Economic Profit

Chapter 1- Question 1

At the beginning of the year, an audio engineer quit his job and gave up a salary of $175,000 per year in order to start his own business, Sound Devices, Inc. The new company builds, installs, and maintains custom audio equipment for businesses that require high-quality audio systems. A partial income statement for Sound Devices, Inc.,

Revenue from sales of products and services - 970,000

Operating Cost and expenses

Cost of products and services sold - 355,000

Selling expenses - 155,000

Administrative expenses - 45,000

Total Operating cost and expenses 555,000

Income from operations - 415,000

Interest expenses (bank loans) - 45,000

Legal expenses to start business - 28,000

Income Taxes - 165,000

Net Income - 177,000

To get started, the owner of sound devices spent 100,000 of his personal savings to pay for some of the capital equipment used in the business. In 2007, the owner of Sound Devices could have earned a 15% return by investing in stocks of other new businesses with risk levels similar to the risk level of Sound Devices.

a. What are the total explicit, total implicit, and total economic costs in 2010?

Total implicit: $830,000

Total explicit cost: $555,000

Total economic cost: $1385,000

b. What is accounting profit in 2010?

Total Revenue – Explicit Cost = Accounting profit

$970,000 – $555,000 = $415,000 accounting profit.

c. What is economic profit in 2010?

Total Revenue – (Explicit cost + Implicit cost) = Economic Profit

$970,000 – ($555,000 + $830,000)

$970,000 – $1388,000 = $415,000 economic profit.

d. Given your answer in part c, evaluate the owner’s decision to leave his job to start Sound Devices. The audio engineer made the right decision to leave his job to start a Sound Device. A positive economic profit means that he made the right decision. A negative economic profit would mean that he made the wrong decision....