Question

You own and operate a bike store. Each year, you receive revenue of \(\$ 200,000\) from your bike sales, and it costs you \(\$ 100,000\) to obtain the bikes. In addition, you pay \(\$ 20,000\) for electricity, taxes, and other expenses per year. Instead of running the bike store, you could become an accountant and receive a yearly salary of \(\$ 40,000 .\) A large clothing retail chain wants to expand and offers to rent the store from you for \(\$ 50,000\) per year. How do you explain to your friends that despite making a profit, it is too costly for you to continue running your store?

Short answer

The profit from running the bike store is less than what you'd earn by renting out the store and working as an accountant, thus financially it's too costly to keep running the store.

Step-by-step solution

Calculate the current profit from the bike store

Subtract the total costs from the revenue to find the profit. Total costs include the cost to obtain the bikes and other expenses. Profit = Revenue - Cost to obtain bikes - Other expenses.

Calculate the opportunity cost of not working as an accountant

The opportunity cost is what you give up by not choosing the next best alternative. In this case, it is the salary you would earn as an accountant.

Calculate the total cost of running the bike store including opportunity cost

The total cost of running the bike store is the sum of operating costs and the opportunity cost (the accountant salary foregone).

Analyze the net benefit of renting out the store

Calculate the net benefit of renting out the store by subtracting the profit from running the store by the rent offer and add the accountant's salary.

Explain the most profitable option

If the profit from continuing to run the store is less than the combined total of renting out the store and working as an accountant, then financially, it makes more sense to rent out the store and work as an accountant.

Key concepts

Understanding Economic Profit

Economic profit is a measure of performance that considers both explicit costs, such as raw materials and labor, and implicit costs, like the value of alternatives you’ve given up. To illustrate, let’s consider your bike store scenario. You have your accounting profit—the direct financial gain which is \( \$200,000 - \$100,000 - \$20,000 = \$80,000 \). However, economic profit also factors in the \( \$40,000 \) you forego by not working as an accountant. Thus, the economic profit is lower than the accounting profit because it includes the opportunity cost, or the cost of the foregone salary. This is a critical concept because it impacts decision-making in business and personal finance, encouraging a deeper analysis beyond apparent profits.

Economic profit is an indicator of efficiency, revealing whether resources could be allocated in a more profitable manner elsewhere. In your case, when considering opportunity cost, you may find your resources—time and effort—could be more profitable if used differently.

Breaking Down Accounting Profit

Accounting profit, the more commonly reported figure in financial statements, is simpler than economic profit as it only considers explicit costs. These are the tangible expenses such as your cost to obtain bikes and other direct operating expenses. For your bike store, this accounting profit is calculated by subtracting these explicit costs from your revenue, resulting in \( \$80,000 \). It's a crucial figure for tax purposes and provides a straightforward view of a business's performance over a period. However, it does not consider the potential income you are missing out on by choosing this business over another occupation. As a result, accounting profit can sometimes paint an overly optimistic picture of financial health.

The Role of Cost-Benefit Analysis

Cost-benefit analysis is a systematic approach to comparing the strengths and weaknesses of alternatives to determine the best course of action. In your situation, it is necessary to weigh the benefit of running the bike store against the benefits of renting it out and working as an accountant. The analysis would factor in all costs, including opportunity costs, and compare them with potential revenues or savings. \( \$80,000 \) from store profits versus \( \$50,000 \) in rental income plus the \( \$40,000 \) accountant salary would be the core of this analysis. This can demonstrate in quantifiable terms why one option may be more advantageous than the other, guiding your decision and helping you explain it to others.

Total Costs in Business Decision-Making

Total costs encompass both the explicit and implicit costs of doing business. For your bike store, this includes not only the \( \$100,000 \) to obtain the bikes and the \( \$20,000 \) in other expenses but also the opportunity costs such as the accountant salary you're foregoing. Total costs influence business strategy because they represent the true economic expense of running a business. Recognizing the breadth of these expenses, as done in step 3 of the provided solution, is crucial in assessing whether the revenue generated is sufficient to justify these costs and support the viability of the business.

Considering Foregone Salary in Opportunity Cost

A foregone salary is a significant part of the opportunity cost when running a business. It represents the income you could have earned had you chosen a different career path—in this case, as an accountant. This potential income, \( \$40,000 \), which is not received because you are dedicating time to your store, must be accounted for when calculating the true profitability of the business, as highlighted in steps 2 and 3 of the solution. When the foregone salary is high enough, it may lead to a situation where continuing the business is not the most financially beneficial option, which is the essence of what you’re explaining to your friends in this scenario.