Definition: An explicit cost is a physical outlay of cash or financial expenditure that the firm reports on its financial statements. These costs pertain to the production factors that a firm owns, utilizes, and spends money for, and have a direct impact on its profitability.
What Does Explicit Cost Mean?
What is the definition of explicit cost? Explicit costs require cash outflows towards the compensation of wages, rent, mortgage, raw materials, advertising, utilities, inventory, and equipment. Some accountants include depreciation and amortization in the explicit costs, but this is incorrect as depreciation and amortization do not pertain to tangible expenses. Conversely, employee wages, payments towards the purchase of raw materials, rent, and utility bills are explicit because they require an outlay of cash and the firm reports them on its financial statements.
Let’s look at an example.
The manager of Company X asks Philip, the general accountant, to calculate the explicit costs for a period of five years. The manager wants to see if the cost-cutting policy he implements brings, in fact, any results. Philip collects the information from 2011 to 2015, and he creates an excel file as follows:
Philip finds out that between 2001 and 2015, the company’s explicit costs have increased by 44.9%. The main increases are in inventory by 8.2%, rent by 11.1%, mortgage by 20.0% and advertising by 30.1%. Raw materials have declined by 1.7% and wages by 6.3%, whereas the electricity bills have slightly increased by 2.9%.
Explicit costs have a direct impact on the firm’s profitability. With a 45% increase in explicit costs, it is evident that the cost-cutting policy that the manager implements is ineffective. Explicit costs need to be managed so that the firm can increase its profitability by lowering its advertising, mortgage and inventory expenses. In the long-term, the manager needs to make sure that the company’s revenues remain strong so that inventories are sold. If on the other hand, the sales decline, the company needs to cut down on inventories and perhaps on staff hours to lower its explicit costs.
Define Explicit Cost: Explicit costs are cash expenditures that are incurred by a company and add up to a distinct amount.