Question

Circle the letter that corresponds to the best answer. A firm with explicit costs of \(\$ 2,000,000\), no implicit costs, and total revenue of \(\$ 3,000,000\) would have (LO2) a) zero economic profit b) zero accounting profit c) an accounting profit and an economic profit of \(\$ 1,000,000\) d) a higher economic profit than an accounting profit e) a higher accounting profit than economic profit

Short answer

c) an accounting profit and an economic profit of \(\$1,000,000\).

Step-by-step solution

Define accounting profit

Accounting profit is the difference between total revenue and explicit costs.

Define economic profit

Economic profit is the difference between total revenue and the sum of explicit and implicit costs.

Calculate accounting profit

Here, the total revenue is \(\$3,000,000\) and explicit costs are \(\$2,000,000\). Therefore, the accounting profit is \(\$3,000,000 - \$2,000,000 = \$1,000,000\)

Calculate economic profit

The economic profit is calculated by considering both explicit and implicit costs. In this exercise, there are no implicit costs. Thus, the economic profit is also \(\$3,000,000 - \$2,000,000 = \$1,000,000\) Now, let's analyze the given options: a) zero economic profit: The economic profit is \(\$1,000,000\), not zero. b) zero accounting profit: The accounting profit is \(\$1,000,000\), not zero. c) an accounting profit and an economic profit of \(\$1,000,000\): This is correct, as we calculated above. d) a higher economic profit than an accounting profit: As the accounting and economic profit are equal, this option is incorrect. e) a higher accounting profit than an economic profit: As the accounting and economic profit are equal, this option is incorrect. Based on the calculated accounting and economic profit, the correct answer is: c) an accounting profit and an economic profit of \(\$1,000,000\).

Key concepts

Understanding Accounting Profit

Let's begin with accounting profit, which is a vital concept for any business trying to determine its financial performance. Accounting profit is essentially the profit that appears on the financial statements of a company. It is calculated based solely on the explicit costs incurred, meaning those actual, out-of-pocket expenses directly associated with the business. To find accounting profit, subtract the total explicit costs from the total revenue:

\[\text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs}\]Explicit costs are straightforward and include items such as:

• Wages and salaries
• Supplies and raw materials
• Rent and lease payments
• Utility bills

In our example, the firm has a total revenue of \(\\(3,000,000\) and explicit costs of \(\\)2,000,000\). Thus, the accounting profit is calculated as \(\$1,000,000\). This figure represents the actual profit a company can report to its stakeholders.

Exploring Economic Profit

Economic profit takes a more comprehensive view than accounting profit. It not only considers the explicit costs but also the implicit costs—the opportunity costs of the resources employed by the firm. These are costs that do not typically show up in financial records but are crucial for evaluating true profitability.

To calculate economic profit, you subtract both explicit and implicit costs from the total revenue:
\[\text{Economic Profit} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})\]If a business owner invests in their company instead of another opportunity, the potential earnings from the alternative investment are considered implicit costs. However, in the example given in the exercise, there are no implicit costs. As a result, the economic profit is exactly the same as accounting profit, which is \(\$1,000,000\). In the real world, economic profit helps businesses understand if they are truly being compensated for using their resources in the current venture.

Role of Explicit Costs

Explicit costs are the monetary expenses a company incurs while operating its business. They are clear, tangible, and easy to identify. These costs are critical for accurate profit calculations as they directly affect cash flow, and they are listed on the financial statements.
Some characteristics of explicit costs include:

• They are recorded transactions, such as invoices and receipts.
• They involve the direct use of cash or other assets.
• They can be easily traced and have a definite cost amount.

Examples of explicit costs include payments for goods and services, like rent, supplies, and wages. In the context of our exercise, the firm's explicit costs amount to \(\$2,000,000\). This makes it easier to see how these impact the accounting profit directly. Tracking explicit costs helps businesses plan financially and understand the immediate impact on profitability.