Profit is calculated as the difference between revenues and costs. This is what we call “accounting profit”. In order to calculate “economic profit”, we need to consider “Sunk costs” and “opportunity costs”. The difference between “economic profit” and “accounting” profit is crucial for managerial decisions and is often the reason for the confusion and misunderstandings.
- When we use the term profit in a typical business situation, we have a pretty good understanding of what it means. In this video, we are going to take it a step further and learn the difference between accounting profit and economic profit, and see where sunk costs and opportunity costs fit in. Profit is calculated as the difference between revenues and costs. This is what we call accounting profit. In order to calculate economic profit, we also need to consider sunk costs and opportunity costs.
The difference between economic profit and accounting profit is crucial for managerial decisions and is often the reason for confusion and misunderstandings. In the most simple form, economic profit can be calculated as accounting profit plus sunk costs minus opportunity costs. Let's bring this equation alive with a few real world examples. Let's assume you are a book seller and you have fifteen copies of a cookbook in your warehouse for which you originally paid 12-dollars per book and the suggested retail price is 18-dollars.
The book is not in high demand and you need to make a decision. You can throw them away to make room for other books and accept an accounting loss of 600-dollars. You can put them on-sale for half price at nine-dollars. You can keep the price at 18-dollars, but put the book on a special shelf and ask your staff to recommend it to customers. Let's start to analyze these choices from an economic viewpoint. First, we need to understand that the 600-dollars that we paid for the cookbooks is the sunk costs.
Since we already paid this, this costs does not matter anymore. It is also not important whether we paid two-dollars for each book or 200-dollars per book. All we have is a stack of books and we need to decide what to do with them. Of course, if you throw them away, the accounting profit is negative, minus 600. However, the economic profit is zero. If you put them on sale for half price, we might able to sell 20 books out of the 50 books and (mumbles) sold 30 books stay in our warehouse.
And because we need space in the store and in the warehouse, we lose the opportunity to promote the different book which might sell better. So how does the cost of that lost opportunity fit into the equation? Let's assume then with this space, we could have sold 80 travel books at the profit of 10-dollars per book. Hence the opportunity costs for keeping the cooking book in store is 800-dollars. In other words, we gave up the opportunity to make 800-dollars of profit on traveling books by putting the cooking book on sale.
We can already see from an economic perspective throwing away the books is more profitable than lowering the price. Of course, from a sustainability perspective and personally speaking, throwing away new books is never a good idea. However, we agree to analyze discretion from an economic viewpoint. If now compare the two options, we see a stark contrast between the economic profit and the accounting profit. From an accounting point-of-view, discounting the book would be the best idea.
However, an economist would advise that you throw away the books that are in low demand and use the space and staff to promote books that are in high demand. The difference between economic and accounting profit is fundamental for decision-making. Business owners and managers can make better decision if they don't focus on the accounting statement, but take an economic perspective. Forget about the sunk costs and include opportunity costs to make the best use of your resources.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
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- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action