Costs and Profit

What you’ll learn to do: calculate, graph and understand production costs in the short run

It’s obvious that a firm’s total revenue must exceed total costs if it wants to make a profit. In this section, you’ll see why it’s helpful for firms to break down and examine their costs in different ways.  We will look at fixed versus variable costs, average versus marginal costs, and more. The purpose of these different concepts is to give the firm a better picture of how they can become more profitable.

Learning Objectives

  • Explain the difference between explicit costs and implicit costs
  • Calculate accounting and economic profit

Explicit and Implicit Costs, and Accounting and Economic Profit

Private enterprise, the ownership of businesses by private individuals, is a hallmark of the U.S. economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General Motors come to mind. But firms come in all sizes, as shown in Table 1. The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, meaning those firms each employ at least 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Indeed, Table 1 does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn.

Table 1. Range in Size of U.S. Firms (Source: U.S. Census, 2010 www.census.gov)
Number of Employees Firms (% of total firms) Number of Paid Employees (% of total employment)
Total 5,734,538 112.0 million
0–9 4,543,315 (79.2%) 12.3 million (11.0%)
10–19 617,089 (10.8%) 8.3 million (7.4%)
20–99 475,125 (8.3%) 18.6 million (16.6%)
100–499 81,773 (1.4%) 15.9 million (14.2%)
500 or more 17,236 (0.30%) 50.9 million (49.8%)

Each of these businesses, regardless of size or complexity, tries to earn a profit:

Profit = Total Revenue – Total Cost

Total revenue is the income brought into the firm from selling its products. It is calculated by multiplying the price of the product times the quantity of output sold:

Total Revenue = Price x Quantity

As we study the theory of the firm, it will become clear that a firm’s revenue depends on the demand for the firm’s products.

We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, payments that are actually made. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources already owned by the firm. Often for small businesses, they are resources contributed by the owners; for example, working in the business while not getting a formal salary, or using the ground floor of a home as a retail store. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate.

Try It

These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.

Watch It

This video explains the difference between accounting profit and economic profit.

CALCULATING IMPLICIT COSTS

Consider the following example. Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he gets established. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. A law clerk could be hired for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?

Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them:

Office rental $50,000
Law clerk’s salary + $35,000
Total explicit costs $85,000

Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.

Revenues $200,000
Explicit costs – $85,000
Accounting profit $115,000

But these calculations consider only the explicit costs. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of $125,000. This would be an implicit cost of opening his own firm.

Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit. The equation is:

Economic Profit = Total Revenues – Explicit Costs – Implicit Costs

Now let’s plug in Fred’s figures to the true economic profit equation:

Economic Profit = $200,000 – $85,000 – $125,000 = –$10,000 per year

Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm.

Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits.

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Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next section.

glossary

accounting profit
total revenues minus explicit costs, including depreciation
economic profit
total revenues minus total costs (explicit plus implicit costs)
explicit costs:
out-of-pocket costs for a firm, for example, payments for wages and salaries, rent, or materials
firm:
an organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs.
implicit costs:
opportunity cost of resources already owned by the firm and used in business, for example, expanding a factory onto land already owned
private enterprise:
the ownership of businesses by private individuals
production:
the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs
revenue:
income from selling a firm’s product; defined as price times quantity sold