What Are Explicit Costs?
Explicit costs are standard business expenses that feature prominently in a company’s general ledger and have a direct impact on its profitability. Given their clearly defined dollar amounts, these costs flow through to the income statement and are crucial for accurate profit calculation. Examples of explicit costs include wages, lease payments, utilities, raw materials, and other direct costs.
Key Takeaways
- In accounting, explicit costs are tangible and easy to track. They appear in the general ledger.
- These costs are essential for calculating a company’s profit as they directly affect the bottom line.
- While the depreciation of an asset cannot be traced physically, it is still considered an explicit cost as it links back to the cost of the underlying company asset.
Why Understanding Explicit Costs is Crucial
Explicit costs, also known as accounting costs, are easy to identify and link to a company’s business activities to which they are attributed. They appear in a company’s general ledger and flow into the expenses listed on the income statement. The [net income (NI)] of a business represents the remaining income after all explicit costs are met.
These costs are the primary metric necessary for calculating a profit, significantly impacting a company’s bottom line. Explicit costs also play a pivotal role in long-term strategic planning and budget forecasting.
Explicit Costs vs. Implicit Costs
Explicit Costs
Explicit costs involve tangible assets and monetary transactions. They are easy to identify, record, and audit due to their paper trail. Some common examples include expenses related to advertising, supplies, utilities, inventory, and purchased equipment. Depreciation, despite being intangible in nature, qualifies as an explicit cost because of its connection to the cost of an underlying asset.
Implicit Costs
In contrast, implicit costs are intangible and not directly itemized as business expenses. They often represent opportunity costs or the potential benefits that a business forgoes when choosing an alternative course of action. An example of an implicit cost is the time invested in one business activity that could otherwise enhance a different aspect of the business.
Companies use both explicit and implicit costs to calculate economic profit, which represents the total returns a company generates while incorporating all costs incurred. In comparison, accounting profit is simply the remaining revenue after deducting explicit costs.
Frequently Asked Questions (FAQs)
What Are Explicit Costs?
Explicit costs are tangible expenses that contribute to a company’s general ledger and profitability, examples including wages, lease payments, utilities, and raw materials.
What Are Implicit Costs?
Implicit costs, though not explicitly stated, represent the cost of opportunities foregone— the potential benefits a business misses out on by choosing one decision over another.
What Is Accounting Profit?
Accounting profit refers to the money left over in a business after explicit costs are deducted from the total revenue.
What Is Economic Profit?
Economic profit considers both explicit and implicit costs and measures how a company fares compared to its competitors. A company can have a positive accounting profit but a zero economic profit.
The Bottom Line
Explicit costs are the out-of-pocket expenses incurred during the production of goods or services. These costs are clear and easily identifiable, playing an essential role in making informed financial decisions regarding pricing, production, and resource allocation. Effective management of explicit costs enables businesses to optimize their resources and secure sound financial health.
Related Terms: Implicit Costs, Economic Profit, Accounting Profit, General Ledger, Opportunity Cost.
References
- ClearTax. “Explicit Cost”.
- Organisation for Economic Co-Operation and Development (OECD) Statistics, via Internet Archive. “Glossary of Statistical Terms: Profit”.
