Question

Use the following information to calculate accounting profit and economic profit. Sales \$100 Employee expenses \(\$ 40\) Inventory expenses \(\$ 20\) Value of owner's labor in any other enterprise \(\$ 40\)

Short answer

Answer: The accounting profit is \$40 and the economic profit is \$0.

Step-by-step solution

Calculate Total Revenue

Total revenue is the sales amount: \$100.

Calculate Explicit Costs

Explicit costs are the employee expenses (\$40) and inventory expenses (\$20). Therefore, the explicit costs are: \(Explicit Costs = \$40 + \$20 = \$60\)

Calculate Accounting Profit

Accounting profit is the difference between total revenue and explicit costs: \(Accounting Profit = Total Revenue - Explicit Costs = \$100 - \$60 = \$40\)

Calculate Implicit Costs

Implicit costs include the value of owner's labor in any other enterprise, which is given as \$40.

Calculate Economic Profit

Economic profit is the difference between accounting profit and implicit costs: \(Economic Profit = Accounting Profit - Implicit Costs = \$40 - \$40 = \$0\) So, the accounting profit is \$40 and the economic profit is \$0.

Key concepts

Total Revenue

When a business sells products or services, the income generated from these sales is known as total revenue. It's a crucial concept because it reflects the ability of a business to generate sales from its primary activities.

For example, if a company sells 100 widgets at \(1 each, its total revenue would be \)100. This figure is the starting point for calculating profitability. It's important to note that total revenue does not account for any costs or expenses; it simply measures the gross income before any deductions.

Explicit Costs

In the context of business and economics, explicit costs refer to direct out-of-pocket expenses that a company incurs to conduct its operations. These costs include wages paid to employees, costs for raw materials, rent for office space, and any other direct payments made to facilitate the day-to-day business activities.

Identifying Explicit Costs

In our exercise, explicit costs are clearly identified as employee expenses and inventory expenses. It is essential to accurately account for these in order to determine the overall profitability of the business. Explicit costs are deducted from total revenue to calculate the accounting profit, offering a baseline financial performance metric.

Implicit Costs

Unlike explicit costs, implicit costs represent the opportunity costs of using resources that could be employed elsewhere. These costs are not directly paid out in cash but reflect the potential income that is foregone by not utilizing resources in their next best alternative use.

For example, if a business owner works in their own company rather than taking up a job elsewhere, the salary the owner could earn is an implicit cost. Implicit costs are crucial for understanding economic profit, as they provide a broader view of a company's resource allocations and foregone opportunities.

Owner's Labor Value

When considering economic profit, it's important to factor in the owner's labor value. This figure represents the amount the business owner could have earned by working elsewhere and thus is considered an implicit cost.

This inclusion is particularly important for small businesses and sole proprietorships where the owner actively participates in running the company. By acknowledging the owner's labor value, we get a better understanding of the true economic cost of business decisions and the real profitability of the enterprise, which can often lead to a significantly different perspective than when looking solely at accounting profit.