5. Robert James worked as a real estate agent for Simms Reality for 12 years. His annual income is approximately $120,000 per year. Robert is considering establishing his own real estate agency. He expects to generate revenues during the first year of $3 million. Salaries paid to her employees are expected to total $2 million. Operating expenses (i.e., rent, supplies, utility services) are expected to total $300,000. To begin the business, Robert must borrow $550,000 from his bank at an interest rate of 15 percent. Equipment will cost Robert $75,000. At the end of one year, the value of this equipment will be $40,000, even though the depreciation expense for tax purposes is only $8,000 during the first year.

a. Determine the (pre-tax) accounting profit for this venture.(6 points)

b. Determine the (pre-tax) economic profit for this venture. (6 points)

c. Which of the costs for this firm are explicit and which are implicit?(6 points)

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Three Contrasts between Accounting and Economic Costs

Depreciation Cost Measurement

The production of a good or service typically requires the use of plant and equipment. As thesecapital assetsare used, their service life is expended, and the assets wear out or become obsolete. Depreciation is a loss of asset value. If the Phillips Tool Company owns a machine that has a current market value of $8,000 and is expected with some considerable certainty to have a value of $6,800 after one more year of use, then the opportunity cost of continuing to own and use the machine for one more year (the economist's measure of depreciation cost) is. Assuming that 2,000 units of output were produced during the year, the depreciation cost per unit would beper unit.

Unfortunately, it is often difficult, if not impossible, to determine the exact service life of a capital asset and the future changes in its market value.Some assets are unique (patents);others are not traded in liquid resale markets (plants); and still others are rendered obsolete with little predictability (computers). To overcome these measurement problems with economic depreciation, accountants have adopted standard allocation procedures for assigning a portion of the acquisition cost of an asset to each accounting time period, and in turn to each unit of output that is produced within that time period. This allocation is typically done by assigning a portion of the historical cost to each year of the service life. If the machine is purchased by Phillips for $10,000 and is expected to have a 10-year life and no salvage value, the straight-line method of accounting depreciationwould calculate the depreciation cost of this asset each year. Assuming that 2,000 units of output are produced in a given year, thenwould be allocated to the cost of each unit produced by Phillips. Note from this example that the calculated accounting depreciation cost does not equal the economic depreciation cost of $0.60 actually incurred if in fact the market value of the machine drops to $6,800 after one additional year.

Example

Opportunity Costs at Bentley Clothing Store

Robert Bentley owns and operates the Bentley Clothing Store. A traditional income statement for the business is shown in Panel (a) ofTable 8.1. The mortgage on the store has been paid, and therefore no interest expenses are shown on the income statement. Also, the building has been fully depreciated, and thus no depreciation charges are shown. From anaccountingstandpoint and from the perspective of the Internal Revenue Service, Bentley is earning apositive accounting profitof $190,000 (before taxes).

Table8.1

Profitability of Bentley Clothing Store

(a) ACCOUNTING INCOME STATEMENTNet sales$650,000Less: Cost of goods sold250,000Gross profit400,000Less: ExpensesEmployee compensation150,000Advertising30,000Utilities and maintenance20,000Miscellaneous10,000 Total210,000Net profit before taxes$190,000(b) ECONOMIC PROFIT STATEMENTTotal revenues$650,000Less: Explicit costsCost of goods sold250,000Employee compensation150,000Advertising30,000Utilities and maintenance20,000Miscellaneous$10,000 Total460,000Accounting profit before taxes190,000Less: Implicit costsSalary (manager)130,000Rent on building88,000 Total218,000Economic profit (or loss) before taxes($28,000)

However, consider the store's profitability from aneconomicstandpoint. As indicated earlier in this chapter, implicit costs include the opportunity costs of time and capital that the entrepreneur has invested in the firm. Suppose that Bentley could go to work as a clothing department manager for a large department or specialty store chain and receive a salary of $130,000 per year. Also assume that Bentley could rent his building to another merchant for $88,000 (net) per year. Under these conditions, as shown in Panel (b) ofTable 8.1, Bentley is earning anegative economic profit($28,000 before taxes). By renting his store to another merchant and going to work as manager of a different store, he could make $28,000 more than he is currently earning from his clothing store business. Thus, accounting profits, which do not include opportunity costs, are not always a valid indication of the economic profitability (or, in this case, loss) of an enterprise.

Inventory Valuation

Whenever materials are stored in inventory for a period of time before being used in the production process, the accounting and economic costs may differ if the market price of these materials has changed from the original purchase price. The accounting cost is equal to the actualacquisitioncost, whereas the economic cost is equal to the currentreplacementcost. As the following example illustrates, the use of the acquisition cost can lead to incorrect production decisions.

Example

Inventory Valuation at Westside Plumbing and Heating

Westside Plumbing and Heating Company is offered a contract for $100,000 to provide the plumbing for a new building. The labor and equipment costs are calculated to be $60,000 for fulfilling the contract. Westside has the materials in inventory to complete the job. The materials originally cost the firm $50,000; however, prices have since declined, and the materials could now be purchased for $37,500. Material prices are not expected to increase in the near future, and hence no gains can be anticipated from holding the materials in inventory. The question is: Should Westside accept the contract? An analysis of the contract under both methods for measuring the cost of the materials is shown inTable 8.2. Assuming that the materials are valued at theacquisition cost, the firm should not accept the contract because an apparent loss of $10,000 would result. By using the replacement cost as the value of the materials, however, the contract should be accepted because a profit of $2,500 would result.

Table8.2

Effect of Inventory Valuation Methods on Measured ProfitWestside Plumbing and Heating Company

ACQUISITION COSTREPLACEMENT COSTValue of contract$100,000$100,000CostsLabor, equipment60,00060,000Materials50,00037,500110,00097,500Profit (or loss)($10,000)$2,500

To see which method is correct, examine the income statement of Westside at the end of the accounting period. If the contractis notaccepted, then at the end of the accounting period the firm will have to reduce the cost of its inventory by $12,500 ($50,000 $37,500) to reflect the lower market value of this unused inventory. The firm will thus incur a loss of $12,500. If the contractisaccepted, then the company will make a profit of $2,500 on the contract, but will also incur a loss of $12,500 on the materials used in completing the contract. The firm will thus incur anetloss of only $10,000. Hence, acceptance of the contract results in a smaller overall loss to Westside than does rejection of the contract. For decision-making purposes, replacement cost is the appropriate measure of the cost of materials in inventory, and West-side should accept the contract.

Sunk Cost of Underutilized Facilities

The Dunbar Manufacturing Company recently discontinued a product line and was left with 50,000 square feet of unneeded warehouse space. The company rents the entire warehouse (200,000 square feet) from the owner for $1 million per year (i.e., $5 per square foot) under a long-term (10-year) lease agreement. A nearby company that is expanding its operations offered to rent the 50,000 square feet of unneeded space for one year for $125,000 (i.e., $2.50 per square foot). Should Dunbar accept the offer to rent the unused space, assuming that no other higher offers for the warehouse space are expected?

One could argue that Dunbar should reject the offer because the additional rent (revenue) of $2.50 per square foot is less than the lease payment (cost) of $5 per square foot. Such reasoning, however, will lead to an incorrect decision. The lease payment ($5 per square foot) represents asunk costthat must be paid regardless of whether the other company rents the unneeded warehouse space. As shown inTable 8.3, renting the unneeded warehouse spacereducesthe net cost of the warehouse from $1 million to $875,000, a savings of $125,000 per year to Dunbar. The relevant comparison is between the incremental revenue ($125,000) and the incremental costs ($0 in this case). Thus, sunk costs (such as the lease payment of $5 per square foot in this example) should not be considered relevant costs because such costs are unavoidable, independent of the course of action chosen.

Table8.3

Warehouse Rental DecisionDunbar Manufacturing Company

DECISIONDO NOT RENTRENTTotal lease payment$1,000,000$1,000,000Less: Rent received on unused space125,000Net cost of warehouse to Dunbar Manufacturing Company$1,000,000$ 875,000