Question

Before last year, Ellie (Luke's wife) taught music and earned $30,400. She also earned $9,600 by renting out their basement as a studio apartment. Ellie saves every month. At the end of a typical year she would have saved a total of 10% from her wages and the income earned from the basement for the entire year, and earned a total of 0.5% in interest (for the entire year). At the beginning of last year, Ellie stopped teaching music. She also stopped renting out their basement, and began to use it as the office for her new web design business. The balance on her savings account was $150,000, and she took $5,000 from this account to buy a new laptop computer and a new printer (which also functions as a scanner and a facsimile). She also borrowed $12,000 from the local bank to purchase additional machinery and equipment (a graphics tablet, desktop computer, studio camera and an external hard drive). Her loan payment is $250 per month. During last year, she paid $3,000 for the lease of a web server and $2,400 for high-speed internet service. She also spent $3,600 purchasing miscellaneous supplies for her business. At the end of last year, Ellie received a total revenue from web site designing of $48,250 and earned 5% interest on her savings account balance (for the entire year). After the first year of operation, Luke (who has his own successful business) believes that Ellie made the right decision. However, Ellie feels a bit skeptic and believes that she should have remained as a music teacher. Before getting into the web design business, she would have saved some of her total earnings, but now, with the web design business, she is not adding any money to her saving account. Also, doing a bit of research, she realizes that the market value (at the end of last year) for the laptop computer and the printer is $4000

How do I solve for the accounting profit, economic profit, and implicit cost?

Answer 1

Implicit cost -

Income from music = $30400

Rent from basement = $9600

Interest on savings is 0.5% =$ 63.2

In total if Ellie remained a music teacher she would have earned = 40063. This is opportunity cost forgone.

Last year starting her balance sheet looks like -

Assets	$	Liabilities	$
Laptop	5000	Borrowings from bank	12000
Machinery and equipment	12000	Capital	150000
Savings account balance	145000
Total	162000	Total	162000

Income statement-

Income from business = 48250

Add: Interest on savings received (10%)= $7250

Less : loan repayment (250×12) = 3000

Less: misc. expenses = 3600

Less: lease on web server= 3000

Less : Revaluation loss on laptop = 1000

Less : Data expenses = 2400

Accounting Profit = $42500

Implicit cost = 40063

Economic profit = Accounting profit - Implicit cost

= 42500 - 40063 = $2437

Luke is right. Ellie's business is earning more revenue than from being a music teacher.