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

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:

• 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.

• 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.

• 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.

• 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.

Entrepreneurs may decide that implicit costs are worth it in the long run. Krisi Smith, one of the founders of the online retail store Bird & Blend Tea, was able to fund the retail expansion of her business by foregoing a salary for the first two years. She doesn’t regret accepting those initial implicit costs. “Our business was everything, and we wanted to prove it would work,” she says on Shopify Masters. “We funneled everything we had into it. Within a couple of years, we had a working business model. We could prove that the revenue coming in through the store was not only breaking even, but was contributing to profit.”

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.

Going back to the example of Bird & Blend Tea, Krisi describes the path her business took after opening its first retail store—and how it led to long-term growth. Having invested money in explicit costs like rent and inventory, she was soon able to increase revenue to a point where her implicit costs decreased. “We were able to recruit our first team, take a proper salary, rent a flat, and then use that to get further leases and expand the business,” she says.

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 conceptions 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. Small businesses could have a positive accounting profit but a zero or even negative economic profit, suggesting that the owner could be earning more by pursuing a different venture or investing their capital elsewhere.

How to use explicit costs to calculate accounting profit

In order 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.

Here is an extended example:

• Total sales revenue: $500,000

• Explicit costs: Wages = $150,000; Rent = $50,000; Raw Materials = $100,000; Utilities = $20,000; Marketing = $30,000; Total explicit costs = $350,000

• Accounting profit: $500,000 (total revenue) - $350,000 (explicit costs) = $150,000

This $150,000 is the profit that would typically be reported on the company’s income statement.

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.

Let’s use the previous example:

• Accounting profit: $150,000

• Implicit costs. Owner’s foregone annual salary: The owner could have earned $80,000 working for another company; Owner's foregone interest: The owner invested $100,000 of their own savings into the business, which could have earned 5% interest ($5,000) in a low-risk investment; Total implicit costs = $85,000

• Economic Profit: $150,000 (accounting profit) - $85,000 (implicit costs) = $65,000

In this scenario, although the business shows a respectable accounting profit of $150,000, its economic profit is $65,000. This positive economic profit still suggests the business is a worthwhile venture compared to the best alternatives for the owner’s time and capital. If the economic profit were zero, it would mean the business is earning just enough to cover all those costs, including the opportunity costs, meaning the owner is doing as well as they could in their next best alternative. A negative economic profit would indicate that the owner could be better off pursuing another opportunity.