Alex has been working as a chef in a large restaurant for many years. He has been earning a salary of $60,000 per year. He has always dreamt of starting a catering business. One day, he decides to do it. He quits his job. He needs money to pay costs for the business, so he withdraws $50,000 from his bank savings account, which had been earning 4% interest revenue. He hires an assistant and a kitchen; and buys some ingredients for cooking ($20,000). In the first year, he sells $80,000 worth of food; pays his assistant $25,000; and pays $12,000 for the hire of the kitchen. What is his economic profit for the year?

Question

BlackTom AI · Accepted Answer

Let’s break down the scenario step by step to distinguish between explicit costs and opportunity costs.

First, identify the revenue for the year: the chef sells food totaling $80,000. This is the top line of the income statement for economic profit purposes.

Next, list the explicit (out-of-pocket) costs incurred in starting and running the business for the year: wages for the assistant ($25,000), the kitchen rental ($12,000), and the cost of ingredients ($20,000). Adding these gives explicit costs of 25,000 + 12,000 + 20,000 = 57,000.

Now account for opportunity costs, which are the economic costs of forgoing alternative choices. The owner quit a salary job paying $60,000 per year, so the foregone salary is an opportunity cost of 60,000. Additionally, by withdrawing $50,000 from savings earning 4% interest, he loses potential interest revenue of 0.04 × 50,000 = 2,000. These are not shown on a cash flow statement but are included in economic profit calculations as costs beyond explicit outlays. Their total is 60,000 + 2,000 = 62,000.

Combine explicit costs and opportunity costs to obtain total economic costs: 57,000 (explicit) + 62,000 (opportunity) = 119,000.

Finally, compute economic profit as revenue minus total economic costs: 80,000 − 119,000 = −39,000.

Therefore, the economic profit for the year is negative $39,000. The negative result reflects that, when considering both explicit costs and the opportunity costs of the owner’s time and capital, the venture did not cover its combined costs in the first year.

Note: If you only looked at accounting profit (revenue minus explicit costs), you would get 80,000 − 57,000 = 23,000, which is not the same as economic profit because it omits the opportunity costs discussed above.

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