What is Explicit Cost?
Explicit cost consists of the cost incurred by the business where the actual cash payment is made for discharging such expenses like rent, salary & wages, sales promotion expenses and other general, administrative and sales expenses and these costs always result in the outflow of cash in the business organization.
These 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 a cash outflow of the company. The emphasis is on “cash” here. That’s why, if an accountant includes depreciation and amortization under this cost then it wouldn’t be correct.
Here’s how we can calculate explicit costs –
Explicit Costs = Cash outflows that are recorded in the company’s financial statements
Classification
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 the 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
There’re two kinds of profit every company ascertains – the accounting profit and the economic profit.
Accounting profit takes implicit expenses 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 expenses are and what their implied expenses. 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 expenses that are recorded in the financial statements.
Example of Explicit Cost
Let’s take a practical example so that we can understand how it works.
The top management of Kingsman Tailors asked the accountant to find out the total explicit costs for the last 5 years – from the year 2013 to 2017.
Here’s a snapshot –
- The raw materials consumption for every year is the 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 by $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 –
| Explicit Cost | 2013 | 2014 | 2015 | 2016 | 2017 |
| Raw Materials | $100,000 | $100,000 | $100,000 | $100,000 | $100,000 |
| Advertisement | $14,000 | $24,000 | $34,000 | $44,000 | $54,000 |
| Rent | $10,000 | $12,000 | $14,000 | $16,000 | $18,000 |
| Equipment | $150,000 | $125,000 | $100,000 | $75,000 | $50,000 |
| Total | $274,000 | $261,000 | $248,000 | $235,000 | $222,000 |
Explicit Cost Video
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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 –
