Chapter 2

Key Measures and Relationships

A Simple Business Venture

The nature of the firm

 Managers manage organizations; thereforewe must first ask the fundamental questions:
what are organizations and why do they exist?

Economic organizations
Organizations occur at many different levels:
•the most comprehensive economic organizations are worldwide
•the United Nations
•the World Trade Organization
•International Monetary Fund
•organizations that are international
•European Union
•economies of individual nations
•All ofthese organizations are ultimately composed of individuals and are created
by individuals in order to serve particular purposes, which are ultimately some
compromise of individual purposes.

Business Organizations
•Sole proprietorships
•Partnerships
•Corporations

Business organizations are independent legal identities, separate from the individuals that form
them. This enables them to enter into binding contracts that can be enforced by the legal system
(albeit at some cost). This means that the firm is really a legal fiction which simplifies business
transactions because it enables the firm to contract bilaterally with suppliers, distributors,
workers, managers, investors and customers, rather than there being a situation where each party
has to enter into complicated multilateral arrangements.

Revenue, Cost, and Profit

Transaction
•refers to an exchange of goods or services

•can be performed in the following three ways:

1 Trading in spot markets
2 Long-term contracts
3 Internalizing the transaction within the firm

Revenue
•The total monetary value of the goods or services sold

Businesses sell either a physical commodity/product or a service. In a modern economy, that sale
is made in return for money or at least is evaluated in monetary terms
Cost
•the monetary value of goods and services that producers and consumers purchase.
 •The collective expenses incurred to generate revenue over a period of time, expressed in
terms of monetary value, are the cost. Some cost elements are related to the volume of
sales; that is, as sales go up, the expenses go up.

•In a basic economic sense, cost is the measure of the alternative opportunities foregone in
the choice of one good or activity over others. This fundamental cost is usually referred to
as opportunity cost.

 Fixed Cost
•A fixed costis a cost that does not change with an increase or decrease in the amount
of goods or services produced or sold. Fixed costs are expenses that have tobe paid
by a company, independent of any specific business activities.

 Variable Cost
•A variable cost is a corporate expense that changes in proportion to how much a
company produces or sells. Variable costs increase or decrease depending on a
company's production or sales volume—they rise as production increases and fall as
production decreases.

Profit
•The difference between the revenue and cost (found by subtracting the cost from the
revenue) is called the profit. When costs exceed revenue, there is a negative profit, or loss.
 Chapter 2
(Part 2)
Key Measures and Relationships

Economic Versus Accounting Measures of Cost and Profit

What is accounting cost?

Accounting cost is the overall cost of anything your business has paid for.
These costs include the following:
•Rent
•Utility expenses
•Food and entertainment expenses
•Travel expenses, including transportation and hotels
•Payroll expenses, including salariesand related payroll taxes
•Supplies
•Insurance
•Any other expenses incurred during the normal course of business

•All of the expenses listed above are considered explicit costs, which means they are direct
costs associated with your business. These costs are automatically accounted for each time
an expense is recorded in your accounting software or ledgers.

What is economic cost?

•Economic cost is calculated by taking your accounting cost, which has already been
calculated, and subtracting any implicit costs.
•Implicit costs are calculated by analyzing your current resources and estimating the cost
of those resources, as well as their impact to your business, should you decide to utilize
them in a different way.

Accounting cost vs. economic cost: What’s the difference?

To understand accounting cost and economic cost, you must first understand the difference
between explicit and implicit costs

Explicit costs
•the total costs of doing business throughout the year
•everything from the cost of the office rent to the salary of employees

Accountants use accounting cost to determine the profitability and financial health of
your business since you will need to determine accounting costs prior to determining
accounting profit.

Implicit costs
•are designed to be used when making decisions.
•used by businesses looking to make strategic decisions, or to determine the true cost of a
business decision they are considering.
Accounting cost and economic cost use different factors in their calculations

ACCOUNTING COST ECONOMIC COST

Uses standard costs incurred in business Uses a “what if” scenario
Uses explicit costs only Looks at a long-term time frame
Determines profit or loss for a specific period Considers both explicit and implicit costs
of time
Used for tac
tax purposes or to determine financial Used to make long-term strategic decisions
health of your business

How to calculate accounting cost

Amanda Cruz is an attorney who wants to start her own small law firm. Amanda expects to earn
$150,000 in revenue her first year of operation. She will also pay a part-time legal assistant $30,000, with
an additional $3,000 in payroll taxes for the year. Amanda will initially be working from home and has
estimated her other expenses.
Here’s what Amanda’s projected profit and loss would be for her first year in business.

Total revenue (projected) $ 150,000

Gross Profit $ 150,000
Expenses (projected)
Salaries $ 30,000
Payroll Taxes 3,000
Utilities 2,500
Insurance 1,500
Office supplies 3,500
Other expenses 2,500
Total expenses $ 55,000
Net Profit $ 95,000

When we look at Amanda’s projected gross profit, we can see that it’s $150,000, while her net
profit, or accounting profit, is $95,000, which is why it’s important to look at revenue vs. profit when
creating a profit and loss estimate for any business.
If Amanda proceeds and opens her business based on the above figures, it’s projected to be
successful, with expenses totaling $55,000. Those expenses are then subtracted from her gross profit to
obtain her net profit of $95,000.
That is Amanda’s explicit, or accounting cost of opening her small firm.

How to calculate economic cost

However, there are several details Jane may want to consider before making her final
decision. This is where calculating economic cost can be helpful.
For instance, when Amanda leaves her current job to open her own firm, she will be losing
her $95,000 salary and medical benefits worth $5,000 when she leaves. When calculating
economic cost, this $100,000 loss is subtracted from Amanda’s current net profit of $95,000,
leaving her with a projected $5,000 loss should she go ahead with her plans.
The economic cost of Amanda opening her own firm

Total revenue (projected) $ 150,000

Gross Profit $ 150,000
Expenses (projected)
Salaries $ 30,000
 Payroll Taxes 3,000
Utilities 2,500
Insurance 1,500
Office supplies 3,500
Other expenses 2,500
Total expenses $ 55,000
Net Profit $ 95,000
Implicit cost 100,000
Net Profit $ (5,000)

When Amanda calculates the loss of her salary into her decision to open her own law firm,
she will need to acknowledge that she is projected to earn less on her own than she currently earns.

What is accounting profit?

 The difference between total monetary revenue and total monetary costs and is computed
by using generally accepted accounting principles (GAAP).
 Same as bookkeeping costs and consists of credits and debits on a firm’s balance sheet.
o These consist of the explicit costs a firm has to maintain production (for example,
wages, rent, and material costs).
 The monetary revenue is what a firm receives after selling its product in the market.
 Accounting profit is also limited in its time scope; generally, accounting profit only
considers the costs and revenue of a single period of time, such as a fiscal quarter or year.

Accounting Profit = Total Revenue – Explicit Costs

What is economic profit?

 The difference between total monetary revenue and total costs, but total costs include both
explicit and implicit costs.
 Includes the opportunity costs associated with production and is therefore lower than
accounting profit.
 Also accounts for a longer span of time than accounting profit.
 Economists often consider long-term economic profit to decide if a firm should enter or
exit a market.

Economic Profit = Total Revenue – (Explicit costs + Implicit Costs)

COST, REVENUE AND PROFIT FUNCTIONS

Cost Functions

Cost is the total cost of producing output

The cost function consists of two different types of cost:
 Variable costs
 Fixed costs
Variable cost
 Varies with the output (the number of units produced).

 The total variable cost can be expressed as the:

o product of variable cost per unit
o number of units produced
 If more items are produced cost is more.

Fixed costs
 Normally do not vary with output
 In general these costs must be incurred whether the items are produced or not.

Cost Function

C(x) = F + Vx C = Total cost

F = Fixed cost
V = Variable cost per unit
x = No. of units produced and sold

It is called a linear cost function.

What Is a Linear Cost Function?

 A mathematical method used by businesses to determine the total costs associated with a
specific amount of production
 This method of cost elimination can be done whenever the cost for each unit produced
remains the same no matter how many units are produced.
 When that is the case, the linear cost function can be calculated by adding the variable cost,
which is the cost per unit multiplied by the units produced, to the fixed costs.
 Performing this equation will give the total cost for a production order, thus enabling
businesses to budget accordingly and make decision on production amounts.

Revenue Function

Revenue is the total payment received from selling a good or performing a service.
The revenue function, R(x), reflects the revenue from selling “x” amount of output items at a price
of “p” per item.

R(x) = px

Profit Functions
The Profit Function P(x) is the difference between the revenue function R(x) and the total cost
function C(x)
Thus;
P(x) = R(x) – C(x)
Profit = Revenue – Cost
P=R-C