Question

A firm had sales revenue of \(\$ 1\) million last year. It spent \(\$ 600,000\) on labor, \(\$ 150,000\) on capital and \(\$ 200,000\) on materials. What was the firm's accounting profit?1.Accounting profit = total revenues minus explicit costs = \(1,000,000 – (\)600,000 + \(150,000 + \)200,000) = $50,000.

Short answer

The firm's accounting profit last year was $50,000.

Step-by-step solution

Identify the given values

The exercise provides us with the following information: - Sales revenue: $1,000,000 - Cost of labor: $600,000 - Cost of capital: $150,000 - Cost of materials: $200,000

Calculate the total explicit costs

We will add the costs of labor, capital, and materials to find the total explicit costs: Total explicit costs = Cost of labor + Cost of capital + Cost of materials Total explicit costs = \(600,000 + \)150,000 + $200,000 Total explicit costs = $950,000

Calculate the accounting profit

Now, we will subtract the total explicit costs from the total revenues to get the accounting profit: Accounting profit = Total revenues - Total explicit costs Accounting profit = \(1,000,000 - \)950,000 Accounting profit = $50,000 So, the firm's accounting profit last year was $50,000.

Key concepts

Sales Revenue

Understanding sales revenue is crucial for any business. It represents the total amount of money generated from the sale of goods or services before any costs or expenses are deducted. To put it simply, it's the starting line for calculating profitability. In our exercise example, the firm's sales revenue is \(\$1,000,000\) for the last year. This figure sets the stage for determining the accounting profit, as it's the 'top line' from which all costs and expenses will be subtracted.

Knowing your sales revenue is vital because it shows the effectiveness of your sales and marketing strategies as well as product popularity. It is the gross income from which a company starts its financial calculations. The goal is to have a high sales revenue which indicates strong sales, although this is just one piece of the financial puzzle.

Explicit Costs

Explicit costs are the direct, out-of-pocket payments a firm makes to purchase the resources it needs for producing goods or services. These costs include wage payments, rent, utilities, and materials, among others. For businesses, being mindful of explicit costs is essential as they directly affect the bottom line - the accounting profit. In the example exercise, the firm's total explicit costs amount to \(\$950,000\), which we calculated by adding up the separate explicit costs such as labor, capital, and materials.

When determining profitability, explicit costs are subtracted from the sales revenue. Reducing these costs, without compromising on quality, can significantly improve a company's profitability. Businesses often analyze such costs to make strategic decisions about where to cut expenses or invest more to increase efficiency or production capacity.

Cost of Labor

Labor costs constitute the payments to employees for their work, including wages, salaries, and benefits. It's one of the largest expenses for most companies, as seen in the example with the firm spending \(\$600,000\) on labor. The cost of labor goes beyond just the salary; it also includes overtime pay, health insurance, payroll taxes, and any other benefits the company offers its employees.

Effective labor cost management can lead to more streamlined operations and improved profitability. Businesses must balance fair compensation to retain quality employees while also ensuring that the cost of labor doesn't erode the company's profit margins too significantly.

Cost of Capital

The cost of capital refers to the returns that investors expect for providing capital to a company. It can be seen as the opportunity cost of investment, the rate of return that could have been earned had the money been invested elsewhere. For businesses, it includes the interest payments on debts and dividends on equity. In our exercise, the firm incurred a cost of capital of \(\$150,000\).

A company's cost of capital is an important factor when making investment decisions and potential project evaluations. The lower the cost of capital, the cheaper it is for a company to finance new projects and drive growth. It is critical that businesses maintain a cost of capital that allows profitability while being attractive enough to keep investors.

Cost of Materials

The cost of materials includes expenses spent on raw materials which are used to produce the final goods or services. It’s a significant part of explicit costs for manufacturing and construction businesses in particular. In the exercise, the cost of materials was \(\$200,000\). These costs fluctuate based on market prices and the effectiveness of the supply chain.

Keeping material costs under control without compromising quality is challenging but necessary for maintaining profitability. Smart purchasing strategies and good inventory management can help reduce material costs. Companies might negotiate better deals, buy in bulk, or find alternative materials to improve their bottom line.