1) At the beginning of the year, an audio engineer quit his job and gave up a sa
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Question
1) At the beginning of the year, an audio engineer quit his job and gave up a salary of $ 175,000 per year in order to start his own business, Sound Devices, Inc. The new company builds, installs, and maintains custom audio equipment for businesses that require high- quality audio systems. A partial income statement for Sound Devices, Inc., is shown below:
2011
Revenues Revenue from sales of product and services . . . . . . . . . . . . . . . . . $ 970,000
Operating costs and expenses Cost of products and services sold . . . . . . . . . . . . . . . . . . . . . . . 355,000
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155,000
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000
Total operating costs and expenses . . . . . . . . . . . . . . . . . . . . . $ 555,000
Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 415,000
Interest expense (bank loan) . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . 45,000
Legal expenses to start business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 177,000
To get started, the owner of Sound Devices spent $ 100,000 of his personal savings to pay for some of the capital equipment used in the business. In 2011, the owner of Sound Devices could have earned a 15 percent return by investing in stocks of other new businesses with risk levels similar to the risk level at Sound Devices.
a. What are the total explicit, total implicit, and total economic costs in 2011?
b. What is accounting profit in 2011? What is economic profit in 2011?
c. Given your answer in part b, evaluate the owner’s decision to leave his job to start Sound Devices.
Explanation / Answer
(a)
(i) Total explicit costs = Total operating costs + Interest expense + Legal expenses + Income taxes
= $(555,000 + 45,000 + 28,000 + 165,000) = $793,000
(ii) Total implicit costs = Annual salary foregone + Implicit return on savings paid in business
= $175,000 + [$100,000 x 15%]
= $190,000
(iii) Total economic costs = Explicit costs + Implicit costs
= $(793,000 + 190,000) = $983,000
(b)
Accounting profit = Net income = $177,000
Economic profit = Net income - Implicit costs = $(177,000 - 190,000) = - $13,000 (Economic loss)
(c)
Even though there is an economic loss in the 1st year, there is no reason to assume the firm will continue incurring this loss every year. The reason is, though the potential interest on saving foregone is a regular implicit cost to be considered every year, the annual salary foregone will become a sunk cost after being considered in year 1.
Also, the legal cost will be a sunk cost from 2nd year and will not be considered into calculate net income, therefore increasing the accounting profit by $28,000.
Therefore, in year 2, even if everything else remains the same, economic profit will increase by $175,000 and convert this economic loss into an economic profit of $ [- 13,000 + 175,000 + 28,000] = $190,000.
Therefore, to make this a long-run loss-making firm, every year there has to be an accounting loss of $190,000 to consider this business decision wrong, which is very unlikely.
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