Profit+-+the+difference+between+economic+and+accounting+costs,+economic+profit,++economic+losses,+and+zero+economic+profit

by Carrie Pickering
"People often refer to an enterprise system as a profit system. This is a mistake. It is a profit //and loss// system, and the loss part, in my opinion, is more important than the profit part. The crucial difference is not in what ventures are undertaken. The crucial difference is in what ventures are continued and which ones are abandoned...The crucial requirement for maintaining growth and progress is that successful experiments be continued and unsuccessful experiments be terminated." Milton Friedman (Sowell, 2000)

__What will this article do for my education in economics?__
What will a study of the most basic levels of economics produce? What ramifications will this have in your life? Hopefully these life shattering questions will be answered by you reading through this entire entry. (However, if you must know the reason behind this entry please read the next two sentences.) This section is designed to help you see that when economists, not accountants, speak about costs they are speaking about opportunity costs. Economic terms such as opportunity cost, economic profit, economic loss, and zero economic profit help to explain why scarce resources move into and out of the economy.

__Economic Costs vs. Accounting Costs__
If you are like most people you hear the word "profit" and immediately accounting profits spring to mind. Accounting profits usually show up in an organization's income statement and are referred to as //explicit costs//. Explicit costs are business expenses that are easily identified and accounted, for example cash outflows from a business that reduce its bottom-line profitability.What are accounting profits? Accounting profits are //Total Revenue minus the Cost of Producing Goods/Services// (Baye, 2006) Economic profit is the difference between //Total Revenue and the Total Opportunity Cost of Producing Goods/Services//. Economic profit is referred to as the //implicit cost// of giving up the next best alternative use of a resource used in producing the good/service. The opportunity cost of producing a good/service is usually higher than the accounting cost because it includes both //explicit// and //implicit// costs (Baye, 2006). Implicit costs can be hard to measure, but hardworking managers will seek to calculate them. Implicit costs are intangible costs, for example the time and effort that an owner puts into the maintenance of the company rather than working on expansion. In essence when studying economics all costs are opportunity costs because resources are scarce and could have an alternative use. Now our equation for economic profit really looks like this: //Economic Costs//=Opportunity Costs//=Explicit Costs + Implicit Costs//. By measuring Accounting Costs and Economic Costs an accurate picture of a market can be seen. This can allow a company to decide to enter into a market, stay in a market, or to leave a market.

What you should remember: Explicit Costs = easily identified and accounted for cash outflows Implicit Costs = opportunity cost of forgoing an alternative, hard to measure Accounting Profit = TR – explicit costs Economic Profit = TR – explicit and implicit costs = Opportunity Cost


 * __Do everyday people take implicit and explicit costs into consideration?__**

Historical examples of abundant and scarce resources abound. Take for example the California Gold Rush. In the beginning people rushed out to make their fortune. And more than likely the first gold miners who came earned a good deal of money. As miners came towns sprang up, businesses such as a store selling shovels prospered. Yet as more and more miners moved in to the mining market, gold became scarce. The scarcity of gold then led to less people coming, a decrease in shovel sales, and ultimately to the decrease in miners and the abandoning of mining towns. Did you see the entering into the market, the decision to stay, and the decision to exit? Did you see where money was made, someone broke even, and maybe someone lost money? Maybe the store owner did not account for all implicit and explicit costs, but he certainly knew when fewer people were moving into town and buying less shovels.

You can even consider technologies this way. Do you remember VCR's? Do you own one anymore? What was the next best alternative for companies who produced VCR's?

Want another example that helps to explain this most basic of economic theories? According to Fisher and Quayyum, high levels of home ownership and residential investment are an excellent example. It was found that high levels of technological progress created vast wealth, which led to an increase in home ownership (Fisher and Quayyum, 2006). With more money, more people were able to purchase homes. Money was no longer scarce which led to people entering into the housing market. What happens if money becomes scarce again? You can look at the extremely high levels of foreclosures in the summer and fall of 2007. People moved into the market and now people are moving out of the market. What are opportunity costs of owning a home vs. renting?

__Economic Profit, Economic Losses and Zero Economic Profit__
If you wanted to calculate your implicit and explicit costs to determine when to enter, stay in or leave a market, and determine what type of economic profits you are generating how do you do that? The best way to show this is by looking at a business. These examples are taken from notes for an economics class at Michigan State University.

__Economic Profit means Entering or Stay in the Market__ Remember that economic costs are different from accounting costs and therefore to find economic profit you must use implicit and explicit costs. The following example is from investopedia.com. Invest 100,000 to start a business, you earn 150,000 in profit, but you could have earned 45,000 in a position in another company Accounting profit= 150,000-100,000=50,000 Economic profit= 150,000-100,000-45,000=5,000

Your firm’s total revenue is more than adequate to cover the sum of explicit and implicit costs. In other words, sales receipts cover more than the opportunity cost of all resources used. The more profitable and greater the resource the more competition will enter into the market. You are receiving more money than the alternative uses of your time and capital. You would choose to stay in the market.

__Economic Loss means Leaving the Market__ What if economic costs, the sum of explicit and implicit costs were larger than your firm's total revenue? This means you have an economic loss. Negative economic profit, therefore, causes resources to move to alternative activities where markets value their services enough to at least pay their opportunity costs. A good example: if economic profit were negative for one or more firms in a high tech industry for any length of time firms would go out of business and people would look for opportunities elsewhere. Invest 200,000 to start a business, you earn 150,000, you could have earned 80,000 in a position with another company. Economic profit= 150,000-200,000-80,000= -130,000

__Zero Economic Profit__ Is it possible to have economic profit of zero? Of course! This simply means the opportunity costs are covered by sales of products and services. Because all resources are receiving just the amount they could get in their best alternative uses, there is no incentive for any of them to be put to use in another activity. A good example: if economic profit were zero for each and every firm in the automobile industry, there would be no one going out of business and leaving. And there would also be no firms entering the industry because they would be earning a profit elsewhere.

__Questions__ 1) Which of the following is true about economic costs? a. Easy to quantify because implicit costs are simple to calculate b. Used as a part of GAAP and income statements c. Are not used by managers to help make decisions d. Are explicit costs and implicit costs The answer is d. Economic costs are explicit and implicit costs. Good managers use them to make decisions, even though implicit costs may be difficult to quantify.

2) From the article above a good definition for opportunity cost is: a. The cost of resources that are forgone when a decision made. b. How much it cost to purchase raw supplies c. The cost of goods sold d. The cost of wages The answer is a. According to Baye opportunity cost is defined as the cost of explicit and implicit resources that are forgone when a decision is made.

3) A young boy decided to sell lemonade. He made $45.00 in revenue. He spent $12.00 on supplies and he could have made $27.00 mowing lawns. What is his accounting profit? a. $18 b. $33 c. $45 d. $39 The answer is b. Accounting profit only considers revenue and explicit costs. In this case it would be $45-$12=$33.

4) Using the same numbers as above does the little boy have: a. Economic loss b. Zero economic profit c. Economic profit The answer is c. The little boy has economic profit. Taking into consideration all costs including opportunity costs the answer looks like this: $45-$12-$27=$6 of economic profit.

5) A man owns a small building in down town Indianapolis that he runs a coffee shop out of. At the end of the year he realizes costs of $20,000, revenues of $80,000. His accounting profit is $60,000. What is an implicit cost for this man? a. Money earned from renting the building. b. The costs of $20,000. c. Cost of wages paid to employees. d. Cost of maintenance on the building. The answer is a. Implicit costs are the cost of giving up the next best alternative. Instead of running a coffee shop the man could have rented the building.

__References__

Baye, Michael R., //"Managerial Economics and Business Strategy"//, McGraw-Hill Irwin. 2006.

Fisher, Jonas D.M., Quayyum, Saad, “//The Great Turn-of-the Century Housing Boom//”, Economic Perspectives, 2006 3rd Quarter. Vol. 30 Issue 3.

http://www.investopedia.com/terms/e/economicprofit.asp

http://www.msu.edu/user/mercuro/opptycosts.htm

Sowell, Thomas. //“Basic Economics: A Citizen’s Guide to the Economy”//. Basic Books. 2000.

__Other Sources__

Aston, Adam. //“The State of Green”//. Business Week Online. September 2007.

Shute, Nancy. //“In Praise of Chop Suey”//. U.S. News and World Report. August 2005. Vol. 139 Issue 6.

Steverman, Ben. “//Investors Rush to Gold”//. Business Week Online. September 2007.

Warren, Marcus. //“Economic Analysis for Property and Business”//. Butterworth Heinemann. 2000.