Question

Keri owns a landscaping business. For each of Keri's inputs given in the list below, indicate whether the associated cost is fixed or variable, explicit or implicit, and whether the cost affects accounting profit only, economic profit only, or both. [LO 12.2,12.3,12.4\(]\) a. Landscapers. b. Plants taken from her home garden. c. Truck rental. d. Owned lawn mowers.

Short answer

Landscapers: variable, explicit, both; Plants: variable, implicit, economic; Truck rental: fixed, explicit, both; Lawn mowers: fixed, implicit, economic.

Step-by-step solution

Analyzing Landscapers Cost

Landscapers' wages are considered a **variable cost** as the cost can change with the amount of landscaping done. It is an **explicit cost**, as it involves direct money outflow for wages, and affects **both accounting profit** and **economic profit**. This is because it appears in the profit and loss statement and influences the total costs subtracted from revenue.

Analyzing Plants Taken from Home Garden Cost

Plants taken from Keri's home garden are considered a **variable cost** because the quantity used can change. They represent an **implicit cost** due to the opportunity cost of using plants she could have sold. This cost affects **economic profit only**. Accounting does not reflect this opportunity cost as there is no actual cash transaction recorded.

Analyzing Truck Rental Cost

The truck rental cost is a **fixed cost** if the rental agreement is a set amount per period regardless of use, such as a monthly leasing fee. It is an **explicit cost** because it involves a direct monetary payment, impacting **both accounting profit** and **economic profit**. This cost reduces profits similar to how wages do, creating an expense line in financial records.

Analyzing Owned Lawn Mowers Cost

Owned lawn mowers represent a **fixed cost**, as they do not change with the level of output. This is an **implicit cost**, assuming the use of the mowers forfeits alternative revenue (like leasing them out). Therefore, this cost affects **economic profit only**, as it does not incur recurrent cash outflows or appear on the accounting profit statement.

Key concepts

Fixed and Variable Costs

In microeconomics, understanding fixed and variable costs is essential for analyzing business expenditures and profits.
Fixed costs are expenses that remain constant regardless of the firm's level of output or activity. Examples include the cost of owned equipment or a flat rental fee per period.
For instance, Keri's truck rental represents a fixed cost when the rental fee does not fluctuate with usage. This is because she has to pay a set amount regardless of how much she uses the truck.
Variable costs, on the other hand, change in direct proportion to production levels. Salaries based on hours worked, such as for Keri's landscapers, are a good example of variable costs. The more work needed, the higher the wages paid.
Plants from Keri's garden might also be variable, as the quantity used varies based on landscaping needs. These costs are crucial for predicting financial performance and making informed decisions.

Explicit and Implicit Costs

Explicit and implicit costs are two important cost categories in microeconomics, each affecting profits differently.
Explicit costs involve direct, out-of-pocket payments. These are straightforward to identify, as they involve actual money leaving the business. Keri's payments for landscapers and truck rental are explicit costs because they require actual cash transactions.
Implicit costs, however, are opportunity costs. They represent the potential earnings lost when resources are not used in their next best alternative. For example, if Keri uses plants from her garden instead of selling them, there's no direct expense recorded, yet she loses the potential income from sales.
Similarly, using her owned lawn mowers instead of renting them out represents an implicit cost.

• Explicit costs affect accounting records showing direct expenses.
• Implicit costs, meanwhile, are crucial for calculating true economic value and profit, influencing strategic decisions.

Accounting vs Economic Profit

Understanding the difference between accounting and economic profit helps business owners evaluate true profitability.
Accounting profit is the net income a business reports on financial statements. It's calculated by subtracting explicit costs from total revenue. It does not account for implicit costs, which is why it's seen as less comprehensive.
Economic profit, however, provides a fuller picture by subtracting both explicit and implicit costs from total revenue. It considers all opportunities foregone.
For Keri, the landscapers' wages and truck rental reduce both accounting and economic profit, as they are explicit.
However, the plants from her garden and the usage of owned lawn mowers, being implicit costs, only affect economic profit.

• Accounting profit shows the tangible, immediate financial output.
• Economic profit includes potential earnings lost, offering insight into overall long-term value generation.

Overall, assessing both types of profit is crucial for strategic planning and understanding the complete cost structure. Analyzing these factors allows Keri and other business owners to better anticipate challenges and capitalize on opportunities.