Explicit and Implicit Cost on Firms in an Informational Efficient Environment - Essay Example

Explicit & Implicit Costs on Firms in an Efficient Informational Environment. Dept. Roll & Section 12th December, 2008 Part 01: Concepts of Explicit VS Implicit Costs & Efficient Informational Environment Explicit Cost: An Explicit cost is the familiar as money cost as it is paid directly in money. Explicit costs occur when a firm pays for its factors of production when it uses those for producing its products and services. So an Explicit cost is a business expense that is transparent that can be easily identified such as wage, rent and materials. By calculating explicit costs, we can get the result of clear and evident cash outflows from business that decreases its end result profitability. Thus, this cost directly decreases revenue. On contrast, to make a distinction for proper understanding we can mention that intangible expenses such as goodwill and amortization are not explicit expenses because these expenses don't show clear effects on a business's revenue and expenses. Explicit Cost = Payments by a firm to purchase the service of productive resources (wages, interest, rent, capital) Implicit Cost: Implicit costs are costs that are not directly paid for but measured in units of money. These costs are the costs of non purchased inputs which are not purchased in a market transaction but they have cash value. Implicit costs occur when a firm uses its capital, inventories or owner's resources. Goodwill is also a good example of implicit cost. Implicit Costs = Opportunity costs associated with a firm's use of resources that it owns (wages foregone by owner, interest rates loss through purchases) Equation of Total Cost of a Firm: Explicit Costs (direct tangible costs) plus Implicit Costs (indirect intangible costs) Informational Efficient Environment: The term of efficiency assumes an informational dimension here, which refers to productive efficiency that it high lights the development of informationally efficient finncial markets.In fact, these markets not only consist of the usual attributes of financial market- notably a large number of investors who have a interst of effective access in to the rich necessary information, but also the important additional assets that have ending points of well defined certain value. It is the most important question faced by economists todays to what extent firms incorporate their environmental information for achieving market efficiency. In this era of Information Technology, information is the key factor to evaluate a firm's stock price as well as its ultimate value.Investors, customers and all other stakeholders need all necessary information to take proper decision regarding investment, trading etc.So a firm should decide to disclose proper information to reach its ultimate goal. Part 02: Measuring a Firm's costs and its goal of Profit Maximization Measuring A Firm's Costs (Opportunity Costs): Economists consider the opportunity costs of all resources of a firm to calculate its costs whether they are paid or not. Opportunity cost is of any action is the highest valued alternative foregone. Opportunity cost of a firm is the value of the firm's best alternative use of resources. Opportunity costs includes both explicit and implicit costs, and it is known as economic cost which is our concern. So economic cost indicates to the value of all resources used to produce a good or service, whether the resources are paid or unpaid. Economic cost = Opportunity Cost= Explicit cost + Implicit Cost = Total cost of a Firm. We have discussed in the introductory part about explicit and implicit costs. Explicit cost is directly paid in money whereas implicit cost is the value of resources used even when no direct monetary payments are made to these resources. Implicit cost is incurred when a firm gives up an alternative action. For example, when a firm uses its own capital, and/or uses its' owner's resources, implicit costs are incurred. So there are two main aspects of a firm's implicit cost: i)The cost of a firm's own capital: If a firm rents capital from another firm, the cost of rental payment is the explicit cost. But if a firm uses its own capital, it incurs an implicit cost or the implicit rental rate of capital which consists of interest foregone, rent foregone and economic depreciation. ii)The cost of the owner's resources: A firm's owner offers his or her resources in two ways: a) As an entrepreneur: The skills and talents of a owners might be used as a entrepreneur in operating another business and receive a return called normal profit. b) As a labor: it is the wage return to the labor . The opportunity cost of the time spent by the owner to run the firm is the wage income foregone by not working in the best alternative job. Economic Profit of a Firm: Economic Profit = Total Revenue - Total Economic Cost = Total Revenue - Opportunity Cost = Total Revenue - (Explicit Cost + Implicit cost) = Total Revenue - Explicit Cost - Implicit cost A Firm's Main Goal: A Firm's Main Goal is to maximize profit. To maximize profit, a firm make the following five basic decisions: What goods and services, it will produce and in what quantities What portion it will produce itself and what to source from other firms How it will produce and what production technology it will use How it will organize and compensate its managers and workers How it will market and price its products and services. So it is the crucial tasks of a firm to control its overall costs to maximize its profit and increase its stock value as well. Part 03: The Effect of Informational Efficient Environment on a Firm's Costs, Profits as well as Its Goal Explicit and implicit costs cover all the costs that an organization has to incur. Implicit costs include opportunity costs of the organization which can only be judged if organization knows the pros/cons of each and every decision. If an organization is able to achieve efficient informational environment, it can better assess the costs of capital, pros and cons of investments, present values of future cash flows, expected profits etc. The Firm's 3 main constraints: We know that there are three main constraints that limit the capacity of a firm's maximizing its profit. The constraints are: 1. Technology Constraints 2. Information constraints 3. Market Constraints Information constraint is the center point of all constraints because without proper information, a firm can not take proper actions to overcome market and technology constraints also. A lack of information is known as the uncertainty which happens because the collection of information has an important alternative cost. A firm faces the constraint regarding limited information of the quality and effort of its workforce, the current and future purchasing trends of its customers, the plan of its competitors, the changing aspects of local and global economies and market conditions. Today's competitive world market, there are many firms selling one identical product. Both firms and buyers must be well informed about the prices and products of all firms in an industry. So undoubtedly it is transparent matter that the lack of necessary information minimizes the profit of a firm. Now let us see why firms do incurs costs to disclose environmental information and does it matter Reporting of environmental information influences how a firm's financial performance is interpreted by stakeholders. In this regard, information that market participants use to forecast the environmental risks is extremely relevant and provides economic incentives for particular disclosure choices. By providing all effective information that helps a company's investors to know about its operations or performance, managers are able to gain investors' confidence by reducing the information gap between them and investors. In return, it benefits a firm to achieve the lower cost of capital, higher stock valuation multiples & interest by institutional investors, increasing stock liquidity. However, there is a potential risk of highly self serving noncredible information towards the investors. So it should be remembered that information of environmental disclosures will be critical about the firm's environmental management to be credible and value-relevant. Informational reporting strategy acts as a quality disclosure of a firm and it increases its reputation. But if the outsiders use the information copying from a firm, it is costly and harmful for that firm. For instance, competitors or pressure groups would use some information of a firm as the evidence of poor environmental management to show the firm as the poor business partner. So a firm should be careful to disclose the information so that it does not compromise their financial condition and doesn't allow any third parties to action against them. In case of ownership that is widely distributed and consists of important proportion of foreign investments, it is effective to provide higher quality environmental disclosure. The foreign investors are far away from the management and incur extensive costs to collect all necessary environmental information to reduce the information gap between them and managers. So the action of disclosing all valued information by managers is very crucial for shareholders. Moreover, a firm with low financial leverage may release potentially damaging, but incredible, environmental information that will give them reputation as a quality discloser. Finally, it is also observed that a firm with old production assests has an economic incentive to provide environmental information as it may make the investors aware that old facilities are more polluting than newer facilities. Besides investors, there is also a range of other stakeholders such as clients, suppliers, employees and governments. So it is the implicit social responsibility of corporate mangers to manage public relations through environmental disclosures for a firm's long term existence. Otherwise it increases the implicit cost of a firm that potentially leads to the demise of a firm. The media conveys public pressures to corporate managers, and thus it plays a very important role to focus on community concerns regarding environmental issues. The influence of public pressures on corporate environmental information disclosure is two dimensional. We can see the examples of these two dimensions as follow: A large visible firm can disclose more than a small firm it can bear the burden of costs resulting from political or lobbying actions. At the same time, that firm is not so sensitive to public pressures concerning their environmental management activities as the disclosure of such type of information has no effective association with the media exposure. However, various print media can play role to highlight the environmental information of this type of firm. It is also observed that many firms disclose the same information in the consecutive years instead of their changing environmental conditions. It is seemed that the disclosure of environmental information becomes a routine process to be cost effective. The factors behind this type of sizable routinely proportion of disclosure of environmental information are economic incentives as well as public pressures. So we can say this process of disclosing environmental information becomes increasingly standardized across firms to save time and cost. The impact of environmental information disclosure on a firm's costs: It a matter of question how stakeholders evaluate firms depending on corporate environmental disclosures and in what manners such information influences their perceptions of firms. Evidence from the adoption of Section 3060 of the CICA Handbook suggests firms do not disclose some environmental information that may negatively affect their stock market value. On the Contrast, Section 3060 mandates the disclosure and recognition into financial statements of future site removal and restoration costs. Many firms delay to disclose of this information directly related to implicit liabilities and takes advantage to implement the new standard. Once such information is disclosed, the implicit liabilities become responsible for incurring the future costs of firms. In fact, no firms disclose such liabilities despite their usefulness to investors that confirms actions of managers strategically in the determination of their environmental disclosure. Moreover, regulatory bodies intervene when interest of managers conflict with that of investors. However, it is interesting to note that investors have found the information conveyed under Section 3060 to be extremely useful in assessing firm value. When firms disclose their environmental information intentionally, they trade off the costs of disclosing potentially damaging information with the potential opportunities of the extended disclosure. In this way, firms enhance their transparency and increase incredibility and reduce the uncertainty of investors. But it is also a matter of concern that stakeholders are concern of some environmental factors and operating risk to evaluate a firm depending on the disclosure of environmental information. It may affect a firm's valuation by increasing the apprehension of uncertainties in the minds of investors. For example, the disclosure of a firm's pollution performance has obviously negative market valuation. Although the existence of such type of environmental liabilities are not shown in the balance sheet, but many stakeholders consider this fact to evaluate the performance of a firm. So it is a sensitive issue and also expensive because of high costs related to the performance of firms that has impacts on environmental issues. From the past experiences of large firms, it is visible that disclosing information regarding its environmental management reduces their perceived risks, and increases the perceived value of their earnings. In other words, the more a firm discloses its environmental management information, the lower its implicit costs of equity capital. We can study in most cases that such value creation because of more information disclosure is greater than any potential reduction in value because of release of negative environmental information. It should be noted by firms that environmental disclosures will be updated rather than being a standardized process. It will involve corporations, their managers, stakeholders, governments, and society. However, there are many firms who don't receive the fullest advantage of information disclosure as its value-creation technique; instead they depend on routine and imitation to extend their next disclosure. As a result of this limited information disclosure, investors and other key stakeholders are under informed about a firm's environmental management condition and may incur a great portion of information costs. However, if every firm discloses the same specific information about environmental management, then all of them take part in the same disclosure game. In fact, it is usually seen that firms' implicit costs of their environmental performance are not assessed adequately in the current forms of financial statements. Hence, analyses and ratios in the financial statements don't consider environmental liabilities explicitly, and these lead to flawed assessments of the monetary impact of such liabilities. Conclusion: Finally, we can say that the evolution of information technology and the emergence of the web are widely used as a reporting platform. The fact is that a firm will decide the degree of environmental information disclosure to grab the market opportunities through an intensive use of web. Now-a-days we prefer the web-based information about sustainable development, environmental management practices but limited disclosure regarding capital expenditures and risks. The size of a firm, its industry and other institutional trends also play a crucial role in disclosing web-based information. Sources : 1. Exam Two Review: An Explicit Cost vs. Implicit Cost & Accounting Costs vs. Economic Costs www.usna.edu/Users/econ/pschmitt/FE210/review2.pdf 2. Alwosabi, Mohammad. Organizing Production (Chapter 9). www.staff.uob.bh/files/620922311_files/micro-notes9.pdf 3.Economic Costs. Explicit & Implicit Costs. http://academic.wsc.edu/faculty/chparke1/pcshortfirm.ppt. 4. Producer's choices (Chapter 5).The Firm's Constraints http://portal.wsiz.rzeszow.pl/plik.aspxid=11478 5 .Williams, Leighton. Information Efficiency in Financial and Betting Markets. http://assets.cambridge.org/97805218/16038/excerpt/9780521816038_excerpt.pdf 6. Cormier, Denis, and Magnan, Michel (2003). "Environmental Reporting Management: A European Perspective." http://www.camagazine.com/1/4/5/3/6/index1.shtml 7. R. Gray, R. Kouhy and S. Lavers (1995). "Corporate Social and Environmental Disclosure." www.ibe.org.uk 8.W. Aerts, D.Cormier & M.Magnan (2006).An Association between web based socio economic disclosure and financial analyst behavior under different governance regimes. http://neumann.hec.ca/cref/pdf/c-06-20e.pdf 9.Cormier, Denis, and Magnan, Michel. 2002. "The Case of Corporate Environmental Disclosure." Working paper." http://inderscience.metapress.com/ 10.Essential Economics. Opportunity Cost. www.economist.com Read More