Comparison of Accounting & Economic Profits
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Peggy-Sue's cookies are the best in the world, or so I hear. She has been offered a job by Cookie Monster, Inc., to come work for them at $125,000 per year. Currently she is producing her own cookies, and she has revenues of $245,000 per year. Her costs are $40,000 for labor, $10,000 for rent, $35,000 for ingredients, and $5,000 for utilities. She has $1,000,000 of her own money invested in the operation, which if she leaves, can be sold for $600,000; she can invest at 5 percent per year.
1. Calculate her accounting and economic profits. Advise her as to what she should do.
2. Assume that Peggy Sue's broker promises her a 10% return on her stock portfolio. Calculate her accounting and economic profits. Advise her as to what she should do.
3. Assume that her broker was wrong—she can only get the original stock return of 5%, but assume that Cookie Monster, Inc., offers Peggy Sue $150,000 per year. Calculate her accounting and economic profits. Advise her as to what she should do.
ACCOUNTING PROFITS
Revenue
Cookie Sales $245,000
Explicit Costs
Labor $40,000
Rent 10,000
Ingredients 35,000
Utilities 5,000
Total Explicit Costs $90,000
Accounting Profit / <Loss> $155,000
ECONOMIC PROFITS (1)
Revenue
Cookie Sales $245,000
Explicit Costs
Labor $40,000
Rent 10,000
Ingredients 35,000
Utilities 5,000
Total Explicit Costs $90,000
Implicit Costs
Opportunity Cost of Owner's Time $125,000
Opportunity Cost of Owner's Capital 30,000
($600,000 X .05 = $30,000)
Total Implicit Costs $155,000
Total Explicit Plus Implicit Costs $245,000
Economic Profit / <Loss> $-0-
ADVICE: Peggy-Sue should be indifferent to owning her own business or working for Cookie Monster on the basis of her economic profits. Perceptions of future trends or preferences to "work for oneself" may be the deciding factors. These have not been figured into this basic revenue-cost analysis.
ECONOMIC PROFITS (2)
Revenue
Cookie Sales $245,000
Explicit Costs
Labor $40,000
Rent 10,000
Ingredients 35,000
Utilities 5,000
Total Explicit Costs $90,000
Implicit Costs
Opportunity Cost of Owner's Time $125,000
Opportunity Cost of Owner's Capital 60,000
($600,000 X .10 = $60,000)
Total Implicit Costs $185,000
Total Explicit Plus Implicit Costs $275,000
Economic Profit / <Loss> <$30,000>
ADVICE: Peggy-Sue should work for Cookie Monster on the basis of her economic profits (that is, a $30,000 loss). The increase in the opportunity cost of capital due to the 10% required return generated an economic loss.
ECONOMIC PROFITS (3)
Revenue
Cookie Sales $245,000
Explicit Costs
Labor $40,000
Rent 10,000
Ingredients 35,000
Utilities 5,000
Total Explicit Costs $90,000
Implicit Costs
Opportunity Cost of Owner's Time $150,000
Opportunity Cost of Owner's Capital 30,000
($600,000 X .05 = $30,000)
Total Implicit Costs $180,000
Total Explicit Plus Implicit Costs $270,000
Economic Profit / <Loss> <$15,000>
ADVICE: Peggy-Sue should work for Cookie Monster on the basis of her economic profits (that is, a $15,000 loss). The increase in the opportunity cost of her time generated an economic loss.
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The expert examines comparison of accounting and economics profits.
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NOTE: Answers are in blue.
In doing this assignment, I learned that economic profit, in comparison to accounting profit, takes into account the opportunity cost of the capital and resources invested into a business. This means that an economic profit is computed by deducting all implicit and explicit costs of doing business from total revenues. Whereas accounting profit ignores the opportunity cost or implicit cost of doing business in evaluating the performance of that business. Lastly, opportunity cost is the alternative return an investor forgoes by choosing to invest in a particular business.
In Peggy-Sue's case, if she continues her cookie business, her opportunity cost would be the alternative rate, 5 per cent, she can earn from the $600,000 proceeds if she sells the business AND the salry she can earn by working for Cookie Monster, Inc.
Peggy-Sue's cookies are the best in the world, or so I hear. She has been offered a job by Cookie Monster, Inc., to come work for them at $125,000 per year. Currently she is producing her own cookies, and she has revenues of $245,000 per year. Her costs are $40,000 for labor, $10,000 for rent, $35,000 for ingredients, and $5,000 for utilities. She has $1,000,000 of her own money invested in the operation, which if she leaves, can be sold for $600,000; she can invest at 5 percent per year.
1. Calculate her accounting and economic profits. Advise her as to what she should do.
Peggy-Sue's accounting income is $155,000 while her economic profit, taking into account the total opportunity cost of $155,000 ...
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