An implicit cost is a cost that has occurred but it is not initially shown or reported as a separate cost. On the other hand, an explicit cost is one that has occurred and is clearly reported as a separate cost. Below are some examples to illustrate the difference between an implicit cost and an explicit cost.
Let's assume that a company gives a promissory note for $10,000 to someone in exchange for a unique used machine for which the fair value is not known. The note will come due in three years and it does not specify any interest. Due to the company's weak financial position it will have to pay a high interest rate if it were to borrow money. In this example, there is no explicit interest cost. However, due to the issuer's financial difficulty 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 and it is implicit. To properly record the note and the machine, the accountant must determine the amount of the interest, which is known as imputing the interest. In effect the accountant must convert the implicit interest to explicit interest. This is done by discounting the $10,000 by using the interest rate that the issuer of the note would have to pay to another lender. If the rate is 12% per year, the interest that was implicit in the note is $2,880 and the principal portion of the note is the remaining $7,120.
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, the interest cost of $2,880 would be explicit. In this situation, there is no need to impute the interest.
Another example of an implicit cost is the opportunity cost of a sole proprietor working in her own business. For example, Gina 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 Gina's work in her business. However, if Gina is foregoing a salary of $40,000 from another company, that is an implicit cost for her business. After considering this implicit cost, Gina is losing $10,000 by working in her proprietorship.
If Gina operates her business as a corporation, Gina will be an employee of the corporation. If her annual salary is $40,000 the corporation's income statement would report the $40,000 salary as an explicit cost for Gina's work.
An implicit interest rate is one that is not explicit; in other words, the rate is not stated. For example, if I lend you $5,000 and you agree to repay me $1,000 at the end of each year for six years you are obviously paying interest. However, our agreement did not specify any interest or interest rate. To find the interest rate that is "implicit" in this arrangement, you would do a present value calculation via a financial calculator, software, or present value tables. If you were to use a present value of an ordinary annuity table, you could use this format:
PVOA = PMT x PVOA factor for n=6, i=?;
$5,000 = $1,000 x PVOA factor for n=6, i=?;
$5,000/$1,000 = PVOA factor for n=6, i=?;
5.000 = PVOA factor for n=6, i=?
The factor 5.000 appears in the row n=6 where i = 5.5%. Hence, this loan has an implicit interest rate of 5.5%.
I use the terms differential cost and incremental cost interchangeably. In other words, I believe the terms mean the same thing: the difference in cost between two alternatives. For example, if a company determined that the annual cost of operating at 80,000 machine hours was $4,000,000 while the annual cost of operating at 70,000 machine hours was $3,800,000, then the differential cost or incremental cost of the additional 10,000 machine hours was $200,000.
The term marginal cost refers to the cost of operating for one additional machine hour.
Some people use cost and price interchangeably. Others use the term cost to mean one component of a product's selling price. Even the same person might use the terms differently.
For example, in standard costing the price variance of the raw materials refers to the difference between the standard cost and the actual cost of the materials.
In other situations we define a product's selling price as: product costs + expenses + profit.
As these two examples indicate, there can be different meanings for the terms cost and price.
How do I determine the cost of missing inventory?
The approximate cost of missing inventory is the difference between 1) the cost of the inventory that is actually on hand, and 2) the cost of the inventory that should be on hand based on the company's records.
If the company uses accounting software along with the perpetual inventory method (and the system is updated, reviewed, and adjusted routinely) then you can subtract the actual inventory on hand from the amounts shown by the software. The difference is the approximate amount of missing inventory.
If the perpetual inventory method is not used (or the system is not maintained properly) you can do the following:
1. Determine the cost of the inventory when the inventory was last counted. Perhaps this was the previous December 31.
2. Determine the cost of all the goods that were purchased since December31.
3. Combine Item 1 and Item 2 to arrive at the cost of goods available for sale.
4. Determine the cost of goods sold percentage. This is 100% minus the company's normal gross profit percentage. (This may appear on the income statements from the previous year.)
5. Multiply the cost of goods sold percentage times the sales since December 31. The result is the approximate cost of goods sold.
6. Subtract the approximate cost of goods sold (Item 5) from the cost of the goods available (Item 3). This is the approximate cost of goods that should be in inventory.
7. Determine the cost of the goods that are actually in inventory.
8. Subtract the cost of the goods that are actually in inventory (Item 7) from the cost of goods that should be in inventory (Item 6). The difference or shortage is the amount of missing inventory.
Generally a cost variance is the difference between a cost's actual amount and its budgeted or planned amount. For example, if a company had actual repairs expense of $950 for May but the budgeted amount was $800, the company had a cost variance of $150. Since the actual cost was more than the budgeted amount, the cost variance is said to be unfavorable. When an actual cost is less than the budgeted amount, the cost variance is said to be favorable.
Cost variances are a key part of the standard costing system used by many manufacturers. In such a system the cost variances explain the difference between 1) the standard, predetermined and expected costs of the good output, and 2) the actual manufacturing costs incurred. These cost variances send an early signal to management that the company is experiencing actual costs that are different from the company's plan. Standard costing systems will report a minimum of two cost variances for each of the following manufacturing costs: direct materials, direct labor and manufacturing overhead
LIFO inventory amounts will not be written-up, even when the current market value of the inventory is far greater than the amount reported on the balance sheet.
The reason inventory is not increased to its current value is the cost principle, the cost flow assumption, consistency, and other accounting concepts and principles. When a company elects the LIFO cost flow assumption, it chooses to put its most recent costs in the cost of goods sold, and to leave its earlier costs in inventory. The company cannot violate the cost principle by later increasing the inventory to an amount that is greater than those earlier actual costs.
One place that you might find part of the difference between the LIFO cost reported on the balance sheet and its current market value is the "Inventories" footnote to the financial statements. For example, in General Electric's 2011 Annual Report to the SEC (Form 10-K), it indicates that if General Electric had not been using LIFO (for many years), its balance sheet inventory amount would have been greater by $450 million. That does not mean that the difference between its inventory cost and its market value is $450 million, but I suspect that it is part of the difference.