ACCOUNTING VS.

ECONOMIC COSTS
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accounting costs (explicit costs) vs. economic costs: The real (economic) costs of production usually exceed the accounting (bookkeeping) costs of production because economic costs include both explicit accounting costs and implicit costs the value of the personal resources the owners of a firm make available (e.g., their labor and capital). economic profit: The excess of total revenues (TR) over the total opportunity costs (TC) of all the resources a firm uses. Economic profits (TR TC) are a premium to the entrepreneur for bearing risks and innovating, and reward an entrepreneur if they exceed the minimum necessary for the firm to survive. psychic income: The subjective value of nonmonetary satisfaction gained from an activity is known as psychic income. _____________________________________________________________________ _______________________________________ Profit 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) $130,000 $85,000 20,000 5,000 5,000 10,000 125,000

Congratulations, your bookkeeper pipes up, you made a

Net (Accounting) Profit of

$5,000!

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 28,000 10,000 3,000 41,000 36,000

Therefore, Ive had an economic profit thats negative, a loss of This harebrained 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 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. 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.

Profit - the difference between economic and accounting costs, economic profit, economic losses, and zero economic profit Edit 7 0 18

Profits: The Difference between Economic and Accounting Costs, Economic Profit, Economic Loss, and Zero Economic Profit by Carrie Pickering

"People often refer to an enterprise system as a profit system. This is a mistake. It is a profit and loss system, and the loss part, in my opinion, is more important than the profit part. The crucial difference is not in what ventures are undertaken. The crucial difference is in what ventures are continued and which ones are abandoned...The crucial requirement for maintaining growth and progress is that successful experiments be continued and unsuccessful experiments be terminated." Milton Friedman (Sowell, 2000)

What will this article do for my education in economics? What will a study of the most basic levels of economics produce? What ramifications will this have in your life? Hopefully these life shattering questions will be answered by you reading through this entire entry. (However, if you must know the reason behind this entry please read the next two sentences.) This section is designed to help you see that when economists, not accountants, speak about costs they are speaking about opportunity costs. Economic terms such as opportunity cost, economic profit, economic loss, and zero economic profit help to explain why scarce resources move into and out of the economy.

Economic Costs vs. Accounting Costs If you are like most people you hear the word "profit" and immediately accounting profits spring to mind. Accounting profits usually show up in an organization's income statement and are referred to as explicit costs. Explicit costs are business expenses that are easily identified and accounted, for example cash outflows from a business that reduce its bottom-line profitability.What are accounting profits? Accounting profits are Total Revenue minus the Cost of Producing Goods/Services (Baye, 2006) Economic profit is the difference between Total Revenue and the Total Opportunity Cost of Producing Goods/Services. Economic profit is referred to as the implicit cost of giving up the next best alternative use of a resource used in producing the good/service. The opportunity cost of producing a good/service is usually higher than the accounting cost because it includes both explicit and implicit costs (Baye, 2006). Implicit costs can be hard to measure, but hardworking managers will seek to calculate them. Implicit costs are intangible costs, for example the time and effort that an owner puts into the maintenance of the company rather than working on expansion. In essence when studying economics all costs are opportunity costs because resources are scarce and could have an alternative use. Now our equation for economic profit really looks like this: Economic Costs=Opportunity Costs=Explicit Costs + Implicit Costs. By measuring Accounting Costs and Economic Costs an accurate picture of a market can be seen. This can allow a company to decide to enter into a market, stay in a market, or to leave a

market. What you should remember: Explicit Costs = easily identified and accounted for cash outflows Implicit Costs = opportunity cost of forgoing an alternative, hard to measure Accounting Profit = TR explicit costs Economic Profit = TR explicit and implicit costs = Opportunity Cost Do everyday people take implicit and explicit costs into consideration? Historical examples of abundant and scarce resources abound. Take for example the California Gold Rush. In the beginning people rushed out to make their fortune. And more than likely the first gold miners who came earned a good deal of money. As miners came towns sprang up, businesses such as a store selling shovels prospered. Yet as more and more miners moved in to the mining market, gold became scarce. The scarcity of gold then led to less people coming, a decrease in shovel sales, and ultimately to the decrease in miners and the abandoning of mining towns. Did you see the entering into the market, the decision to stay, and the decision to exit? Did you see where money was made, someone broke even, and maybe someone lost money? Maybe the store owner did not account for all implicit and explicit costs, but he certainly knew when fewer people were moving into town and buying less shovels. You can even consider technologies this way. Do you remember VCR's? Do you own one anymore? What was the next best alternative for companies who produced VCR's? Want another example that helps to explain this most basic of economic theories? According to Fisher and Quayyum, high levels of home ownership and residential investment are an excellent example. It was found that high levels of technological progress created vast wealth, which led to an increase in home ownership (Fisher and Quayyum, 2006). With more money, more people were able to purchase homes. Money was no longer scarce which led to people entering into the housing market. What happens if money becomes scarce again? You can look at the extremely high levels of foreclosures in the summer and fall of 2007. People moved into the market and now people are moving out of the market. What are opportunity costs of owning a home vs. renting?

Economic Profit, Economic Losses and Zero Economic Profit If you wanted to calculate your implicit and explicit costs to determine when to enter, stay in or leave a market, and determine what type of economic profits you are generating how do you do that? The best way to show this is by looking at a business. These examples are taken from notes for an economics class at Michigan State University. Economic Profit means Entering or Stay in the Market

Remember that economic costs are different from accounting costs and therefore to find economic profit you must use implicit and explicit costs. The following example is from investopedia.com. Invest 100,000 to start a business, you earn 150,000 in profit, but you could have earned 45,000 in a position in another company Accounting profit= 150,000-100,000=50,000 Economic profit= 150,000-100,000-45,000=5,000 Your firms total revenue is more than adequate to cover the sum of explicit and implicit costs. In other words, sales receipts cover more than the opportunity cost of all resources used. The more profitable and greater the resource the more competition will enter into the market. You are receiving more money than the alternative uses of your time and capital. You would choose to stay in the market. Economic Loss means Leaving the Market What if economic costs, the sum of explicit and implicit costs were larger than your firm's total revenue? This means you have an economic loss. Negative economic profit, therefore, causes resources to move to alternative activities where markets value their services enough to at least pay their opportunity costs. A good example: if economic profit were negative for one or more firms in a high tech industry for any length of time firms would go out of business and people would look for opportunities elsewhere. Invest 200,000 to start a business, you earn 150,000, you could have earned 80,000 in a position with another company. Economic profit= 150,000-200,000-80,000= -130,000 Zero Economic Profit Is it possible to have economic profit of zero? Of course! This simply means the opportunity costs are covered by sales of products and services. Because all resources are receiving just the amount they could get in their best alternative uses, there is no incentive for any of them to be put to use in another activity. A good example: if economic profit were zero for each and every firm in the automobile industry, there would be no one going out of business and leaving. And there would also be no firms entering the industry because they would be earning a profit elsewhere.

Accounting Versus Economics by David A. Mayer

An accountant asked an economist why she had chosen a career in economics over accounting. The economist replied, I'm good with numbers, but I don't have enough personality to be an accountant. Personality differences aside, a key distinction between economics and accounting is in determining total cost and profit. To the accountant, total costs are the sum of all of the explicit fixed and variable costs of production. In addition, profits are equal to total revenue minus total cost. To the economist, however, total cost is equal to all of the explicit fixed and variable costs plus opportunity cost. Profits to the economist are equal to total revenue minus total cost including opportunity cost.

Imagine that you are a teacher earning $5,000 a month and decide to quit your job and start selling snow cones instead. You buy a freezer cart that you can wheel around, order all of the supplies you need, and pay the required licensing fees. Assume your total cost equals $2,000. So you get out there and start hustling snow cones, and you're actually good at it. At the end of the month, you calculate that you have earned $6,000 in total revenue. What are your accounting profits? $6,000 in total revenue $2,000 in total cost = $4,000 in accounting profit. What are your economic profits? $6,000 in total revenue ($2,000 in explicit cost + $5,000 in opportunity cost) = -$1,000 economic loss. The opportunity cost is what you could have been earning as a teacher. Many people confuse the concepts of revenue and profit. Revenue is all of the income a business earns. For a firm selling a single type of product at one price, revenue is equal to the quantity sold multiplied by the price. Profit, on the other hand, is the income a company has left over after covering all of its costs. Revenue Cost = Profit Economic profits in an industry are important because they provide firms in other industries with an incentive to employ their land, labor, capital, and entrepreneurial ability in the economically profitable industry. Economic profits draw resources to their most efficient use. In the long run, competition eliminates economic profits. Industry is most efficient when economic profits are equal to zero. At zero economic profit, there is no incentive for existing firms to leave or for new firms to enter the market. In the example above, the $1,000 economic loss is a signal for you to leave the snow cone industry because your resources could be put to better use in another industry