Question

1. Describe the impact of explicit and implicit costs in calculating accounting profit and economic profit.

2. Assume you are a business manager for a firm that does a few million dollars worth of business each year. Select the profit measure (accounting profit or economic profit) you believe provides the most helpful information in making business decisions, and explain why?

Note: once again, no hedging your bet here by selecting both measures or combinations of both measures. :-) Select one measure only.

Answer 1

1. Explicit costs are the costs which are actually incurred in the course of businesses. For example, the wages paid to workers or the electricity bill paid are examples of explicit costs. Implicit costs are the opportunity costs which are not actually incurred but which are the benefits forgone. For example, an entrepreneur could take up a job and earn a salary rather than operating a business. So, the entrepreneur is sacrificing the salary in order to do the business. So, the foregone salary is an opportunity cost or implicit cost here.

Accounting profit only considers explicit costs. It does not take implicit costs into accounts. So,

Accounting Profit = Total Revenue - Total Explicit Costs

Economic profit considers both explicit and implicit costs to derive profits. So:

Economic Profit = Total Revenue - (Total Explicit Costs + Total Implicit Costs)

The relationship between accounting profit and economic profits is as follows:

Economic Profit = Accounting Profit - Implicit Costs.