Definition of Implicit Cost
An implicit cost is present but it is not initially shown or reported as a separate cost.
Definition of Explicit Cost
An explicit cost is a cost that is present and it is clearly shown or reported as a separate cost.
Examples of Implicit Costs and Explicit Costs
Let’s assume that a company gives a promissory note for $10,000 to a seller of a unique used machine for which the fair value is unknown. The promissory note will come due in three years and it does not specify any interest. Due to the company’s weak financial position it would normally have to pay a high interest rate if it were able to borrow money. In this example, the promissory note does not show an explicit interest cost. However, due to the issuer’s weak financial position and the seller having to wait three years to collect the money, there has to be some interest cost. In other words, there is some interest cost, but it is implicit. (To record the interest cost, accountants will discount the $10,000 by the approximate interest rate that the maker of the note would normally have to pay.)
If another company with the same financial condition purchased this unique machine by issuing a $7,120 note with a stated interest rate of 12% per year (and the rate is a fair interest rate for the situation), the compounded interest cost of $2,880 is explicit.
Another example of an implicit cost is the opportunity cost of a sole proprietor working in her own business. For example, Jane works as a sole proprietor and her business reported a net income of $30,000 for the year. Since a sole proprietor does not receive a salary or wages, there is no explicit cost reported for Jane’s work in her business. However, if Jane is foregoing a salary of $40,000 from another company, this is an implicit cost. When considering this implicit cost, Jane is losing $10,000 by working in her proprietorship.
If Jane operated her business as a corporation, Jane will be an employee of the corporation and her annual salary will be an explicit cost presented as salary expense on the corporation’s income statement.
