Explicit Cost Meaning
Explicit costs are the culmination of all direct and indirect expenses recorded in a company’s ledger. It includes expenses that impact the profitability of a business—raw material, wages, rent, administrative charges, and sales expenses.
They are mentioned in the financial statements of a firm. They are tangible costs—actual cash payments are made. These expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital. must result in a cash outflow—depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. and amortization cannot be considered.
Table of contents
- Explicit cost refers to a tangible expense that leads to a cash outflow and is recorded in a company’s books of accounts. It is also reffered to as explicit expense.
- Explicit expenses are computed by aggregating all the business expenditures. It is an important element in audits and accounting.
- It is the opposite of implicit cost; a non-tangible expense—also known as opportunity cost.
- Accountants focus on explicit expenses for cost management and strategic planning.
Explicit Cost Explained
Explicit costs, also known as explicit expenses, are the real expenses incurred by a company. Explicit expenses are recorded in the company’s financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.. It includes all the direct and indirect costsIndirect CostsIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc. spent on a company’s business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.. For an expense to be considered, an “actual cost,” it must fulfill three conditions:
- The expense should be made in cash—there should be a cash outflow;
- It should be a tangible cost;
- The expense should appear on the firm’s financial statements.
For example, when a company buys an advertisement space in a newspaper, it pays the newspaper agency in cash. This transaction is an actual expense that is recorded in the company’s income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. and general ledgerGeneral LedgerA general ledger is an accounting record that compiles every financial transaction of a firm to provide accurate entries for financial statements. The double-entry bookkeeping requires the balance sheet to ensure that the sum of its debit side is equal to the credit side total. A general ledger helps to achieve this goal by compiling journal entries and allowing accounting calculations. . Thus, advertisement expenses are considered explicit expenses. However, when managers invest time in training subordinates, the cost is intangible—there is no cash outflow. Therefore, training is not an explicit expense.
Explicit Cost Formula
There is no specific formula for computing the explicit cost. It is the aggregate of all the business expenses that leads to cash outflow. We can say that:
Explicit Costs = Cash outflows recorded in the company’s financial statements
These direct and indirect expensesIndirect ExpensesIndirect expenses are the general costs incurred for running business operations and management in any enterprise. In simple terms, when you want to buy grocery from a supermarket, the transportation cost to get you to the supermarket and back is the indirect expenses. include the following:
- Equipment and machinery purchased for the production of goods and services;
- Salary, wages, commission, bonus, and other monetary compensation paid to employees;
- Other allowances, benefits, and reimbursements—travel, food, accommodation, business trips, and healthcare expenses;
- Rent or leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.” paid for the property;
- Mortgage payments;
- Electricity, internet, water bills, and other utility expensesUtility ExpensesUtilities Expenses are the prices incurred by a Company for the usage of utilities like sewage, electricity, waste disposal, water, broadband, heating, & telephone. These are included as operating expenses in the Company’s income sheet. ;
- Taxes and legal charges;
- Advertisement, sales, and marketing expenses.
Explicit Cost Example
Let’s take a practical example:
The accounting departmentAccounting DepartmentThe accounting department looks after preparing financial statements, maintaining a general ledger, paying bills, preparing customer bills, payroll, and more. In other words, they are responsible for managing the overall economic front of the business. of Kingsman Tailors wants to find the total explicit expenses for the year 2021.
The details of various costs for 2021 are as follows:
- Raw materialRaw MaterialRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods. consumption worth $108000,
- Advertisement expense of $14000,
- Electricity expense of $9000,
- Office rent amounting to $10000,
- Factory rent paid to the owner of Kingsman Tailors – $15000,
- Purchase of new equipment worth $67,000,
- Office staff salary amounting to $35,000,
- Factory worker wages aggregated to $40,000.
Explicit Cost = Raw material + Advertisement + Electricity bill + Office rent + Equipment + Salary + Wages
Explicit Cost = 108000 + 14000 + 9000 + 10000 + 67000 + 35000 + 40000 = $283,000
Thus, the total explicit expense for the year 2021 is $283.000. In the above calculation, we have excluded the factory rent since it is never paid—the factory belongs to the owner of Kingsman Tailors.
Explicit Cost serves the following purposes:
- Facilitates Profit Computation: Every company ascertains two kinds of profit—the accounting profitAccounting ProfitAccounting profit is the net income available after deducting all explicit costs and expenses from total revenue, and it is calculated in accordance with generally accepted accounting principles (GAAP). Operating expenses, labour, transportation, and sales expenses are common examples of these costs. and the economic profitEconomic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.. Accounting profit considers both implicit and explicit expenses. However, economic profit considers only explicit expenses.
- Helps in Cost Management: During cost managementCost ManagementCost management is an integral part of business management that works on the basis of estimates, where various activities such as data collection, data analysis and mechanisms, process evaluation, and event reporting are carried out so that the decision-maker can plan and control the organization's budget requirements, allowing the decision-maker to make informed decisions., finance departments focus on explicit expenses.
- Supports Corporate Strategic Planning: Companies consider explicit expenses for planning long-term profitability.
Explicit Costs vs. Implicit Costs
Comparing explicit costs vs. implicit costsImplicit CostsImplicit cost is the opportunity cost of the organization's resources where the organization calculates what the business would have earned if the resource had been employed for some other purpose instead of the business activity., they are very different. The former refers to cash or monetary expense incurred by a business—an “out of pocket” expenseOut-of-pocket expenses are the expenses that an employee pays out of their own pocket and then gets reimbursed from their employer. Transportation, meals, and lodging expenses are common examples. or cost. The latter is an opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven. that is not incurred by the company but implied.
Explicit expenses are shown on the organization’s general ledger and income statements. These expenses can be audited and used to determine a firm’s accounting and economic profits.
On the contrary, implicit costs are not mentioned in a company’s financial statements—nor is it audited. Implicit costs are only used for computing the economic profits of a business.
Rent, interest on the loan, freight charges, employee compensation, and taxes are examples of explicit expenses. On the other hand, interests on the owner’s capital and rent of the owner’s building are implicit costs.
Frequently Asked Questions (FAQs)
For computing accounting costs, only explicit expenses are considered, as they are mentioned in the general ledger of a company. Accounting costs are calculated to compute a company’s accounting profit.
Explicit expenses are evaluated as the total business-related expense incurred—reflected in a company’s cash outflow. Also, it is the aggregate of money expended on equipment, raw material, rent, salary, wages, administrative costs, sales expenses, insurance premiums, and advertisements.
Explicit is a term that denotes something which is obvious and can be expressed. In contrast, “implicit” refers to indirect or something that is implied. Thus, explicit expenses include all direct or indirect monetary expenses that a company bears in its ordinary course of business operation.
On the contrary, the implicit cost can be explained as the opportunity cost that isn’t incurred by the company but borne by it. Such costs emerge when the company relinquishes the alternative use of its resources to generate income—meanwhile pooling it into another project.
This article has been a guide to explicit costs and its meaning. Here we discuss formula, example, calculation, and explicit costs vs. implicit costs. You may learn more about Corporate finance from the following article –