The discipline of accounting provides guidelines for the measurement of revenue, cost, and profit. Having analyses based on generally accepted principles is important for making exchanges in our economy. For example, corporations must produce financial statements to help investors and creditors assess the health of the corporation. Individuals and businesses must produce tax returns to determine a fair measurement of income for taxation purposes.
Costs as measured according to accounting principles are not necessarily the relevant measurements for decisions related to operating or acquiring a business. For example, accounting standards dictate that businesses depreciate long-lived assets, like buildings, by spreading the cost over the life of the asset.The particulars on depreciation can be found in any financial accounting text. However, from the perspective of the business, the entire expense was incurred when the asset was acquired, even if borrowing was necessary to make the purchase and there will be the opportunity to take increased tax deductions in future years.
Likewise, there are other business costs relevant to decision making that may not be considered as costs from the perspective of accounting standards. For example, the owner/operator of a proprietorship invests time and effort in operating a business. These would typically not be treated as expenses on the proprietorship’s tax return but are certainly relevant to the owner in deciding how to manage his self-run business.
Based on these differences in perspective, it is useful to distinguish accounting costsThe sum of variable cost and fixed cost. from economic costsThe sum of variable cost, fixed cost, and the value of the next best alternative use of the money involved in a business.. In turn, since profit is the residue of revenue minus costs, we also distinguish accounting profitThe difference between revenue and accounting costs. from economic profitThe difference between revenue and economic costs..
Consider our three students who are now in a quandary about whether to sell ice cream bars on the beach or accept the summer internships, and let us see how distinguishing the economic cost/profit from the accounting cost/profit helps to clarify their decision.
There is the matter of the students’ time and energy, which is not reflected in the projection of the $27,200 profit based on last year’s operation. One way to measure that cost is based on how much they will forfeit by not using their time in the next best alternative, which in this case is the summer internship. We can consider this forfeited income as being equivalent to a charge against the operation of the ice cream business, a measurement commonly referred to as an opportunity costThe value of the next best alternative forgone.. The students’ time has an opportunity cost of $30,000. This should be added to the earlier fixed cost of $16,000, making an economic fixed cost of $46,000, a total economic cost of $56,800, and an economic loss of $2800. So maybe the ice cream business would not be a good idea after all.
However, recall that the students have already made a $6000 nonrefundable deposit. This money is spent whether the students proceed to run the summer business or not. It is an example of what is called a sunk costMoney that has been spent in the past and should not be taken into account in the current decision.. Assuming the fixed cost of the business was the same as for the prior operator, the students would have a $16,000 accounting fixed cost to report on a tax return. Yet, from the perspective of economic costs, only $10,000 is really still avoidable by not operating the business. The remaining $6000 is gone regardless of what the students decide. So, from an economic cost/profit perspective, viewed after the nonrefundable deposit but before the students declined the summer internships, if the students’ other costs and revenue were identical to the previous year, they would have economic costs of just $50,800 and an economic profit of $3200.
If a business properly measures costs from an economic perspective, ignoring sunk costs and including opportunity costs, you can conclude that a venture is worth pursuing if it results in an economic profit of zero or better. However, this is generally not a valid principle if you measure performance in terms of accounting profit. Most stockholders in a corporation would not be satisfied if the corporation only managed a zero accounting profit because this means there is no residual from the business to reward them with either dividends or increased stock value. From an economic cost perspective, stockholder capital is an asset that can be redeployed, and thus it has an opportunity cost—namely, what the investor could earn elsewhere with their share of the corporation in a different investment of equivalent risk.Readers interested in estimating the opportunity cost of investment capital are encouraged to consult a general text in financial analysis, such as Brigham and Ehrhardt (2010). This opportunity cost could be estimated and included in the economic cost. If the resulting profit is zero or positive after netting out the opportunity cost of capital, the investor’s participation is worthwhile.