Accounting and economic costs and profits Accounting Accounting

Accounting and economic costs and profits • • Accounting • Accounting costs are monetary (usually explicit) meaning actual cost paid like • wages, raw materials and rent. Accounting profit = Revenue – • Accounting costs. Remember • Revenue = Price X Quantity sold • Economic costs are always larger than accounting costs as the opportunity cost is included. Opportunity cost = cost of alternative forgone when a decision is made. Economic costs = accounting costs + opportunity costs. Economic profit = revenue – economic costs. Economic profit = revenue – (accounting costs + opportunity costs).

Decision making • In economic analysis we use economic costs. • To make a wise decision we need to consider all costs and not only monetary costs. • Opportunity costs should be considered as they have an important bearing on our decision making.

Example • Bill owns a farm worth $1 m. His yearly revenue is $100, 000 and his expenses are $60, 000. The current interest rate is 5% for savings. What is Bill’s accounting profit and what is his economic profit? • Answers AP $40, 000 and EP $-10, 000

Example • Chen runs her own business. She receives no wage or salary. She could work full-time for $25, 000 pa. Her business revenue for last year was $30, 000 and her expenses $10, 000. What is her accounting profit and her economic profit? • Answers = AP $20, 000 • EP $(-5000)

Example • Tao must travel from Wellington to Auckland for business. Tao is paid $20 per hour and he must travel in work time. Prices and times are: Which is cheapest? Mode Price $ Hours Plane $150 1 Car $100 6 Bus $70 10 Plane is cheapest. If we consider opportunity costs, total cost for plane travel is $170 – much cheaper than the other options.