You own a Down Under Sandwich Shoppe that has gross sales averaging $420,000 a y

Question

You own a Down Under Sandwich Shoppe that has gross sales averaging $420,000 a year. You pay $40,000 a year in interest on a business bank loan. You also invested $70,000 of your own money in the business (on which you were earning 6% per annum interest). NOTE: neither the bank loan principle, nor the $70,000 of your own money is an explicit or an implicit expense. However, the interest paid on the loan is explicit and the interest foregone on your savings is implicit. You quit a good job as the manager of Ramani’s Pizzeria that paid you $30,000 a year to go into business for yourself. You have to pay Down Under Inc. a franchise fee of $3,000 a year plus 2% of gross sales. Your shop is located in a building you own (but you formerly leased it for $21,600 so you no longer receive this rent). The labor you hire costs you $160,000 a year. Utilities cost $4,000 a year. Food ingredients (pizza dough, meat, cheese, sauce, soft drinks, etc) cost $130,000 a year. You will spend 2% of gross sales on advertising. Income taxes last year were 3.5% of gross sales, and are an explicit business expense and will again be this year.

-You pay 10% per annum interest for your bank loan. How much did you borrow?

-From the economic viewpoint, should you stay in this business? Explain.

Explanation / Answer

(1) Loan from bank = Annual interest / Interest rate = $40,000 / 0.1 = $400,000

(2)

Accounting costs ($) = Loan interest + Franchise fee + Labor cost + Utilities + Food ingredients + Advertising + Income tax

= 40,000 + [3,000 + 2% x 420,000] + 160,000 + 4,000 + 130,000 + (420,000 x 2%) + (420,000 x 3.5%)

= 40,000 + 3,000 + 8,400 + 160,000 + 4,000 + 130,000 + 8,400 + 14,700

= 368,500

Implicit cost ($) = Interest foregone + Rent foregone

= 70,000 x 6% + 21,600 = 4,200 + 21,600

= 25,800

Economic profit = Revenue - Accounting cost - Implicit cost

= $(420,000 - 368,500 - 25,800)

= $25,700

Since economic profit is positive, I would stay in business.

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