I tried answering b, but stuck with a. Can someone please take a look at this and help me out? Also check, if answer to b is correct?
1)Bob and Jane decide to open their own business selling ergonomically correct office furniture that Jane has designed. 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 ?
Is this correct?
Payments to furniture subcontractors $3.5 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
Total revenues are 5.0, total costs are 4.5, so accounting profit is $500,000 However, Bob and Jane, while likely working just as hard before, gave up $250,000 in wages. Add to this the $50,000 in lost interest income. So, economic profit is 500,000 - 300,000 = $200,000
thanks! Is b correct?
I would characterize payments to the subcontractors as variable costs, NOT fixed costs.
Lease Payments and Overhead are definately fixed costs. I would count advertising as a fixed cost (as it was purchased at the start of the year). However, one could argue that advertising costs are variable costs.
o.6
To answer question a), we need to determine if Bob and Jane's economic profit is different from their accounting profit. Economic profit accounts for both explicit costs (such as payments to subcontractors, lease payments, overhead expenses, and advertising expenses) and implicit costs (opportunity costs or the forgone return on their investment in a diversified portfolio).
To calculate economic profit, we subtract both explicit and implicit costs from total revenues:
Economic Profit = Total Revenues - Explicit Costs - Implicit Costs
Total Revenues = $5.0 million
Explicit Costs = $4.5 million (listed costs)
Implicit Costs = Opportunity cost of the $500,000 investment in the diversified portfolio (10% annual return)
Explicit Costs:
Payments to furniture subcontractors = $3.5 million
Lease Payments on Office Space and Computer Equipment & Software = $0.1 million
Overhead Expenses: Insurance, utilities, etc. = $0.1 million
Advertising on Internet & Magazines (Purchased at the start of the year) = $0.5 million
Additional Sales Expenses (phones, business travel, entertaining clients, etc.) = $0.2 million
Total Explicit Costs = $4.5 million
Implicit Costs:
Opportunity Cost = $500,000 * 10% = $50,000
Total Implicit Costs = $50,000
Now, let's calculate the economic profit:
Economic Profit = $5.0 million - $4.5 million - $50,000 = $450,000
Therefore, Bob and Jane's economic profit during the first year of operation is $450,000.
To answer question b), we need to determine the fixed costs incurred by Bob and Jane during their first year of operation. Fixed costs are costs that do not vary with the level of production or sales.
Fixed Costs:
Lease Payments on Office Space and Computer Equipment & Software = $0.1 million
Overhead Expenses: Insurance, utilities, etc. = $0.1 million
Total Fixed Costs = $0.1 million + $0.1 million = $0.2 million
So, the fixed costs during their first year of operation are $0.2 million.
Based on your provided information, your answer for question b) is correct.
Please note that the calculations and answers are based on the information provided in the question. If there are any additional details or clarifications, the answers may vary.