Bob and Jane decide to open their own business selling economically correct offi
ID: 1219533 • Letter: B
Question
Bob and Jane decide to open their own business selling economically correct office furniture that Jane has designed. Assume they operate this business from leased office space near their home. Also assume that they lease their computer equipment and data base software. The actual production of the furniture is subcontracted to various commercial factories as customer orders arrive and the unassembled kits are shipped via UPS to clients throughout the U.S. Their target market is small businesses including those run out of home offices. They have so much faith in the potential of Jane's designs that they quit corporate jobs in marketing and MIS administration (which jointly had earned them $300, 000 per year), and sink $600, 000 (.6 million) of their own funds into this venture at the start of their first year to place advertising in trade journals and on the internet. (Assume this $600, 000 had previously been invested in a diversified portfolio that had been averaging a 10% annual before tax rate of return.) At the end of the year they calculated that they had the following costs and revenues. a) Is Bob & Jane's economic profit different from their accounting profit? If so, how much economic profit did they earn during this first year of operation? b) What were Bob & Jane's fixed costs during their first year of operation ? Explain briefly.Explanation / Answer
Economic profit is the monetary costs and opportunity costs a firm pays and the revenue a firm receives.
Economic profit = total revenue - (explicit costs + implicit costs)
Or in calculating the economic profit, the opportunity costs are deducted from revenues earned by the business. Opportunity costs are the alternative returns foregone by using the chosen inputs.
Whereas the accounting profit is the difference between the total revenue and the total cost. This cost is only the explicit cost ignores the implicit cost.
Accounting profit= total revenue - (explicit costs)
In the above problem, they jointly quit corporate jobs which paid them $300,000 per year jointly, that is ($0.3 million) this is the opportunity cost for doing this new business.
Sink $600,000($0.6 million) of their own funds into this venture at the start of their first year to place advertising in trade journals and on internet. This $600.000 bear average a 10% annual before tax rate of return. That is the return is $60,000 ($0.06 million). This is also an opportunity cost for this business.
Total Revenue
$8.0 million
Cost
Payments to furniture subcontractors
$6.0 million
Shipping costs
$.20 million
Lease payments on office and computer equipment & software
$.20 million
Overhead expenses: insurance utilities etc
$0.10 million
Advertisement on internet and magazine (Purchased at first year)
$0.60 million
Additional sale expenses ( phones, business travel entertaining etc)
$0.30 million
Total Cost
$7.4 million
Therefore
a) The accounting profit is $(8.0-7.4)million=$0.6 million.
Here total opportunity cost is $(.3+0.06) million or $0.36 million.
Therefore the economic profit is
Economic profit = total revenue - (explicit costs + implicit costs)
or: $(8.0-7.4-0.36)million=$0.24 million.
Bob's and Jane's economic profit differ from their accounting profit.
They earn only $0.24 million economic profit in the first year operation.
b)
Payments to furniture subcontractors and Lease payments on office and computer equipment & software are the part of fixed cost as it will remain same for the next time but Overhead expenses: insurance utilities etc, Advertisement on internet and magazine (Purchased at first year) , Additional sale expenses ( phones, business travel entertaining etc) and Shipping costs all are variable cost on the basis of time and requirement.
Therefore the total fixed cost of first year is $(6.0+02) million=$6.2 million.
Total Revenue
$8.0 million
Cost
Payments to furniture subcontractors
$6.0 million
Shipping costs
$.20 million
Lease payments on office and computer equipment & software
$.20 million
Overhead expenses: insurance utilities etc
$0.10 million
Advertisement on internet and magazine (Purchased at first year)
$0.60 million
Additional sale expenses ( phones, business travel entertaining etc)
$0.30 million
Total Cost
$7.4 million