In this module, I want to tackle ahead on the intriguing difference between

how the bean counters in the accounting department of a firm measure profits and

how economists do so.

And of course make the case that the economists definition of

profits is the more relevant one for making most business decisions.

In a nutshell, a financial accountant will only count explicit costs.

In contrast, an economists will count both explicit and implicit cost.

So what is the difference between explicit and implicit cost?

Well if you remember our lesson in which Pradesh and Maria were trying to decide

whether Pradesh getting an MBA degree might be a good investment for their family.

Maria's calculations certainly counted the explicit cost of the school tuition and fees.

But Maria also included the implicit,

so called opportunity cost,

of the wages that Pradesh would have to forego by going back to school.

More broadly in a business context,

explicit cost or the firm's monetary payments to outsiders for things like labor,

materials, fuel, transportation and power.

In contrast, implicit opportunity costs represent the money

payments the firm could have earned by

employing its resources in their best alternative use.

In fact the implicit opportunity cost of business decisions are often far more

important than the strategic decision making process than the explicit cost.

Let me Illustrate this point with this example.

Suppose both you and your spouse earn after tax salaries of

$45000 a year as sales representatives for a hospital equipment distributor.

But, you have much higher aspirations and no shortage of entrepreneurial ambition.

So what do you do?

Well you both quit jobs to open up

your own business and one that leverages your expertise in health foods.

In fact your new business is a health food juice bar called,

Juice me up, Scotty.

For your startup capital,

you borrow $20000 from the bank at10 percent interest.

You kick in another $30000 of your own savings that had been earning you $1500

annually in interest income from your portfolio bond investments.

And, you also kick out the tenant in the storefront that

you own so you can use it for your own business.

A tenant by the way who is paying you $800 in rent per month.

Now take a look at this income statement that your accountant

has prepared for your business after a year of operation

Items two, three and four represent your cost of goods sold,

which are basically your variable costs.

These total $97000 and include employee compensation,

operating costs such as utilities and materials like

the 400 pounds of carrots and 1000 bushels of oranges that you juiced.

Items six, seven and eight represent your fixed costs because,

in the short run as we know,

these costs can't be changed.

You can see that these fixed cost total another

$18000 and they include things like selling and administrative costs as well as rent,

which your case is zero cause you own the building.

And also note this curious item as part of the fixed cost of running your business,

there is also a category called, depreciation.

Here's how to think about this category of expense.

When your company buys say,

a cash register for your store,

It may have an estimated useful life of 10 years.

So each year you are in operation,

you are in effect using up a portion of that machine's useful life.

Appreciation is therefore simply a way of measuring and

accounting for the annual cost of each capital input that your company owns.

That's depreciation. Now subtracting net sales from operating expenses.

You come up with a net operating income of $140000.

Not to sharp but of course from

this net operating income you will also

have to subtract the taxes you pay to the government,

as well as the interest payments on your loan.

So what's your bottom line.

Well you wind up with an accounting profit of net income before taxes of $135000.

But in after tax accounting profit of $ 90450.

And that looks pretty good for a year's work, doesn't?

And it is at least a few dollars

more than the $90000 you and your spouse earned in your old jobs.

So all in all and given that you are now your own bosses,

maybe this is all worth it, right?

But wait, what implicit costs have you ignored in this calculation?

Think about that for a few minutes and try redoing the analysis as an economist,

rather than as an accountant and tell me what your bottom line really is.

Take a minute to pause the presentation now to do

so and this exercise is well worth doing.

Here's my calculation.

It shows that at least in this case you and your spouse actually

wound up being worse off by going into business for yourselves.

Consider that by providing your own financial capital,

you gave up $1500 in foregone interest.

In addition, by kicking out your tenant you also gave up $9600 in annual rent.

And then of course there's the aforementioned $90000 in after

tax salaries and you and your spouse gave up to work for yourselves.

Tracking all of these implicit costs from the accounting profit,

you actually wind up throw all your blood,

sweat and carrot juice with a negative economic profit,

that's not very good. In fact,

people make mistakes like this all the time,

in both their personal and professional lives because they

base important decisions on accounting rather than economic profits.

So please be careful and always consider

your implicit costs and opportunity costs when you make a decision.

And of course, with this example I certainly don't want to

discourage you from being entrepreneurial, quite the opposite.

Instead I just want to help you choose

the right enterprise when it comes time to maybe set up your own.

With that said, it's on to an overview of

the important field in business of

operations and supply chain management in the next module.

Well have at it, when you're ready.

Accounting vs. Economic Profits

Strategic Business Management - Microeconomics

Meet the Instructors