Hi,
Could you please help me with the following question?
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. 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 $250,000 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: $5.0 million
Costs:
Payments to furniture subcontractors $3.5 million
Shipping Costs $.1 million
Lease Payments on Office Space and Computer
Equipment &Software$.1 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 = $4.5 million
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 ?
Thanks
Do a little research, then take a shot. Hint: accounting profit does not take into account opportunity costs. Hint 2:, fixed costs are costs the firm must pay regardless of output.
To answer the first question, we need to calculate both the economic profit and the accounting profit.
Accounting profit is calculated by subtracting all explicit costs (the actual out-of-pocket expenses) from the total revenue. In this case, the explicit costs include payments to furniture subcontractors, shipping costs, lease payments on office space and computer equipment/software, overhead expenses, advertising expenses, and additional sales expenses. Therefore, the accounting profit can be calculated as:
Accounting Profit = Total Revenues - Total Listed Costs
= $5.0 million - $4.5 million
= $0.5 million (or $500,000)
Economic profit, on the other hand, takes into account both explicit costs and implicit costs (the opportunity costs of the resources used). Since Bob and Jane quit their corporate jobs that were collectively earning them $250,000 per year, this amount can be considered their implicit cost.
Economic Profit = Accounting Profit - Implicit Costs
= $500,000 - $250,000
= $250,000
Therefore, Bob and Jane's economic profit is different from their accounting profit, and they earned an economic profit of $250,000 during their first year of operation.
To answer the second question, fixed costs for Bob and Jane's first year of operation would include the lease payments on office space and computer equipment/software. These costs do not change with the level of production or sales. From the given information, we can see that the lease payments amount to $0.1 million (or $100,000).
Therefore, Bob and Jane's fixed costs during their first year of operation were $100,000.