ACCOUNTING VS. ECONOMIC COSTS
accounting costs (explicit costs) vs. economic costs: The real (economic) costs of production usually exceed the accounting (bookkeeping) costs of production because economic costs include both explicit accounting costs and implicit costs – the value of the personal resources the owners of a firm make available (e.g., their labor and capital).
economic profit: The excess of total revenues (TR) over the total opportunity costs (TC) of all the resources a firm uses. Economic profits (TR – TC) are a premium to the entrepreneur for bearing risks and innovating, and reward an entrepreneur if they exceed the minimum necessary for the firm to survive.
psychic income: The subjective value of nonmonetary satisfaction gained from an activity is known as psychic income.
Economists include explicit and implicit costs when they think of total (opportunity) cost, while bookkeepers commonly fail to include in total cost many implicit costs incurred by the owners of a firm.
Economic profit occurs only when a firm’s revenue exceeds all costs, including explicit and implicit costs.
Here is an example of how economic profits and accounting profits differ.
Imagine that two years after receiving your college degree your annual salary as an assistant store manager is $28,000, you own a building that rents for $10,000 yearly, and your financial assets generate $3,000 per year in interest. On New Year’s Day, after deciding to be your own boss, you quit your job, evict your tenants, and use your financial assets to establish a pogo-stick shop. At the end of the year, your books tell the following story:
Total Sales Revenue $130,000
Cost of pogo sticks $85,000
Employees’ wages 20,000
Advertising expenses 10,000
Total (Explicit) Costs –125,000
(subtract from revenue)
“Congratulations,” your bookkeeper pipes up, “you made a
Net (Accounting) Profit of $5,000!”
“Hold it just a moment,” you say, “I have studied economics.
You forgot to subtract my implicit costs. Being in this business
caused me to lose as income
Total Implicit Costs –41,000
“Therefore, I’ve had an economic profit that’s negative, a loss of –36,000
This harebrained business is a loser!”
If, however, you enjoy operating the pogo-stick shop more than your best alternative (assistant store manager), your higher job satisfaction is called psychic income. Psychic income is an implicit revenue that refers to nonmonetary satisfaction gained from an activity. Bookkeeping profit typically overstates economic profit because bookkeepers fail to subtract implicit costs, which tend to be significant, while implicit benefits are usually small. The explicit cost data used to compute accounting profit for tax purposes are more accessible than the additional implicit cost data needed to estimate economic profits or losses. Thus, taxes and national income accounts are based on accounting data. Business decisions tend to be rational, however, and so are most frequently based on expected economic costs and profits.
Accountants typically recognize that conventional bookkeeping costs and profits are inadequate; after calculating taxable profits, they subtract estimates of implicit costs from bookkeeping profit. This type of managerial accounting provides a better picture of a firm’s track record.
Author: Ralph Byrns
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