Question

A business student is considering opening a business selling ice cream next summer. The student views this as an alternative to taking summer employment with a local firm where he would earn £4,000 during the 3-month summer period. It would cost £2,000 to obtain a license to operate their stand, £1,200 per month to rent the stand with the necessary equipment and £150 per month for insurance. Petrol costs are estimated at £12 per day and are not affected by sales. The ice cream ingredients can be bought for £5.60 per kilo and cones cost £1.80 per dozen. The ice cream cones contain 100 grams of ice cream and would sell for £1.50 each. a) Find the accounting cost function for the proposed business. b) Find the economic cost function for the proposed business. c) Calculate the level of output where the business would make normal profit. a. Chocolate flakes can be bought at £5 for a box of 20, and the ice creams with flakes are sold for £2.20. If 40% of the customers buy these, calculate the effect of this on the output necessary to make normal profit. d) If the student can sell 200 ice creams a day, 40% with flakes, estimate the economic profit he would make. Advise him whether he should enter the business.

Answer 1

Cost of Buiness Selling Ice Cream -

Fixed Costs = 2,000 + 1,200*3 + 150*3 + 12* 90 ( 90 because, per month I am assuming there are 30 days ) = 7,130

Variable Cost per cone = 5.6/10 + 1.8 /12 = 0.71

(Divided by 10 beacuse it takes 100gm to make a ince cream and 5.6 is the cost of 1 kg, 12 because 1.8 is the cost of one dozen.)

a) Accounting cost = Fixed Cost + Variable cost

Accounting Cost = 7,130 + 0.71y (Where y is the number of cones sold)

b) Economic Cost = Accounting Cost + Opportunity Cost

(Note opportunity is the cost of what you are giving up to obtain something, since he woulsd be giving up the summerintership which would pay him 4,000 that is the opportunity cost.)

= ( 7,130 + 0.71y ) + (4000)

= 11,130 + 0.71y

c)  Output to be sold to earn Normal profit (Normal profit is earned when the Economic cost is zero).

= 11,130 +0.71y - 1.5y = 0

y = 14,088 Cones

Additional  cost of selling a cone with chocolate flakes

= 5/ 20 = 0.4 . Total additional cost 0.4* 0.4y (0.4y because only 40% of the output sold contains chcolate flakes)

If 40% Customers buy the cone with chocolate flakes,  the sales revenue earned from it will be

= 2.2y* 0.4  

Output to earn normal profit

=11,130 + 0.71y + 0.4*0.4y - (1.5y*0.6 + 2.2y*0.4) =0

11,130 + 0.87y - 17.8y = 0

y = 12,230

d)

Total Revenue earned = (200*0.6*1.5 + 200*0.4*2.2 ) * 90    (90 number of days)

(180+176 ) * 90 = 31,800

Economic profit = Total revenue - Total economic cost

= 31,800 - (11,130 + 0.71*1800)

= 31,800- 12,408  

=19,392

He should enter the business since his economic profit is higher that the opportunity cost i.e. higher than what he would earn at the internship. If he enters the business he will be earning more than he would at the summer internship where he would just get 4,000 whereas in the business he can get a economic profit of 19,392.