Measuring Your True Profit: Understanding Explicit and Implicit Costs

Is your business as profitable as you think? The answer might surprise you. While many companies are satisfied with their reported profits, they may not be as profitable as they appear. Their financial statements show a positive figure when expenses are subtracted from the revenue. This figure may not accurately represent the business’s profitability. Traditional accounting methods calculate the profit figure by deducting explicit costs, such as visible, monetary outlays, from the total revenue. However, a company’s performance is determined by going beyond these tangible expenses. A more accurate measure of a business’s success is its economic profit. The real profitability lies in examining economic profit versus accounting profit, which accounts for both explicit and implicit costs. 

If you own a business and want to make an actual profit, then you have reached the perfect place. This article will help you understand explicit vs implicit costs. Furthermore, if you are wondering what an explicit cost is and how to calculate economic profit, then stay with this article till the end. Till the time you finish this article, measuring actual profit in business will be a piece of cake for you. 

What Are Explicit Costs? The Costs You Can See

Explicit costs are the most straightforward and tangible expenses that are clearly visible to the business. They represent actual out-of-pocket expenses that involve direct monetary transactions. The real cash outflows or payments made by the company for products and services fall under explicit costs. The payments made for rent, the money spent on buying inventory, and the wages distributed to employees are all explicit costs. 

These expenses are reflected on the company’s financial statements and are easily traceable. Explicit costs play a vital role in determining a company’s accounting profit and are therefore also referred to as accounting costs. Explicit costs are easy to manage and identify because of the direct transactions and actual payments. These payments leave behind traces of transactions, such as invoices and receipts. 

Here are some of the most common examples of explicit costs that entrepreneurs encounter daily:

• Paying rent for the shop, office, or store.
• Giving wages and salaries to the employees.
• Cost of raw materials or supplies, including flour, sugar, or packaging.
• Utility bills such as electricity, water, and internet.
• Money is spent on marketing, such as advertisements and promotional campaigns.
• Payments are made for professional services, such as those provided by accountants, lawyers, or consultants. 

Although explicit costs are essential for a company’s financial standing, they provide an incomplete picture of the business’s overall financial health. Implicit costs also need to be taken into consideration when determining the actual profit of the company. A combined understanding of both can help you gain a clearer picture and avoid making decisions based solely on surface-level profits.

What Are Implicit Costs? The Hidden Cost of Opportunity

While explicit costs are visible to everyone, implicit costs often remain hidden. They typically do not appear on the company’s financial statements and involve no direct payment. Implicit costs are the opportunity costs of using resources that a business already owns or possesses. Opportunity cost in business refers to the value of resources that a business could have utilized in a different way. These are non-monetary costs that do not involve a direct cash transaction and are often overlooked by the industry. Although implicit costs involve no direct transaction, they still reduce a company’s real profitability. 

Some implicit cost examples for business owners are as follows:

• Suppose a business owner leaves their job and runs their own business. In that case, the salary the owner forgoes by running their business instead of working for another company becomes an implicit cost. 
• Similarly, if a business owns and uses a property for its own purposes rather than renting it out, the rent that could have been earned by leasing the property becomes an implicit cost.
• Another example is if a business owner uses his personal savings to run a business instead of investing it, the interest income lost from using personal savings to fund the company will also become an implicit cost. 

These hidden expenses are of great importance as they show the sacrifices made to operate the business. Ignoring implicit costs can create a false sense of profitability, which can ultimately be detrimental to the company. 

The Key Difference: Accounting Profit vs. Economic Profit

The key distinction between economic profit and accounting profit is in whether you use implicit costs in the calculations or not. The differences are explained in detail below.

Accounting Profit

Accounting Profit = Total Revenue – Explicit Costs

The accounting profit is calculated by subtracting only the explicit costs from the total revenue of the business. This is the figure that most businesses use for financial statements and tax purposes. 

Economic Profit

Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)

Economic profit is calculated by subtracting both explicit costs and implicit costs from the total revenue of the business. This is the true measure of profitability, considering all costs.

Let’s take a simple example to show how a business can have a positive accounting profit but a negative economic profit. Consider a small bakery that generates $200,000 in annual revenue. If its total explicit costs are $150,000, then its accounting profit will be $50,000. However, if the owner left a job with a salary of $60,000, it would become his implicit cost, and the economic profit would come down to –$10,000. 

Why Understanding This Matters for Your Business

Understanding the distinction between explicit costs and implicit costs is crucial for both planning expenses and strategizing operations for entrepreneurs. Misunderstanding can hamper your decisions and have severe consequences for the business. When entrepreneurs prioritize accounting profit over other factors, they may put their business at risk. The accounting profit may mislead them by not showing them the true health of their business. Therefore, it is essential to include implicit costs in calculating earnings so that you can uncover the real profitability of your business. 

Here are a few of the reasons why focusing on economic profit leads to better decision-making for the business.:

• Understanding the actual viability of a business model.
• Making better choices about resource allocation (e.g., is using my time worth the forgone salary?).
• Evaluating the performance of a business against its next-best alternative.

Focusing on economic profit enables business owners to make more informed decisions about investments and the company’s growth. It prevents them from making costly mistakes and ensures their choices align with financial realities and personal goals. 

5 Steps to Calculate Your True Profit 

You are required to calculate both accounting and economic profit to understand the business’s profitability. This step-by-step guide will help you apply the concepts correctly. Let’s revisit the bakery example from earlier:

• 1. List and total all explicit costs like rent, wages, supplies, and utilities. Suppose they total $150,000.
• 2. List and total all implicit costs such as forgone salaries, lost rental income, or missed investment returns. Assign a monetary value to each. Suppose the owner forgoes a salary of $60,000. 
• 3. Calculate the total revenue of the business by summing up all sales and income generated by the company. Suppose it comes down to $200,000.
• 4. Calculate accounting profit by subtracting only the explicit costs from the total revenue.
• Accounting Profit = $200,000 – $150,000 = $50,000.
• 5. Calculate economic profit by subtracting both explicit costs and implicit costs from the total revenue.

Economic Profit = $200,000 – ($150,000 + $60,000) = –$10,000.

Conclusion: The Full Picture of Your Business’s Health

The profitability of a business is not just about the money on paper. It is about comparing actual results with the opportunities forgone. That is why it is crucial to consider both explicit and implicit costs when determining the actual profit of the business. While explicit costs are clearly visible and leave a financial trail, implicit costs often remain invisible. Explicit costs include actual transactions such as rent, wages, and utilities. 

On the other hand, implicit costs include forgone salaries or lost rental income. Entrepreneurs are required to look beyond the numbers on their financial statements. For a complete and accurate picture of a business’s health and long-term success, both types of costs must be considered when calculating the profit.