Question

Bob recently quit a job that paid him $2,500 per month in order to buy a bed and breakfast house in a remote corner of Vancouver Island. The motivation for his life style change came from a surprise inheritance from his long lost uncle who he had never met. His uncle, feeling guilty for never sending "birthday money" to his sister's son, had left Bob $65,000 dollars in his will. Bob's mom told him to put the money in a corporate bond that was paying 9% return annually. Instead Bob decided to "check out" of the busy city life and buy the B&B. For the down payment and renovations, Bob used $50,000 of his inheritance. It turned out that Bob's remote B&B was much more popular than expected and his two rooms were rented out for a total 425 nights combined between them, in the first 12 months of operation! The nightly rental rate was $200.

Bob paid the following out-of-pocket costs during the first year of operating the bed and breakfast business. Monthly Interest he pays on a bank loan $ 2,100 Utility and Maintenance Expenses quarterly $ 4,140 Property Taxes and Insurance annually $ 2,210 Food for the year (cheap breakfasts!) $ 3,000 Part-Time Cleaning Staff monthly $ 300 Other (supplies, etc.) in total for the year $ 1,330

Based on your calculation of economic profit , would you advise Bob to stay in this business?

Explain your answer first considering only the Economic profit/loss calculation. AND then ALSO include a more "common sense" answer considering your calculation in question.

Answer 1

The economic profit does take into consideration the explicit cost as well as implicit cost.
The opportunity cost of getting into the venture is nothing but the benefits forfeited for choosing the next best option.

Accounting Profit = Total Revenue - Total Cost

Economic Profit = Total Revenue - (Accounting Cost + Opportunity Cost)

The two rooms have been rented out for 425 nights combined between then in a year

Revenue =
425 * 200 = 85000

Accounting Cost
(2100 * 12) + (4140 * 4) + (300 * 12) + 2210 + 3000 + 1330
= 51900

Operating Profit
85000 - 51900 = 33100

Bob is earning operating profit here.

We have not taken into account the $50000 into consideration here because that amount is for total years of operation and could result in wrong calculations if assumed for the first year of operation


The economic cost is the benefits of wages and interest earnings

(2500 * 12) + (50000 * 0.09) = 34500

Economic Profit
85000 - (51900 + 34500) = -1400

Bob has incurred an economic loss of $-1400 for the year

The criteria of only economic profit indicate that he is better off by doing the job and investing the fund in the bonds rather than doing business of B&B.

However, this is not completely correct.
The total available nights in a year are 365 which means the probable business of 730 nights out of which 425 nights were occupied here by the customers. This indicates an occupancy ratio of only 58.2%.
The economic loss is marginal and some advertising, as well as increasing facilities, might increase the occupancy rate which will translate into higher operating profit and ecoomic profit also.