way, a reward or remuneration for the services of the entrepreneurs. It is part of the cost of production because entrepreneurs expect to get it in the long run, he/she is not likely to undertake production. From an economic perspective, normal profit is also called cost.
The economic cost now can be defined as the sum of both explicit and implicit costs, including normal profit.
Accounting Cost= Explicit Cost.
Economic cost= Explicit cost + Implicit cost (including normal profit)
Implicit Cost Analysis
In other words, we can say that any cost which is already incurred in the production process but that is not accounted for or reported in the accounting section as a separate expense, is known as the implicit cost. The implicit cost represents all kinds of opportunity cost which arises when the company or the business is using internal sources of investment in the production process without any external fund that is being used or utilized in the form of resources.
These costs represent the loss of income but it does not represent the loss of profit. It is a kind of opportunity cost which is the benefit that the company gives up for choosing one alternative for the other production or option that is being exercised or operated. For example, a company can earn its income from using its building for renting purposes and also it can earn revenue by using that building for manufacturing purposes, production of goods and services which is meant to be sold in the market which will ultimately benefit the producer or the supplier or the owner of the business in terms of profit.
Explicit Cost Analysis
From the above discussion, it is already understood that implicit costs are those costs that are not taken into account or are recorded in the accounting process.
- Explicit costs are the normal money costs that are undertaken by the businessman or the owner and which generally appear in the accounting process or are recorded in the account which affects the company's profitability.
- Some of the examples of explicit costs are wages, expenditure on raw materials, utilities, fixed costs, any kind of cost that is done for hiring the factor of production, etc.
- Explicit costs are generally the money costs that happen in a business for running it smoothly.
- Any expenditure or investment undertaken for the sake of the production process of the business, or any payment made for the sake of hiring any factor of production which can be land, labor, capital, or entrepreneurship, those expenditures or expenses for the business comes under explicit costs which are recorded in the accounting process that consequently affect the profitability of the business in the long run.
Implicit cost is not included or accounted for and also cannot be accurately measured for accounting as there is no cash exchange involved in the implicit cost. Whereas the explicit cost is the expenses that are broadly done on the business.
The main distinction between these two types of costs is that:
- The implicit costs are nothing but the opportunity cost while the explicit cost is the costs that are paid or done by the tangible assets of the company. Therefore, it can be said that implicit costs can also be called imputed costs while explicit costs can be called the out-of-pocket expense of the company.
- From the perspective of ease of calculating, implicit costs are hard or difficult to measure or calculate whereas explicit costs are easier to calculate or measure. Economic profit can be calculated with the help of implicit cost whereas, economic profit and accounting profit can be calculated with the help of explicit cost.
Context and Applications:
This topic is significant in the professional exams for both undergraduate and graduate courses, especially for
- BA in economics
- MA in economics
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