What are Explicit Costs?
Explicit costs are business operating costs, or expenses, that are easily quantifiable and identifiable. Also referred to as accounting costs, the explicit costs of a company are recorded in its books (accounting ledgers) and become listed expenses on the company’s financial statements – such as its balance sheet and income statement.
Explicit costs are referenced as such partly to distinguish them from implicit costs. Explicit costs come with an identifiable dollar value and always involve a payment of money – for example, wages paid to employees.
Implicit costs do not involve a payment of money but do represent an expenditure of resources. An example of an implicit cost is the time required and spent training a new employee on how to operate a machine or compile and submit a report.
- Explicit costs are all the expenses incurred as part of the normal operating costs of a business.
- The costs are readily quantifiable and identifiable, and are recorded in a company’s accounting records; for this reason, they are sometimes alternately referred to as accounting costs.
- Explicit costs are contrasted with implicit costs; implicit costs represent an expenditure of resources but do not involve a direct monetary payment or cash outflow.
Two Types of Profit – Accounting and Economic
The issue of explicit costs versus implicit costs is tied to two other concepts – accounting profit and economic profit. A company’s accounting profit is the bottom-line figure on its income statement. Accounting profit is calculated by subtracting all of the company’s explicit costs from its total revenues – the remainder is the company’s profit. It only considers explicit costs in its calculation – revenues versus expenses and cash flow in versus cash flow out.
Economic profit, on the other hand, takes into account not just explicit costs, but implicit costs as well. Therefore, a company’s economic profit is calculated as total revenue minus explicit costs, minus implicit costs. The implicit costs that a company incurs are often what is referred to as opportunity costs.
Opportunity costs are used to compare various alternatives for utilizing or deploying a company’s resources. To better understand the concept, let’s consider an example.
Company A keeps $15,000 in a deposit account. It can leave the money in the account, where it will earn a 10% annual interest – $1,500. Alternatively, it can spend the money on advertising its new product line. If it chooses that alternative, then the implicit opportunity cost is the $1,500 in interest that it could’ve earned by leaving the money in its bank account.
The advertising expenditure would be an explicit cost. Opportunity costs can be looked at as the value of the next best opportunity, the choice that company executives decided against making.
Companies must, of course, look at accounting profit to assess the profitability of their business. However, in making decisions regarding the ongoing and long-term viability of the business, they must also consider implicit costs and opportunity costs.
|Explicit Costs (Easily identified and quantified; recorded in company accounting records)||Implicit Costs (With value but not easily quantifiable and not recorded in accounting)|
|Salaries and wages||Opportunity Costs|
|Rent||Time spent training a new employee|
|Material costs||Cost of temporary downtime in production|
|Marketing and advertising costs||Time and resources used creating displays|
|Taxes||Cost of capital|
Explicit Costs – Examples
As noted, the explicit costs of a company include all monetary payments that the company makes – all outgoing cash flow – in the ordinary course of operating its business.
Common explicit business costs include the following:
- Salaries, wages, bonuses, commissions, and any other form of compensation dispensed to company employees
- The cost of benefits provided to employees, such as insurance
- Material costs – Refers to any materials that a company must purchase to produce the products and/or services that it sells
- Marketing and advertising costs
- Rent or mortgage payments on company facilities
- Utilities, such as electricity and internet service
- The costs of purchasing or leasing, and maintaining, equipment that a company requires in order to operate, such as manufacturing machines or vehicles
- Taxes, insurance, legal fees, etc.
- Depreciation (depreciation is an exception to the definition of explicit costs as being monetary payments made; while depreciation does not involve a payment of money, it does have an identifiable, quantifiable value and represents an ordinary operating expense of a business)
CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: