Skip to main content
Business LibreTexts

9.17: Costs and Profit

  • Page ID
    48397
  • \( \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \) \( \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}} \)\(\newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\) \( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\) \( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\) \( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\) \( \newcommand{\Span}{\mathrm{span}}\) \(\newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\) \( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\) \( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\) \( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\) \( \newcommand{\Span}{\mathrm{span}}\)

    Learning Objectives

    • Explain the difference between explicit costs and implicit costs
    • Calculate accounting and economic profit

    Explicit and Implicit Costs, and Accounting and Economic Profit

    Private enterprise, the ownership of businesses by private individuals, is a hallmark of the U.S. economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General Motors come to mind. But firms come in all sizes, as shown in Table 1. The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, meaning those firms each employ at least 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Indeed, Table 1 does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn.

    Table 1. Range in Size of U.S. Firms (Source: U.S. Census, 2010 www.census.gov)
    Number of Employees Firms (% of total firms) Number of Paid Employees (% of total employment)
    Total 5,734,538 112.0 million
    0–9 4,543,315 (79.2%) 12.3 million (11.0%)
    10–19 617,089 (10.8%) 8.3 million (7.4%)
    20–99 475,125 (8.3%) 18.6 million (16.6%)
    100–499 81,773 (1.4%) 15.9 million (14.2%)
    500 or more 17,236 (0.30%) 50.9 million (49.8%)

    Each of these businesses, regardless of size or complexity, tries to earn a profit:

    Profit = Total Revenue – Total Cost

    Total revenue is the income brought into the firm from selling its products. It is calculated by multiplying the price of the product times the quantity of output sold:

    Total Revenue = Price x Quantity

    As we study the theory of the firm, it will become clear that a firm’s revenue depends on the demand for the firm’s products.

    We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, payments that are actually made. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources already owned by the firm. Often for small businesses, they are resources contributed by the owners; for example, working in the business while not getting a formal salary, or using the ground floor of a home as a retail store. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate.

    These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.

    Watch It

    This video explains the difference between accounting profit and economic profit.

    A link to an interactive elements can be found at the bottom of this page.

    CALCULATING IMPLICIT COSTS

    Consider the following example. Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he gets established. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. A law clerk could be hired for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?

    Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them:

    Office rental $50,000
    Law clerk’s salary + $35,000
    Total explicit costs $85,000

    Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.

    Revenues $200,000
    Explicit costs – $85,000
    Accounting profit $115,000

    But these calculations consider only the explicit costs. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of $125,000. This would be an implicit cost of opening his own firm.

    Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit. The equation is:

    Economic Profit = Total Revenues – Explicit Costs – Implicit Costs

    Now let’s plug in Fred’s figures to the true economic profit equation:

    Economic Profit = $200,000 – $85,000 – $125,000 = –$10,000 per year

    Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm.

    Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits.

    Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next section.

    Learning Objectives

    [glossary-page][glossary-term]accounting profit[/glossary-term]
    [glossary-definition]total revenues minus explicit costs, including depreciation[/glossary-definition][glossary-term]economic profit[/glossary-term]
    [glossary-definition]total revenues minus total costs (explicit plus implicit costs)[/glossary-definition][glossary-term]explicit costs:[/glossary-term]
    [glossary-definition]out-of-pocket costs for a firm, for example, payments for wages and salaries, rent, or materials[/glossary-definition][glossary-term]firm:[/glossary-term]
    [glossary-definition]an organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs.[/glossary-definition][glossary-term]implicit costs:[/glossary-term]
    [glossary-definition]opportunity cost of resources already owned by the firm and used in business, for example, expanding a factory onto land already owned[/glossary-definition][glossary-term]private enterprise:[/glossary-term]
    [glossary-definition]the ownership of businesses by private individuals[/glossary-definition][glossary-term]production:[/glossary-term]
    [glossary-definition]the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs[/glossary-definition][glossary-term]revenue:[/glossary-term]
    [glossary-definition]income from selling a firm’s product; defined as price times quantity sold[/glossary-definition]
    [/glossary-page]

    Contributors and Attributions

    CC licensed content, Shared previously
    All rights reserved content

    9.17: Costs and Profit is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

    • Was this article helpful?