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A dentist owns her own practice. After paying staff, supplies, rent, and equipment costs, she shows $180,000 in accounting profit. Her accountant is pleased. Her economist would ask: what else could she be doing with her time and money? She works 55 hours a week and could earn $160,000 in annual salary as an employed dentist. She has $400,000 of personal capital invested in the practice that could earn 8 percent ($32,000) if invested in index funds. Her implicit costs total $192,000. Her economic profit: $180,000 – $192,000 = –$12,000. The practice is destroying value even while reporting accounting profit.
The quick distinction
Explicit costs are the direct monetary payments a firm makes to purchase or rent inputs: wages paid to employees, rent paid to a landlord, interest paid on business loans, prices paid for raw materials, utility bills, insurance premiums. These are the costs that appear in accounting statements.
Implicit costs are the opportunity costs of inputs the firm already owns or that the owner provides directly — costs with no cash payment but a real economic value:
- The owner's time (foregone salary in best alternative employment)
- Capital tied up in the business (foregone return on invested funds)
- Use of owned facilities (foregone rental income)
Economic profit = Revenue – Explicit Costs – Implicit Costs Accounting profit = Revenue – Explicit Costs only
| Explicit cost | Implicit cost | |
|---|---|---|
| Cash payment? | Yes | No |
| In accounting statements? | Yes | No |
| Included in economic profit? | Yes | Yes |
| Example | $5,000 monthly rent | $3,000 monthly foregone salary |
Explicit costs, explained
Explicit costs are straightforward — they are the invoices paid, wages settled, and purchases made. The IRS business expense guidance catalogs the explicit costs eligible for deduction against business income. These are the costs accounting profit subtracts from revenue, producing the taxable income figure.
Implicit costs, explained
Implicit costs are why accounting profit is not a complete measure of business performance. A sole proprietor working 80-hour weeks at a break-even accounting profit is not doing well — their time has an opportunity cost. A firm earning 4 percent return on invested capital in an industry where the market return is 10 percent is destroying economic value even if accounting profit is positive.
The Federal Reserve's Flow of Funds data captures the return on capital across sectors — the benchmark against which implicit capital costs should be compared. Sectors with persistently low returns on invested capital are covering explicit costs but failing to cover implicit capital opportunity costs — a signal of capital misallocation.
How to keep them straight
Ask: did money change hands? If yes — explicit. If not, but a resource is being used that has an alternative market value — implicit. Economic analysis requires accounting for both. Businesses that track only explicit costs risk retaining resources in uses that appear profitable by accounting standards but are destroying value economically.
