Updated July 17, 2023
Definition of Explicit Cost
Explicit cost refers to all accounting costs which the business incurred in actual in production and selling of its output and is deducted from total revenue to derive the accounting profit. Thus the explicit cost is actual expenses directly incurred by the business, easily identifiable, and are admissible by the business as the cost of production following the accounting rules followed by it. it is also known as out of pocket cost.
Explanation
The business incurs a lot of expenses to produce a product or service. these costs can be broadly classified into the explicit cost (the one which is incurred by the business) and implicit cost (opportunity cost etc). Explicit costs are those costs that are easily identifiable, measurable, and can be validated as well by the business as they are recorded in the books of accounts of the business.
Explicit cost doesn’t leave any room of confusion as these are real cash outflows and impact business cash flows. Further explicit cost items are analyzed to understand and take action where necessary to improve the efficiency of the business.
Examples of Explicit Cost
All cost which is directly incurred by the business and form parts of its book of account is explicit costs. The financial statements which are analyzed by various stakeholders include all explicit costs incurred by the business. Let’s understand the explicit cost with the help of an example:
Springboard company has provided the following information for the year ended 31.03.2020. based on the below information compute the accounting profit.
|
Account Name |
Amount in USD |
| Net Revenues | 250,000 |
| Expenses
Rent paid Electricity charges paid Salary Interest paid Raw material cost The implicit cost of owner premises Implicit salary of Promoter skillset |
20000 5000 9000 15000 120000 15000 20000 |
Based on the above let’s compute Accounting Profit:
- Accounting Profit = ($250000 – $20000 – $5000 – $9000 – $15000 – $120000)
- Accounting Profit = $81000
For computing accounting profit, we have not taken the cost of owner premises and promoter knowledge as these are implicit cost and can’t be measure directly like explicit cost.
Representation of Explicit Cost
Explicit cost is a tangible cost which is well documented and forms part of business expenditure. It is a representative of the cost incurred and is tracked by business to measure its efficiency and efficacy on various business parameters. Explicit costs are closely tracked by analysts and stakeholders in measuring business performance.
Uses of Explicit Cost
There are many uses of explicit Cost. Few are enumerated below:
- The first and foremost use of Explicit Cost is to measure the profitability of the business as this cost is directly adjusted from Revenues to determine Profit.
- It helps in analyzing the long term trend for the business as different cost trends can be analyzed over a period and projection can be undertaken easily.
- Explicit cost form part of the Income statement. An income statement is incomplete without Explicit Cost.
Importance of Explicit Cost
Explicit cost is important and an indispensable part of the business. These costs are accounted for and its importance is well understood. Explicit cost is accounting costs that involve actual payments made by the business for different goods and services which are required in the regular running and production activities of the business. It is important to note that for measuring profitability only explicit cost is taken into consideration as the implicit cost is used for measuring economic profit for the business.
Advantages of Explicit Cost
Some of the advantages are:
- Explicit cost is a reliable source of determining business expenses which are well accounted and included in Income Statement.
- Easily recognizable and can be ascertained in cash leaving no room for ambiguity in ascertaining the cost.
- Explicit cost is required for computing both accounting profit as well as economic profit. Even if a business wishes to include opportunity cost for determining total return they will have to include explicit cost and if they just want accounting return then also the explicit cost is a must.
- All reporting and recording of costs undertaken by businesses relate to explicit costs. However, there are other non-cash expenses also which form part of business expenditure which is not an explicit cost.
How Explicit Cost Differs From Implicit Cost?
The two costs are frequently named whenever business performance is to be measure. however, the two costs differ. Key differences are enumerated below:
|
Basis |
Explicit Cost |
Implicit Cost |
| Meaning | It refers to all direct cash expenses undertaken by the business which forms part of the income statement. | It refers to those costs which cannot be ascertained directly and which are more of an opportunity cost perspective. |
| Type of Profit | It is required to be included for computing both accounting profit as well as economic profit. | It is required to be included for computing both economic profit only and doesn’t form part of income statement. |
| Opportunity Cost | It doesn’t involve the concept of opportunity cost | It is based on the premise of opportunity cost itself. |
| Rationale | The purpose of including explicit cost is based on the premise that whatever cost incurred which can be determined and decimated only needs to be accounted for. | The purpose of implicit cost is to include all those expenses which are not directly determinable; however, all those costs have directly contributed revenues for the business and true measure profit will be one which includes these costs as well. for instance, time spent by promoter using their expertise, usage of owner premises which otherwise would have been utilized/rented elsewhere is some examples of implicit cost. |
Conclusion
Explicit cost is direct cash outflows undertaken by the business in its regular business operations. these costs can take the form of wages, salaries, interest paid, material cost, etc, or any other cost which can be thought of and which can be ascertained as directly incurred by the business. Here it is important to note that explicit cost involves a cost that results in cash outflow and as such expenses like depreciation and amortization which are non-cash expenses are not explicit cost.
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