Question

You are thinking about becoming a Paradise Coffee franchisee. Franchisees are offered a business specializing in producing an exclusive line of exotic coffee drinks (similar to Starbucks). Franchisees have had good success in towns without a Starbucks (Paradise franchises gross $220,000 sales on average per year, and you believe you can gross as much, too). You will have to pay Paradise Coffee, Inc., a franchise fee of $3,000 a year plus 2.5% of gross sales. You will also pay an annual National advertising fee of 3% of gross sales. Paradise requires that you use their logo-imprinted goods (plates, cups, napkins). They are purchased in bulk from Paradise and will cost you $40,000 per year. You also have to use their special Paradise coffee beans, which cost $12.00 per pound. You estimate you will use 400 pounds of beans a year. Other food ingredients (syrups, biscotti, whipped cream, soft drinks, etc) will cost $18,000 a year. You will have to hire three workers for a total annual cost will be $70,000. Other annual costs are utilities $4,800; rent $12,000; and liability insurance $6,000. You will have to invest $80,000 of your savings (presently earning 4% per annum) and borrow another $60,000 (on which you will pay explicit interest of $2500 a year). Note: neither the amount of the bank loan nor the $80,000 of your own money you invest is an explicit or implicit cost. However, the interest paid on the bank loan is explicit and the interest foregone on your savings is implicit. You are presently employed as an assistant manager at Little Nero Salads earning $45,000 a year (a job you will have to quit to go into Paradise Coffee). Treat this as an additional implicit cost: You estimate you must earn $10,000 more than Little Nero is presently paying you because you realize owning your own business is extra stress and strain.

Answer 1

The table below lists the various costs associated with becoming a Paradise franchise.

Explicit costs	Amount in $
Franchise fee	3000
Sales + Advertising	2.5% + 3 % of 220000 = 12100
Paradise logo goods	40000
Paradise coffee beans	48000
Other food ingredients	18000
Cost of 3 workers	70000
Cost of utilities	4800
Rent	12000
Liability insurance	6000
Borrowing cost on loan of $60000	2500
Total Explicit costs	216400

Given below is the implicit costs -

Interest foregone	4% of $80000 =3200
Salary foregone	45000
Extra pressure of owning a business	10000
Total	58200

a. Implied interest rate on bank loan is

= 2500 / 60000 ×100 = 4.167%

b. Accounting Profit = Total Revenue- Total costs

= $(220000 - 216400) = $3600

From Accounting standpoint view, business is viable as it generates profits.

However from economic standpoint view we have to take implicit costs into consideration as well. So from Accounting profit we deduct implicit costs. i.e.

3600 - 58200 = -$ 54600

Since the business generates negative income and does not cover implicit costs, therefore it is NOT viable for economic standpoint view.