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 recorded in the company’s financial statements
Here are these conditions –
- First, the “item” should be expended in cash. For example, if you are buying an advertisement space in the newspaper, you need to pay cash to the newspaper company. Thus you would consider advertisement expenses as explicit expenses. However, depreciation expense doesn’t mean an outlay of cash. That means you won’t consider depreciation expense as an explicit expense.
- Second, the expense should be tangible in nature (and not intangible).
- Third, a company should record the expense in its financial statements.
To understand this, we also should understand the 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.. Implicit costs are costs that are 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 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.The Accounting Profit And The Economic Profit.Accounting profit refers to profits that are recorded in the books of accounts calculated by deducting all the explicit cost incurred. Economic profit refers to the profit which is calculated taking into consideration both explicit as well as implicit cost.
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 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..
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 the company records in its 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..
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 and reduced by $25,000 every year.
Find out the total explicit costs for the tear 2013 to 2017.
Here’s the calculation –
Explicit Cost Video
This article 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 –