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  • Background voice: Let's say this past year

  • I started a restaurant

  • and I want to think about

  • what type of a profit

  • I've been making at that restaurant.

  • We're going to think about it

  • in 2 different ways.

  • We're going to think about it

  • in terms of an accounting profit,

  • which is really the type of profit

  • that most of us associate

  • with a business or a firm.

  • We're also going to think about it

  • in terms of economic profit,

  • which we'll see is a little bit different.

  • Instead of telling us whether a business

  • is producing income,

  • it tells us whether it makes sense

  • to even run the business

  • in the way that we're

  • actually running it.

  • First, let's focus on

  • the traditional way

  • of calculating profit.

  • Let's say my firm,

  • my restaurant,

  • (my firm in a restaurant)

  • in year 1 it brings in, in revenue,

  • it brings in $500,000.

  • Revenue literally is the amount of money

  • the customers pay me to eat at the restaurant.

  • They are paying for their dinners.

  • This is literally the money that's coming in the door.

  • Sometimes people call it the top line,

  • because it's literally the top line

  • of our income statement.

  • I just wrote it.

  • It's the top line.

  • Now we have to think about our expenses.

  • Expenses.

  • Now, when you're running a restaurant

  • one of the obvious expenses

  • is going to be the cost of food.

  • Food, we're going to say

  • cost us $100,000.

  • $100,000.

  • Then, you have the cost of labor.

  • I have the wait staff.

  • I have the chefs and the bus boy.

  • On all of those people,

  • in this past year,

  • I spent $100,000.

  • Then, I have,

  • and I am going to assume

  • that I don't own the building,

  • that I rent the building.

  • So, building rent.

  • I'm assuming this is on the building,

  • let's say that that was $200,000.

  • Then finally, I really just rented everything.

  • I also rented the equipment,

  • all of the stoves, the fridges,

  • all of that stuff.

  • None of this is stuff that I own,

  • so the equipment rent.

  • Equipment rent,

  • I spent another $50,000.

  • How much profit do I have here?

  • Those are all of my expenses.

  • I didn't borrow any money,

  • so I didn't have any interest expense

  • or anything like that.

  • How much profit do I have

  • before paying tax,

  • or essentially my pretax profit?

  • The reason why we think of it in those terms

  • is because the amount you pay in tax

  • is usually derived from your pretax profit.

  • That depends on where this business is,

  • what country,

  • what state,

  • what type of business it is.

  • The easy way to calculate pretax profit,

  • pretax profit.

  • This is pretax and we're thinking

  • in terms of accounting profit right over here.

  • We take how much money comes through the door

  • and then we just have to subtract out

  • all of the payments we essentially have to make

  • to other people.

  • What we have left is out pretax profit.

  • 500,000 minus 450,000

  • gives us a pretax profit

  • (I'll do it in that same bright yellow)

  • of $50,000.

  • I'm assuming that I'm the only owner

  • of this business,

  • so I can essentially take it all out

  • for myself.

  • Maybe help pay

  • my own personal rent or whatever else,

  • or I could take some of this

  • or all of this

  • and reinvest it back into the business.

  • Maybe I start buying my equipment

  • or I expand in some way.

  • Who knows what I might do with that money.

  • This is just traditional accounting profit.

  • This is how profit is calculated.

  • Although, this is a super simple example.

  • In the future I would like to do

  • more nuanced examples

  • in the accounting world.

  • This, you would refer to

  • as just accounting profit.

  • Accounting profit.

  • When people in the everyday world

  • talk about profit,

  • this is normally what they're talking about.

  • Now, when economist talk about profit,

  • they're talking about something slightly different.

  • The best way to realize that

  • is to just calculate economic profit

  • for this exact same business,

  • or this firm, as a economist would call it.

  • A firm really is a general idea

  • for an organization

  • that is trying to maximize profit.

  • Once again, it's year 1.

  • Actually let me just copy and paste it.

  • It's year 1, that's our revenue.

  • I'm going to copy

  • and I'm going to paste it.

  • This right over here.

  • So far, so good.

  • Looks pretty similar.

  • Now, we're going to think about things

  • in a slightly different way.

  • Economist view cost in terms of opportunity cost.

  • As we'll see,

  • some of the opportunity cost

  • you can measure in terms of dollars.

  • Some are less explicit.

  • I'm going to write here,

  • just so we can get in the economist frame of mind,

  • opportunity cost.

  • Within opportunity cost

  • there are going to be

  • explicit opportunity cost

  • and implicit opportunity cost.

  • First, let's do the explicit.

  • Explicit opportunity cost.

  • Actually, all of these

  • are explicit opportunity cost.

  • Let me just copy and paste that.

  • I will copy and paste.

  • All of these are explicit opportunity cost.

  • The reason why they are explicit

  • is I'm actually making up ...

  • I'm paying money for all of these things.

  • Even the equipment and the rent of the apartment,

  • I don't own it.

  • I'm actually paying whoever does own it.

  • These are direct outlays out of the business.

  • I'm explicitly making these payments.

  • The reason why we can think of them as opportunity cost,

  • even though they're given in dollar terms,

  • is that if I was spending $100,000 on food,

  • that's $100,000 that I couldn't spend on something else.

  • If I'm spending $100,000 on labor,

  • that's $100,000 that I couldn't spend on something else.

  • I'm just measuring the opportunity cost in terms of dollars,

  • but dollars that I could have spent on other things.

  • So far, it looks pretty much identical.

  • I'm just viewing it with a slightly different lens.

  • You're like, "Well, what's the big deal here?"

  • We're going to see a little bit of divergence

  • when we start thinking about the implicit cost

  • that really weren't taken into account here,

  • the implicit opportunity cost especially.

  • Implicit cost.

  • If I am running this business

  • and let's say, in order to run it

  • I actually had to focus on it full time.

  • I couldn't have actually quit my job.

  • Then, there's an implicit cost of

  • An implicit opportunity cost

  • of the job that I gave up,

  • or my wages foregone.

  • Let me write this down,

  • wages foregone.

  • Let's say, and this will depend on who we're talking about.

  • Let's say I was a doctor

  • and I was making a nice steady, risk free $150,000 a year.

  • I was giving up $150,000 a year.

  • Now, we've listed all of the explicit

  • and the implicit opportunity cost.

  • Now we're ready to calculate our economic profit.

  • Let me draw a line over here.

  • Our economic profit is going to be

  • our revenue that we're taking in,

  • minus all of these expenses.

  • That gives us a positive $50,000.

  • Now, we have to subtract the wages foregone.

  • Then, I get to negative $150,000.

  • This is interesting.

  • This is kind of a big discrepancy here.

  • In accounting terms, I'm profitable.

  • In economic terms, I'm not profitable.

  • The important thing to realize

  • is economic profit, when it's negative,

  • isn't saying,

  • or you say that you have $100,000 economic loss,

  • or an economic profit of negative $100,000.

  • This isn't saying that the business or the firm

  • isn't spinning out money.

  • What it is saying,

  • is it probably doesn't make sense to run this business

  • or at least to run this business in this way.

  • If this was 0, that means,

  • hey, it's probably making money,

  • but you're kind of neutral whether it makes sense

  • to run it this way or not.

  • If it's positive, that means

  • it definitely does make sense to run the firm in this way

  • and that it is definitely doing better

  • than all of the alternatives.

  • This right over here is saying,

  • look, you're making $50,000 a year,

  • that's the 50,000 that you have to spend,

  • if you're the owner,

  • or reinvest in the firm.

  • This is saying, essentially,

  • look, you could have been making more money

  • than that $150,000.

  • Instead of making $50,000 doing this,

  • you could have been making $100,000 more

  • doing something else.

  • You are essentially giving up,

  • you are giving up $100,000 to do this restaurant.

  • If you are a rational decision maker

  • and you're really are about maximizing your profit,

  • this actually might not make so much sense for you.

Background voice: Let's say this past year

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A2 US profit cost opportunity explicit accounting implicit

Economic Profit vs Accounting Profit

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    iamkai903232 posted on 2015/05/06
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