a) What are the total explicit, total implicit and total economic costs in 2010?
Explicit costs are the costs paid directly in money; these costs are also referred to as accounting costs. Implicit costs are also measured in money units, but these are the costs associated with unused opportunities, i.e. implicit costs consist of the revenues which could have been incurred using current resources for earning interest or wages. Implicit costs may also include owner’s resources, capital and inventories used for pursuing a business instead of getting income in some other way. Accounting costs include only explicit costs, while economic costs are the sum of explicit and implicit costs.
In our case, total explicit costs are the sum of all operating costs and expenses, interest expenses, expenses needed to start the business and income taxes.
Thus, explicit costs are: EC = $555,000 + $45,000 + $28,000 + $165,000 = $793,000.
Total implicit costs in this case consist of three parts: costs needed to purchase the capital equipment, costs of earning an investment return, and costs of leaving the job.
IC1 = $100,000 (costs incurred to purchase the capital equipment)
IC2 = (15%*$100,000 – $100,000) = $15,000 – $100,000 (interest payment minus invested capital)
IC3 = $175,000 (if this is a post-tax income)
Total implicit costs are: IC = $100,000 + $15,000 – $100,000 + $175,000 = $190,000
Total economic costs are: C = EC + IC = $793,000 + $190,000 = $983,000
In this case, it is suggested that annual salary of the audio engineer of $175,000 is given as post-tax value (since tax rates and conditions defining the engineer’s tax rates are not mentioned in the assignment). If this annual income is given as a pre-tax number, total economic costs would have to be reduced by the amount of income tax. In addition to this, the engineer might also get “psychic profit”¯ of starting Sound Devices instead of working as a someone’s employee, which should also be included into the model.
b) What is accounting profit in 2010?
Accounting Profit = Revenues ”“ Implicit Costs = $970,000 – $793,000 = $177,000
c) What is economic profit in 2010?
Economic Profit = Revenues ”“ Economic Costs = $970,000 – $983,000 = -$13,000
d) Given your answer in part c, evaluate the owner’s decision to leave his job to start Sound Devices.
Since economic profit for the engineer is below zero, the decision to start Sound Devices is economically inefficient. However, this conclusion was made using a number of suggestions. First of all, it was suggested that annual income of the engineer ($175,000) was the after-tax value. If this income is taxed, then the engineer would have to pay about $39,950 as income tax, and $9,159 as social security. Thus, total value of IC3 would be equal to $125,884 instead of $175,000. In this case, economic profit of the engineer will be equal to $36,116, and the decision to leave the job and to start Sound Devices will be economically efficient. Finally, if the engineer enjoys being an individual entrepreneur, his “psychic income”¯ will constitute at least $10,000 per year, which would result in economic profit of $46,116. In addition to this, if Sound Devices is expected to generate more revenue in the future years, the decision to start this company become even more attractive. Thus, although existing data show that the idea to start Sound Devices was not effective, there are a lot of issues not mentioned in the assignment which would finally make the economic profit of the engineer significantly greater, and then the decision can be evaluated as quite effective.