Explicit Cost: Definition, Examples, and How It Works

What Is Explicit Cost?

Explicit costs are normal business costs that appear in a company’s general ledger and directly affect its profitability. They have clearly defined dollar amounts that flow through to the income statement. Examples of explicit costs include wages, lease payments, utilities, raw materials, and other direct costs.

Understanding Explicit Costs

Explicit costs—also known as accounting costs—are easy to identify and link to a company’s business activities to which the expenses are attributed. They are recorded in a company’s general ledger and flow through to the expenses listed on the income statement. The net income (NI) of a business reflects the residual income that remains after all explicit costs have been paid.

Explicit costs are the only accounting costs that are necessary to calculate a profit, as they have a clear impact on a company’s bottom line. The explicit-cost metric is especially helpful for companies’ long-term strategic planning.

Explicit Costs vs. Implicit Costs

Explicit costs involve tangible assets and monetary transactions and result in real business opportunities. Explicit costs are easy to identify, record, and audit because of their paper trail. Expenses relating to advertising, supplies, utilities, inventory, and purchased equipment are examples of explicit costs. Although the depreciation of an asset is not an activity that can be tangibly traced, depreciation expense is an explicit cost, because it relates to the cost of the underlying asset owned by the company.

In contrast, implicit costs are not clearly defined, identified, or reported as expenses. They often deal with intangibles and are described as opportunity costs—the value of the best alternative not accepted. An example of an implicit cost is time spent on one activity of a business that could better be spent on a different pursuit. Management will utilize explicit costs when reviewing a business’ operations, including profits, but will calculate implicit costs only for decision making or choosing among a variety of alternatives.

Companies use both explicit and implicit costs when calculating a company’s economic profit, which is defined as the total return a company receives based on all costs incurred to attain that revenue, as opposed to accounting profit, which is the amount of money left over after costs and expenses are deducted from total revenue. Specifically, economic profit shows whether a company is earning more than the competitive norm. It can be used to determine if a business should enter or exit a market or an industry. In a perfectly competitive market, economic profit is zero.

The Bottom Line

Explicit costs are the out-of-pocket expenses incurred by a business in the production of goods or services. These costs are easily identifiable and can be directly attributed to a specific activity or business function. By accurately tracking explicit costs, businesses can make informed decisions about pricing, production, and resource allocation. Overall, businesses should carefully monitor their explicit costs to ensure that they are managing their resources effectively and making sound financial decisions.