Profit

____________________________________________________________________________________________________________

Such slogans as buy low, sell high or never give a sucker an even break echo peoples expectations that firms try to maximize their profits. Profit maximization is the standard economic assumption used to analyze the behavior of firms. Profit is a firms total revenue minus its total cost; loss is incurred when revenue fails to cover costs. Profits are positive, while losses are negative. Although, economists and bookkeepers define profits and losses similarly, economic profits and accounting profits often differ. Different definitions of costs explain this inconsistency. Economic vs. Accounting Costs You know that the value of the best alternative forgone is the economic cost of anything from lard to romance. All costs, whether monetary or nonmonetary are opportunity costs. One way to break down economic (opportunity) costs of production is to view them as either explicit or implicit costs. Explicit costs require outlays of money. For example, wages paid to employees, rent payments, and utility bills are all explicit costs. Implicit costs are the opportunity costs of resources the firms owner makes available for production with no direct cash outlays. Examples include the value of an entrepreneurs labor and the interest that could be earned were the owners assets (including the values of stock in corporations) not tied up in the business. In entering the software business and creating Windows, and subsequently Microsoft, Bill Gates dropped out of college and made a conscious decision to surrender what wages he could have made as a college graduate if his endeavor failed. Though it paid off for him, similar decisions are made on a daily basis by people all over the world and it doesnt always end favorably for everyone. Firms must all bear both implicit and explicit costs into consideration to make rational business decisions. Economic costs of production include both explicit and implicit costs. On the other hand, bookkeeping tends to focus on monetary costs. Bookkeeping is a mechanical exercise focused only on explicit costs; it primarily records flows of funds and provides a base for computing taxes. Accounting requires evaluation of data for decision-making, a purpose not well served by some standard bookkeeping practices for cost accounting or tax accounting. Fortunately, standards for managerial accounting increasingly conform to the economic view of cost. Let us look at some problems that emerge when implicit costs are ignored.

Economists include explicit and implicit costs when they think of total (opportunity) cost, while bookkeepers commonly fail to include in total cost many implicit costs incurred by the owners of a firm. Economic profit occurs only when a firms revenue exceeds all costs, including explicit and implicit costs. Here is an example of how economic profits and accounting profits differ. Imagine that two years after receiving your college degree your annual salary as an assistant store manager is $28,000, you own a building that rents for $10,000 yearly, and your financial assets generate $3,000 per year in interest. On New Years Day, after deciding to be your own boss, you quit your job, evict your tenants, and use your financial assets to establish a pogo-stick shop. At the end of the year, your books tell the following story: Total Sales Revenue Cost of pogo sticks Employees wages Utilities Taxes Advertising expenses Total (Explicit) Costs (subtract from revenue) Congratulations, your bookkeeper pipes up, you made a Net (Accounting) Profit of $5,000! $130,000 $85,000 $20,000 $5,000 $5,000 $10,000 $125,000

Hold it just a moment, you say, I have studied economics. You forgot to subtract my implicit costs. Being in this business caused me to lose as income: Salary Rent Interest Total Implicit Costs Therefore, Ive had an economic profit thats negative, a loss of This business is a loser! If, however, you enjoy operating the pogo-stick shop more than your best alternative (assistant store manager), your higher job satisfaction is called psychic income. Psychic $28,000 $10,000 $3,000 $41,000;

$36,000

income is an implicit revenue that refers to nonmonetary satisfaction gained from an activity. Bookkeeping profit typically overstates economic profit because bookkeepers fail to subtract implicit costs, which tend to be significant, while implicit benefits are usually small (e.g. you no longer have to ride the bus to work to your old assistant manager job, whereas you can live where you work at the pogo stick factory, saving 500 dollars per year in transportation). The explicit cost data used to compute accounting profit for tax purposes are more accessible than the additional implicit cost data needed to estimate economic profits or losses. Thus, taxes and national income accounts are based on accounting data. Business decisions tend to be rational, however, and so are most frequently based on expected economic costs and profits. Accountants typically recognize that conventional bookkeeping costs and profits are inadequate; after calculating taxable profits, they subtract estimates of implicit costs from bookkeeping profit. This type of managerial accounting provides a better picture of a firms track record.