The upcoming discussion will update you about the differences between explicit cost and implicit cost.
When most people think of cost, they think only of the explicit cost — the actual payment by firms to labour, capital, and other factors of production. Whether these costs are fixed or variable, they are straightforward: they are the amounts that firms must pay to owners of the resources in order to bid these resources away from alternative uses.
Producers also incur some costs referred to as implicit costs and in any complete analysis of costs one must take implicit costs into consideration. Managerial decision makers should do the same. To aid in analysing the nature of implicit costs, consider two firms that produce identical amounts of the good. The owner of one firm rents the building in which the good is produced.
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The owner of the other firm inherited the building the firm uses and therefore pays no rent. Whose costs are higher? For decision making purposes, the costs for both are the same even though the second firm makes lower payments to outside factors of production. The reason for the same costs is that using the building to produce goods costs the second firm the amount of income that could have been earned had it been leased at the prevailing rent.
Since these two buildings are the same, presumably the market rentals would be the same. In other words, a part of the cost incurred by the second firm is the (implicit) payment from firm owners to themselves as the owners of a resource (the building). Thus, one implicit cost would include what the owner of a firm could make from selling or leasing the capital he own instead of using it in his own firm.
Another implicit cost would include the value of the firm owner’s time that is used to manage the business. Presumably, if the owner of a firm were not managing the business or working for the firm in another way, he or she could obtain a job with some other firm, possibly as a manager. The salary that could be earned in this alternative occupation is an implicit cost that should be considered as part of the total cost of production. These implicit costs are just as real as explicit costs.
The implicit costs incurred by firms in producing a specific commodity consist of the amounts that could be earned in the best alternative use of the owner-manager’s time and of any other of his resources currently used to produce the commodity in question. Implicit costs must be added to explicit costs in order to obtain total costs.
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In short, explicit cost is called outlay cost and refers to any payment to an outsider and is reflected in a company’s book of account. By contrast, implicit cost is opportunity cost and is not taken into consideration by the accountant. But in economics it is added to explicit cost and is called normal profit. Due to inclusion of implicit cost economic profit is less than accounting profit.