Question

Sam gave up his job earning $150,000/year and converted a house that he owns into a museum for his collection of clocks. Before this, Sam had been renting the house out for $20,000/year. Sam hired 2 employees for his museum at a total cost of $50,000/yr, and had to pay $10,000/yr for utilities.

His museum brought in revenues of $125,000 the first year. Someone even offered him $1,000,000 to purchase his entire collection of clocks. He declined this offer.

1. What is Sam's accounting profit during the year?
2. What is Sam's economic profit? Please explain.

Answer 1

Answer)

1. Accounting profit implies the bottom line of the company or what is left off of total revenue after deducting total costs,now these costs are costs which actually took place and does not include opportunity costs,like wages or cost raw materials or cost of managers' salary,these are the costs which companies produce in their quarterly results wherein they show total revenue and total costs which actually happened and then net profit,so for accounting profit in this case our formula is total revenue-Costs which actually took place which gives us following

• Total accounting profit for Sam during the year=$125,000-$50,000(total cost of 2 employees Sam hired)-$10,000(cost of utilities) which gives us $125,000-$60,000=$65,000

2. We have discussed accounting profit above and we discussed that we do not take into account opportunity costs,but economic profit does take this into account,so economic profits takes into account what could have been had another alternative been chosen,so here our economic profit formula is

• Economic profit=Total revenue-Costs which actually took place-Opportunity costs which gives us following
• Economic profit=$125,000-$50,000(total cost of 2 employees Sam hired)-$10,000(cost of utilities)-$150,000(Cost of Sam leaving his job in terms of yearly salary)-$20,000(Income from rent Sam was getting)-$1,000,000(someone offered to buy Sam 's clocks) which gives us $125,000-$60,000-1,170,000=-1,105,000(Negative economic profit or economic loss)

In case you are wondering why someone will use economic profit is,it is to know true cost and benefit of choosing one alternative over other which gives us a different perspective while taking a decision.

Answer is complete.Thank you!