Explicit Costs

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Last Updated:January 18, 2024

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What Is Explicit Cost?

Explicit costs, also known as accounting costs, are simple to identify and relate to the business activities attributable to the expenses.

They are reported for a company's general ledger and pass through to the income statement's expenses.

After all explicit expenditures have been paid, the residual revenue is reflected in a business's net income (NI).

They directly influence a company's bottom line (Net Profit); explicit expenses are the only accounting charges required to determine a profit.

The explicit cost measure is particularly useful for long-term strategic planning in businesses.

When a firm buys ad space in a newspaper, it pays the newspaper agency in cash. This is an actual cost documented in the income statement and general ledger.

As a result, advertising costs are classified as explicit expenses.

However, when managers devote time to educating subordinates, the cost is intangible—no money is spent. As a result, training is not an outright cost.

Ordinary business costs that appear in the general ledger and directly impact a company's profitability are known as explicit costs. These costs have monetary values that are clearly stated and passed through to the income statement.

These costs include wages, leasing payments, utilities, raw materials, and other direct expenditures.

They are referenced in a company's financial statements. They are observable expenses for which actual financial payments are made.

Depreciation and amortization cannot be considered since these expenditures must result in a cash outflow.

These costs are a company's actual expenses, often known as explicit expenses.

These costs are reflected in the financial accounts of the firm. It encompasses all direct and indirect costs associated with a company's operations.

An expense must meet three characteristics to be deemed an "actual cost":

The expense should be paid in cash—there should be a cash outflow
It should be a measurable cost
It should reflect on the financial accounts of the company.

An explicit cost is a tangible expense resulting in a cash outflow documented in a company's books of accounts. It is also known as an explicit expenditure.

Explicit expenses are calculated by adding all company expenses together. Therefore, it is a crucial part of auditing and accounting.

A non-tangible expense, often known as opportunity cost, is the opposite of implicit cost. However, cost accountants concentrate on these costs and cost management.

explicit Costs Vs. implicit costs

Explicit costs are associated with actual assets and monetary transactions and lead to genuine business prospects. Moreover, their paper trail makes explicit expenses simple to identify, document, and audit. These costs include advertising, materials, utilities, stock, and acquired equipment.

Depreciation expenditure is an explicit cost since it corresponds to the cost of the underlying asset owned by the firm, even though it is not a physically traceable activity.

Implicit or implied costs, on the other hand, aren't explicitly defined, specified, or recorded as expenses. These costs frequently include intangibles and are referred to as potential costs worth the best alternative that is not chosen.

Time spent on one business activity that may be best invested in another is an example of an implicit cost.

When assessing a business's operations, including earnings, management will use explicit costs; however, implicit costs will only be calculated when making decisions or choosing between various options.

Companies employ explicit and implicit costs when assessing a firm's economic profit—defined as the total return a company obtains based on all expenditures paid to achieve that revenue.

Economic profit is frequently used to decide whether a company should enter or depart a market or sector.

An explicit cost is a monetary expense that can be quantified. To put it another way, the corporation has spent $5000 on 5/hour Wage, energy prices, and rent, for example, are all instances of such costs.

On the other hand, an implicit cost is an expense of choosing one choice over another. Choosing not to work overtime, for example, the implicit cost will decrease since no extra wage is added.

Explicit costs involve productive assets and monetary transactions, which result in real-world market possibilities. In addition, clear expenses are easier to identify, disclose, and audit because of the paper trail.

Specific expenditures include ad charges, supplies, services, inventory, and equipment purchases, to name a few.

Even though depreciation is not a physically measurable procedure, the value of depreciation is a real expense since it is linked to the cost of the underlying asset owned by the company.

Implicit or inferred costs, on the other hand, are not expressly specified, recorded, or acknowledged as expenses. They frequently deal with intangibles and are referred to as the cost of opportunity—the worth of not-so-good alternatives.

Time spent on one corporate operation that may be better spent on a specific endeavor is an example of an implied expenditure.

When analyzing a company's actions, including earnings, management will utilize explicit costs; however, implied costs will be used solely when making decisions or choosing between various options.

How to Calculate Explicit Costs?

As simple as knowing your company expenses, calculating these costs is straightforward. Add all your business expenses to the general ledger to compute the costs.

This might include things like insurance, rent, equipment, supplies, and the cost of items sold, among other things. Keep in mind that costs differ from one company to the next.

As a result, there is no one-size-fits-all formula for calculating it. However, it is rather simple to calculate if you have a list of your company costs at your fingertips.

For example, Kingsman Tailors' accounting department is looking for the total explicit costs for 2021. The following are the specifics of different costs for 2021:

$108000 in raw material consumption,
$14000 in advertising expenses,
$9000 in electricity expenses,
$10000 in office rent,
$15000 in factory rent was given to the owner of Kingsman Tailors
Purchase of new equipment for $60,000,
compensation for office employees of $30,000, and
salaries for factory workers totaling $40,000

Explicit Cost = Raw material + Advertisement + Electricity bill + Office rent + Equipment + Salary + Wages

EC = 108000 + 14000 + 9000 + 10000 + 15000 + 30000 + 40000 = $226,000

Thus, the total explicit expense for the year 2021 is $226.000. In the above calculation, we have excluded the factory rent since it is never paid—the factory belongs to the owner of Kingsman Tailors.

Another example. The general accountant, James, is asked by Company X's boss to calculate the explicit expenses over five years.

The manager wants to determine if the cost-cutting approach he is enacting produces results.

James gathers data from 2011 to 2015 and prepares an Excel file that looks like this:

James discovers that the company's explicit costs climbed by 44.9 percent between 2001 and 2015.

Inventory is up 8.2 percent, rent is up 11.1 percent, mortgages are up 20.0 percent, and advertising is up 30.1 percent.

The cost of raw materials has decreased by 1.7 percent, salaries have climbed by 6.3 percent, and the cost of power has increased by 2.9 percent.

Explicit expenses have a direct influence on the profitability of the company. The manager's cost-cutting approach is unsuccessful, as evidenced by a 45 percent increase in explicit expenses.

The company must handle these costs to achieve profitability by reducing advertising, mortgage, and inventory expenditures. The management must ensure that the company's sales stay high to sell inventory.

relation between the explicit and implicit cost to company profit

The distinction between explicit and implicit costs is linked to two additional terms: accounting profit and economic profit. The bottom line of a company's income statement is its accounting profit.

Accounting profit: They are computed by deducting a company's explicit costs from total sales and calculating the remaining profit. Its calculations solely analyze explicit costs – revenues vs. expenses and cash flow in versus cash flow out.
Economic profit: Consider both the explicit and the implicit expenses. As a result, total revenue minus explicit expenses minus hidden costs equals a company's economic profit.
Opportunity costs: It is typically defined as the hidden costs that a firm incurs. The term "opportunity costs" refers to the expense of the most valued option forgone among the several options for using or deploying a company's resources. Consider the following scenario to grasp the concept better.

Example

Company A has a bank account with $15,000 in it. It can leave the money in the account, where it will receive a 10% annual interest rate of $1,500.

Alternatively, it might use the funds to promote its new product line. If it opts for that option, the implied opportunity cost is the $1,500 in interest it might have received by keeping the money in its bank account.

The expense of advertising would be a precise cost. However, the value of the following best option, the decision that firm management chose against, may be considered opportunity costs.

Accounting profit must, of course, be included when evaluating a company's profitability.

However, they must also consider hidden and opportunity costs when making judgments about the business's long-term survival.