Explicit and Implicit Costs

Typically, the costs of using resources in production involve both out-of-pocket costs, or explicit costs, and other noncash costs, called implicit costs. Wages, utility expenses, payment for raw materials, interest paid to the holders of the firm's bonds, and rent on a building are all examples of explicit expenses. The implicit costs associated with any decision are much more difficult to compute. These costs do not involve cash expenditures and are therefore often overlooked in decision analysis. Because cash payments are not made for implicit costs, the opportunity cost concept must be used to measure them. The rent that a shop owner could receive on buildings and equipment if they were not used in the business is an implicit cost of the owner's own retailing activity, as is the salary that an individual could receive by working for someone else instead of operating his or her own establishment.

An example should clarify these cost distinctions. Consider the costs associated with the purchase and operation of a law practice. Assume that the minority partners in an established practice, Donnell, Young, Doyle & Frutt, can be bought for $225,000, with an additional $25,000 needed for initial working capital. Lindsay Doyle has personal savings of $250,000 to invest in such an enterprise; Bobby Donnell, another possible buyer, must borrow the entire $250,000 at a cost of 15 percent, or $37,500 per year. Assume that operating costs are the same no matter who owns the practice and that Doyle and Donnell are equally capable of completing the purchase. Does the $37,500 in annual interest expenses make Donnell's potential operating cost

MANAGERIAL APPLICATION 8.1

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