Bob and Jane decide to open their own business selling ergonomically 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. Their lease agreements are for 1 year.
The actual production of the furniture kits 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 $500,000 (.5 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 $500,000 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.
Total Revenues: $6.0 million
Costs:
Payments to furniture subcontractors $4.0 million
Shipping Costs .1 million
Lease Payments on Office Space and Computer
Equipment &Software $ .5 million
Overhead Expenses: Insurance, utilities etc. $ .1 million
Advertising on Internet & Magazines
(Purchased at start of year) $ .5 million
Additional Sales Expenses (phones, business travel, $ .2 million
Entertaining clients etc.)
Total Listed Costs = $ 5.4 million
a) What were Bob & Jane's fixed costs during their first year of operation ? Explain your answer. 3
b) Bob and Jane brag to their friends that their business earned a profit of $600,000 in its first year. Would an economist agree? Explain, and if not identify their economic profit level.
Do a little research and then take a shot, what do you think?
Hint a) fixed costs are costs the firm incurs regardless of the level of production/sales. Variable costs are directly related to the levelo of production/sales. Except for advertising, the cost listed are clearly fixed or variable. Whether advertising is a fixed cost or a variable cost is a topic for discussion and disagreement.
hint b: Think opportunity costs.
5.1 million for VC
a) To determine the fixed costs during their first year of operation, we need to identify the costs that do not vary with the level of production or sales. In the given information, the lease payments on office space and computer equipment/software, overhead expenses (insurance, utilities, etc.), and the advertising costs are fixed costs.
Lease payments on office space and computer equipment/software are fixed costs because they remain constant regardless of the number of furniture kits produced or sold. Similarly, overhead expenses such as insurance and utilities are also fixed costs because they do not change with production or sales levels. Finally, the advertising costs are considered fixed because they were purchased at the start of the year and their payment does not depend on subsequent sales.
Therefore, the fixed costs for Bob and Jane's first year of operation include lease payments on office space and computer equipment/software, overhead expenses, and advertising costs, which amount to $0.5 million.
b) An economist would not agree with Bob and Jane's claim of earning a profit of $600,000 in their first year of operation. This is because economic profit takes into account both explicit costs (such as payments to subcontractors, shipping costs, lease payments, overhead expenses, advertising costs, and additional sales expenses) and implicit costs. Implicit costs refer to the opportunity cost of using their own funds in the business instead of alternative investments.
In this case, Bob and Jane invested $500,000 of their own funds into the business at the start of the year. These funds were previously invested in a diversified portfolio that had been averaging a 10% annual before-tax rate of return. Therefore, the economist would consider the opportunity cost of their investment as part of the implicit costs.
To calculate the economic profit, we need to subtract both the explicit costs and the implicit costs from the total revenues. The explicit costs amount to $5.4 million, as mentioned in the information.
To calculate the implicit costs, we need to determine the opportunity cost of their investment. At a 10% annual before-tax rate of return, the opportunity cost of their $500,000 investment would be $50,000.
Therefore, the economic profit would be calculated as follows:
Total Revenues - Explicit Costs - Implicit Costs
$6.0 million - $5.4 million - $50,000
= $550,000
Hence, the economist would determine that Bob and Jane's economic profit in their first year of operation is $550,000, not $600,000 as claimed by them.