The valuation process involves assessing the economic costs and benefits of a decision, considering both explicit and implicit factors. Explicit costs and benefits can be measured in terms of actual cash receipts and disbursements, while implicit costs reflect the opportunity cost or the highest valued alternative foregone. Valuation analysis aims to estimate the value of various entities such as a firm’s equity, commodities, assets, or real estate using different approaches like net present value (NPV) and internal rate of return (IRR).
Explicit costs are tangible and can be directly accounted for, while implicit costs or opportunity costs are not incurred through actual cash flows and are often challenging to estimate precisely for accounting purposes. Implicit costs are associated with foregone opportunities or resources allocated to pursue a particular decision.
Here are some hypothetical examples that illustrate implicit cost estimation:
1. Hiring and Training Costs: Suppose a company hires a new worker with a wage rate of $50 per hour, working 8 hours a day. During the training period, the company incurs an opportunity or implicit cost of $400 ($50 * 8) to provide training to the worker. Although the worker is not engaging in productive activities during training, the company needs to sacrifice one day of work to train the worker.
2. Owner’s Sacrificed Salary: In the early stages of a small business, the owner may decide to forgo their salary to enhance revenue and reduce costs. The owner’s salary becomes an opportunity cost and implicit cost as they are not being compensated for their business skills during this period.
3. Opportunity Cost of Land: Joe inherits a piece of land in the city that was purchased long ago for $5,000. However, the current assessed value of the land is $400,000. Joe plans to set up a bakery on this land, with direct costs for equipment totaling $110,000 and other related costs amounting to $12,000. Although Joe’s actual cash outflow for setting up the bakery is $122,000, he should consider the opportunity cost. If he does not use the land for the bakery, it could be sold for $400,000. Thus, the $400,000 represents the opportunity cost or implicit cost that should be factored into the financial analysis of his proposed bakery business.
Valuation involves considering both explicit and implicit costs and benefits to accurately assess the financial viability of a decision or investment.
References:
Investopedia: Implicit Cost Definition
“Valuation: Measuring and Managing the Value of Companies, University Edition, 7th Edition” by McKinsey & Company Inc. Staff / Koller, Tim
