How to calculate economic cost
Understanding the economic cost is crucial to making informed decisions in businesses and policy-making. Economic cost encompasses both explicit and implicit costs. In this article, we’ll discuss the concept of economic cost and how to calculate it accurately for well-informed decision-making.
a) Explicit Costs
– Direct monetary expenses tied to resources acquired or used in production
– Examples: wages, rent, materials
b) Implicit Costs
– Indirect costs associated with using resources that the company already owns
– Examples: opportunity cost of capital, the value of time contributed by the owner
2. The Relationship between Accounting Cost, Implicit Cost, and Economic Cost
– Accounting Cost: refers to costs recorded in a company’s financial records (usually includes only explicit costs)
– Economic Cost: the sum of both explicit and implicit costs
3. Calculating Economic Cost
A) Explicit Costs
– Identify all direct monetary expenses connected with production or service delivery.
– Calculate total explicit costs by adding up these expenses.
B) Implicit Costs
1) Opportunity cost of capital:
i) Determine initial investment.
ii) Calculate expected return on comparable investments.
iii) Multiply initial investment by expected return percentage.
2) Value of owner’s time:
i) Estimate hours contributed by the owner per week.
ii) Determine an appropriate market wage rate.
iii) Multiply hours by wage rate.
C) Add up implicit costs from opportunity cost of capital and value of owner’s time.
4. Determining Total Economic Cost
– Add explicit and implicit costs together to find the total economic cost.
5. Importance of Calculating Economic Cost in Decision-Making
– Efficient allocation of resources
– Improved understanding of profitability
– More informed decision-making on investments and pricing
Calculating the economic cost is essential for businesses and policy-makers to make well-informed decisions. By understanding and incorporating both explicit and implicit costs, one can allocate resources efficiently, determine the true profitability of a business, and make informed decisions related to investments and pricing.