Question

Michael is a manager in a large consulting company earning a salary of $75,000 per year.  He also earns an average return of 8% per year in his investment account at Schwab. He purchases a bed and breakfast inn by taking $300,000 out of his investment account. He does some of the work himself.  His company generates $500,000 in revenues each year. He spends $200,000 a year in employee salaries, $150,000 a year in materials and supplies related to the upkeep and running of the company and $25,000 in office supplies and property taxes.  

1. What is Michael's accounting or business profit? Explain.
2. What is Michael's economic profit? Explain.
3. Assuming that Michael is indifferent between working as a manager and owning the company, should Michael continue to own the Company?  Explain why?

Answer 1

Ans:

1)

Accounting profit = $125,000

2)

Economic profit = $26,000

3)

Michael should continue to own the Company. Since the economic profit is positive, Michael should continue to own the Company.

Explanation

Explicit cost = salaries + materials + office supplies

= $200,000 + $150,000 + $25,000

= $375,000

Implicit cost = salary + return on investment

= $75,000 + ($300,000 * 8%)

= $75,000 + $24,000

= $99,000  

Accounting profit = Revenue - Explicit cost

= $500,000 - $375,000

= $125,000

Economic profit = Revenue - Explicit cost - Implicit cost

= $500,000 - $375,000 - $99,000

= $26,000