What Is Accounting Cost in Economics?
Explore the fundamental distinction between accounting and economic costs. Understand how this broader perspective guides smarter business decisions.
Understanding the true cost of business decisions is paramount for resource allocation. Costs can be viewed through accounting and economic lenses. These distinct viewpoints offer varying insights into a company’s financial health and operational efficiency.
Defining Accounting Cost
Accounting cost, also known as explicit cost, refers to the direct, out-of-pocket expenses a business incurs during its operations. These are tangible monetary expenditures, easily identifiable and recorded in a company’s financial statements. Examples include employee wages, rent for office space, utility bills, and the cost of raw materials.
These costs represent actual cash outflows and are systematically tracked in a business’s general ledger. Depreciation, the systematic allocation of an asset’s cost over its useful life, is also considered an accounting cost, even though it does not involve a direct cash outflow at the time of recognition.
Understanding Economic Cost
Economic cost is a broader concept than accounting cost, representing the total cost of an action or decision. It includes both explicit (accounting) costs and implicit costs, considering all resources consumed or foregone.
While explicit costs are straightforward and reflected in financial records, implicit costs are less obvious and do not involve direct cash payments. The inclusion of these unrecorded, non-monetary costs differentiates economic cost from accounting cost, providing a more complete picture of resources utilized.
The Components of Economic Cost
Economic cost comprises both the explicit costs, which are the direct financial payments a business makes, and implicit costs. Explicit costs, as previously discussed, include expenses like salaries, rent, and materials. These are the visible costs of doing business, such as the actual money paid for inputs like labor, rent, and raw materials.
Implicit costs are the opportunity costs of using resources that the firm already owns or that are provided by the firm’s owners. They represent the value of the next best alternative that must be given up when a choice is made. For example, if a business owner uses their personal savings to fund the business, the foregone interest that could have been earned on those savings in an alternative investment is an implicit cost. Similarly, the salary an owner could have earned working for another company, rather than running their own business, is an implicit cost.
Why the Distinction is Important
Understanding the difference between accounting cost and economic cost is crucial for sound business decision-making. Accounting profit, calculated as total revenue minus explicit costs, indicates a company’s financial viability and is used for financial reporting and tax purposes. However, it does not fully capture the true cost of resource utilization.
Economic profit, which subtracts both explicit and implicit costs from total revenue, reveals a venture’s true success relative to its alternatives. A business might show an accounting profit but still have a negative economic profit if its implicit costs are high, meaning resources could have generated more value elsewhere. This comprehensive view helps businesses make better long-term strategic decisions by considering all costs, including the value of foregone opportunities.