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What is Explicit Cost?
Explicit costs are the costs that a company spends to pay for the wages, raw materials, utilities, advertisements, mortgage, rents etc. We record these costs in the financial statements.
The only condition is that it should be cash outflow of the company. The emphasis is on “cash” here. That’s why, if an accountant includes depreciation and amortization under explicit costs, it wouldn’t be correct.
Here’s how we can calculate explicit costs –
Explicit Costs = Cash outflows that are recorded in company’s financial statements
Explanation of Explicit Cost
As you can understand, there isn’t a set of formula that can express such costs; however, there are few conditions that the “item” should adhere to, to be considered as an explicit cost.
Here are these conditions –
- First, the “item” should be expended in cash. For example, if you are buying advertisement space in the newspaper, you need to pay cash to the newspaper company. Advertisement expenses would be thus considered as explicit expenses. However, depreciation expense doesn’t mean an outlay of cash. That means depreciation expense won’t be considered as an explicit expense.
- Second, the expense should be tangible in nature (and not intangible).
- Third, the expense should be recorded in the financial statements of the companies.
To understand this, we also should understand implicit costs. Implicit costs are costs that are actually not spent but implied. Interest on owner’s capital, rent of owner’s building etc. are implicit costs.
On the other hand, explicit expenses are just the opposite of implicit costs and they actually are called “out of pocket” costs.
Use of Explicit Cost
To understand the usefulness of explicit cost, first, we need to talk about implicit cost.
There’re two kinds of profit every company ascertains – the accounting profit and the economic profit.
Accounting profit takes implicit costs into account along with explicit expenses. However, economic profit doesn’t take implicit costs into account. If we deduct the implicit costs from the accounting profit, we get economic profit.
By using the explicit expense, the company can understand what their actual costs are and what their implied costs are. For example, if top management decides to reduce the cost of the company, they usually look at the explicit expenses and not the implicit costs.
Explicit expenses are real costs that are recorded in the financial statements.
In the example below, we will see how explicit costs are used in a company.
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Example of Explicit Cost
Let’s take a practical example so that we can understand how explicit costs work.
The top management of Kingsman Tailors asked the accountant to find out the total explicit costs for last 5 years – from the year 2013 to 2017.
Here’s a snapshot –
- The raw materials consumption for every year is same, i.e. $100,000.
- The advertisement expenses increased every year by $10,000. In 2013, the advertisement expense was $14,000.
- The rent for the factory increased $2000 every year. In 2013, it was $10,000.
- The equipment expense reduced drastically over the years. It was $150,000 back in 2013. It reduced $25,000 every year.
Find out the total explicit costs for the year 2013 to 2017.
Here’s the calculation –
This has been a guide to explicit costs, its explanation and top uses. Here we also calculate explicit costs with the help of an example. You may learn more about Corporate finance from the following article –