Sometimes referred to as accounting costs, they have clearly defined amounts and are listed on the expenses section of your income statement. They always involve a payment of money. Some common examples are wages/salaries, rent, stock and utility bills. Understanding your explicit costs is important as they:
Are used to calculate profit Facilitate long-term strategic planning
Explicit Costs Vs Implicit Costs
While explicit costs are easily identified and valued, implicit costs are often difficult to quantify. For example: A coffee shop needs new equipment. The cost of that equipment is easily identified as $30,000. This is an explicit cost. The implicit cost is the loss of income while the shop was closed. The shop owners can predict what they would have made based on historical data, but they won’t know for certain. Other implicit costs from the coffee shop being closed could be:
The stock wasted from accidents, testing the equipment or being consumed by the tradespeople. The advertising that usually comes from social media. If the shop is closed, there is no content being generated by the owners or customers. This can cause a drop in brand value, which is often unquantifiable and very valuable. Training the staff to operate the new equipment, because no money is generated despite the fact they are still being paid.
Why Are Explicit Costs Important?
As a stand-alone element, explicit costs are important for three reasons:
Calculating accounting profit Planning for the future Calculating economic profit
Calculating Profit
It is common knowledge that businesses operate according to money in and money out. To be successful, you need more money coming in than you do going out. This profit is also referred to as accounting profit.
Planning for the Future
When you fully understand your explicit costs, you can start making strategic changes for the future. Some businesses experience points in their growth where they will make more money if they had more staff, but they don’t currently have the funds to recruit someone. Knowing your explicit costs allows you to see where you can make changes and free up some capital. For example, could you find a cheaper website host or use influencer marketing instead of paid advertising for a month or two? Likewise, explicit costs also show where you could improve or spend more. Do you now have the funds for a better coffee machine or a more advanced printer? Could you offer a better healthcare insurance provider to your staff or offer better financial incentives?
Calculating Economic Profit
Implicit costs deducted together with explicit costs gives you your economic profit. Economic profit is important, as it allows you to assess your company’s financial performance. To keep a company viable, you need to maintain a certain level of economic profit. While implicit costs are not always 100% accurate, they do allow you to see where you are losing money and hopefully improve your profit. When working with stakeholders, they will evaluate your economic profit to see if you are a reliable business owner that will bring them revenue. From previous income statements, they know how much it costs to run their business from the office and how much income was generated during that time. At the start of the pandemic, they might have predicted income to fall due to lower productivity while still having to pay all the office outgoings. The economic profit would have dropped significantly in that scenario. However, some industries found that working from home improved productivity, leading to a higher income. If you calculate the economic profit having removed the office-related explicit costs, the company’s profit is much healthier and may lead to a new business model.
Examples of Explicit Costs
The most common explicit costs include:
Salaries, wages, commission, incentives, bonuses Employee benefits – gym memberships, health insurance, 401K Taxes Insurance Legal fees Material costs – Anything you need to buy to make the products/service you provide Promotional materials and advertising/marketing costs Rent or mortgage – Factories, offices, stores Utility bills Purchase or leasing of essential equipment and machinery Maintenance and upkeep for equipment and machinery Depreciation
Calculating Explicit Costs
As your explicit costs are easily identified as your operating costs, overheads, or outgoings, it is easy to calculate them. Step 1: Make a list of all your costs that ensure your business is able to function Step 2: Add the costs together Example of explicit costs for a bakery It is advised that you review your explicit costs at the end of each working day, as unexpected costs do appear. Perhaps a machine broke or you needed someone to work overtime, or you needed more ingredients than you thought.
Final Thoughts
Calculating explicit costs is already something you are aware of as one of the first steps to running a business. Increasing your awareness of how they fit into a business plan alongside your implicit costs will improve your company’s overall financial health. During the various global lockdowns, implicit and explicit costs have been re-evaluated continuously to help companies survive. Those who already had a good understanding of explicit and implicit costs could adapt quicker, and with more success. Take the time to fully understand the finances of your business. It may be tempting to leave that to an accountant. But having that knowledge yourself will allow you to make faster, more informed decisions.
