ECOMAN

Chap. 5: Production and Cost Analysis in the Short Run // TQ No. 3, p. 169

Jim is considering quitting his job and using his savings to start a small business.

He expects that his costs will consist of a lease on the building, inventory, wages for two

workers, electricity, and insurance.

Explicit and Opportunity (Implicit) Costs

Explicit costs are easily quantifiable and identifiable because it is reflected in

payment to another individual and is recorded in the company’s bookkeeping or

accounting system (Farnham, 2014). These costs are paid by the company’s own

tangible assets and is important because it determines their overall profit.

Jim’s explicit costs will include the payment he will render to lease a building,

wages for his two workers, electricity, and insurance; however, Jim might have missed a

few explicit costs. He will also have to pay for equipment, utilities, marketing and

advertising, taxes, utilities (including electricity, water, and internet), and legal fees.

Implicit costs on the other hand is often more difficult to measure because it is

not explicitly paid, and hence, not recorded in a company’s accounting system

(Farnham, 2014). It is important to identify because these costs represent a loss on

potential income. It is a type of opportunity cost because the company misses out on a

benefit by choosing an option or alternative versus another.

Jim’s implicit costs will include opportunity costs, time spent interviewing and

hiring potential employees, time spent training a new employee, cost of temporary
downtime in production, time and resources spent on creating marketing and

advertising materials, cost of capital, the use of the owner’s car, computer, or other

personal equipment to conduct business.

Screening potential employees is time consuming and when Jim hires a new

employee, there is an implicit cost because if Jim spends his time training the new

employee for 3 hours, that could have been 3 hours spent for the employee’s hourly

wage. This is meant to be allocated for the employee’s current role but instead it is now

spent on training.

During the early stages of Jim’s business, production might slow down because

of his lack of capital to purchase high-tech equipment. This is an implicit cost because

manual labor that can be spent on formulating new products, creating marketing

campaigns, or processing deliveries will be spent on production time instead.

It is also no secret that it is difficult to create marketing and advertising

campaigns. Your company has to be enticing, engaging, current, and creative to

capture the attention of your target market. The time spent on formulating unique ideas

could be spent on training new employees, deliveries, or production.

Jim’s capital includes not only the monetary value Jim needs to pay for lease,

electricity, and employees’ wages, but also his time and skills spent to start up his

business and train his employees. His cost of capital may therefore take a long time to

be returned as his business will be new, and many variables may affect its success. The

rate of return on his capital will be dependent on the demand for his new business, and

the supply that his business will be able to give, which makes it an opportunity cost.
Instead of using his savings or taking up loans to start up his business, Jim could spend

this money for other things like investments, while still taking up his current job.

Particularly during this COVID-19 pandemic, a lot of people are losing their jobs and find

it difficult to earn money. Jim should give importance to his current job especially if it

pays well.

In starting a business, it is not new that the owner must purchase his own

personal equipment in order to make his business work. This will entail not only the cost

of buying the equipment but also its maintenance over time. Due to the heavy cost of

this personal equipment, along with the other costs in starting the business, Jim may

have to take on loans.

From the perspective of opportunity cost, the issue is what Jim’s capital

equipment could earn in its next best alternative at the current time, that is in his current

job (Farnham, 2014). Rather than using his money to purchase equipment, Jim could do

something more out of it, since it is known that the value of equipment usually

depreciates over time, and will entail maintenance costs over time as well.

Fixed and Variable Costs

Managers like Jim, use both fixed costs and variable costs in a production

function. Fixed costs are those whose quantity cannot be changed in a given period of

time, while variable costs are those whose quantity can be changed in a given period of

time (Farnham, 2014).

 A fixed cost remains constant regardless of the amount of output produced, even

if output is zero. Fixed costs that Jim might have to pay for are internet fees, leases,

employees salaries, taxes, insurance, loans he may have to acquire, and cost of

equipment.

Variable costs increase as more output is produced. The cost of additional output

depends directly on what additional inputs are required and how much they cost. When

deciding on what additional inputs are required, fixed costs are usually not considered

since these costs stay the same no matter what. Variable costs that Jim might have to

pay for are sales commissions, advertising and publicity, utilities such as electricity,

water, and fuel, and maintenance dues.

There is a need for Jim to determine these costs because the success of his

business depends on its capacity to pay these costs, at the same time gaining a profit

out of it. Jim has to set a goal for his business to be able to settle these fixed and

variable costs, while also weighing whether these costs are worth risking.

References:

Farnham, P. G. (2014). Economics for managers. Pearson.