Question

Opportunity Cost Exercise. Please show how you solved the questions.   

You have been working for your brother (owner of a Down Under Sandwich Shoppe). The franchise company is now offering you a chance to franchise one of their new Big Bird Stick-e-Chicken shops (which sells their honey-roasted chicken-on-a-stick). You estimate your business can gross 45% of Down Under’s $500,000 sales. Shop space is available between Down Under Sandwiches and Little Nero Salads that leases $8,400 a year plus a yearend rent bonus to the property owner of 3% of your gross sales in excess of $200,000.   You intend to invest $20,000 of your own savings (which is presently earning you 6% per annum interest). A bank will loan you $100,000 (annual interest on this loan will be $7000). NOTE: neither the bank loan principle you borrow from the bank nor the $20,000 of your own money you invest is an explicit or implicit cost. However, the interest paid on the bank loan is explicit, and the interest foregone on your savings is implicit. You estimate that hired labor will cost you $70,000 a year, utilities $5,900 a year, and ingredients for the food $100,000 a year. You will have to pay Big Bird, Inc., an annual franchise fee is $3,000 plus 2% of your gross sales for the year. Another 1% of gross sales must be paid for national advertising. You are presently an Assistant Manager at Down Under earning $12,000 a year plus a yearend bonus of 2% of gross (a job you will have to give up), but you do not think you can earn more than this working for yourself, in spite of the extra strain of owning your own business.

1. What is the estimated explicit (accounting) cost of your proposed business? Itemize in detail.
2. What is the accounting profit you project for your business?
3. What is the total implicit cost you estimate for your venture? Itemize in detail.
4. Do you project any economic profit? How much?
5. What is the annual interest rate the bank will charge you for its loan?
6. From the economic profit viewpoint, would this be a viable business to start? Explain:

Answer 1

Gross Sales /REVENUE = 45% of 500000$ = 225000$

a) Explicit costs are the direct payments made to others in the course of the business. They involve outflow of cash like payment of rent ,wages, cost of materials consumed etc. They do not include opportunity costs.

Explicit costs = rent including bonus +interest on bank loan + labour cost+ utilities+ ingredients(cost of material consumed) + franchise fee + advertising fee

= (8400 + 3% of 25000)+ 7000$ +70000+5900+100000+(3000+2% of 225000)+ 1% of 225000
= 8400+750+7000+70000+5900+100000+3000+4500+ 2250
= 201800$

b) It is the gross earnings of the company excluding opportunity costs and implicit costs.
Accounting profit= Gross sales-explicit costs
= 225000-201800
= 23200$

c) Implicit costs are the costs that arises when someone uses personal resources for a project without receiving any compensation for the utilisation of the resources.

implict cost here = interest on savings
= 6% of 20000
1200$

NOTE:- the opportunity cost is not included because implicit cost involves the use of self owned inputs.

D) Economic profit
The difference between the total revenue received by the firm from its sales and the total opportunity costs of all the resources used by the firm. In calculating economic profit, opportunity costs and explicit costs are deducted from revenues earned. They are the costs of the next best alterative.

Economic profit = Revenue - explicit costs- opportunity costs (including implicit costs)
= 225000$ - 201800$-(1200$+12000$+2% of 500000)
= 225000-201800-(13200+10000)
= 23200-23200
=0

There is no economic profit.
NOTE Opportuniy costs include implicit costs

E) interest rate - interest / loan amount
= 7000/100000
= 7%

F) No the busniess in not economically viable s economic profit is zero.