In the operational process, businesses spend a lot of money to produce products or services. It is known as an explicit cost related to the production factors that the company has and has a direct impact on profitability.
Understanding explicit cost
This cost is recorded in accounting ledger and is listed in the company’s financial statements, such as the balance sheet and income statement. It also directly affects the company’s profitability. Some examples include wages, rent payments, utilities, raw materials, and other direct costs.
These costs, also known as accounting costs, are easy to identify and link to the company’s business activities. Net business income reflects the residual income that remains after all direct expenses have been paid. It is the only accounting cost required to calculate profit because it has a clear impact on company profits and helps in its long-term strategic planning.
Accounting profit and economic profit
In economics, there are two main types of costs for companies. The first is explicit costs. When looking at a company’s financial statements, these expenses are deducted from the company’s revenue to get accounting profit.
Second, there is an implicit cost, which is a factor in calculating a company’s economic profit. This is equivalent to accounting profit, but it also reduces implicit costs. So economic profit is calculated by taking the firm’s revenue and subtracting both explicit and implicit costs.
Explicit cost vs. implicit costs
Here’s a comparison between the two costs:
It can be seen that the first cost involves more tangible assets and financial transactions that generate business opportunities. This species is easy to identify, record and audit because it has a track record. Apart from the above examples, depreciation expense is also an explicit cost because it relates to the primary assets owned by the company.
In contrast, implicit or implied costs are not clearly defined, identified, or reported as costs. They often deal with intangibles and are described as opportunity costs. An example of implicit cost is time spent on one business activity that could be better spent on a different activity.
Is it essential to know the explicit cost?
The total amount of implicit and explicit costs represents the total economic cost, which is the total profit received by the company based on all expenses incurred to achieve that income. When evaluating business operations, companies will use explicit costs to determine the profitability of the business. However, businesses typically rely on implicit costs for decision making or when choosing between different options.
Explicit costs are easy to recognize and track because they can be calculated in cash. Carrying out these cost calculations proves to be very important as it helps in calculating profit, controlling costs, and making decisions. Accounting systems will be handy for collecting all the data and elements needed in calculating explicit costs.