Question

Gomez runs a small pottery firm. He hires one helper at $14,500 per year, pays annual rent of $7,500 for his shop, and spends $18,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $5,000 per year if alternatively invested. He has been offered $23,000 per year to work as a potter for a competitor. He estimates he could use his talents to earn an additional $6,000 per year in consulting fees if he were working full time as a potter. Total annual revenue from pottery sales is $86,000.

Instructions:
A. Calculate the accounting profit for Gomez’s pottery firm.
B. Now calculate Gomez's economic profit.

Answer 1

Gomez

Accounting Vs. Economic Profit

Accounting profit:

Sales revenue $86,000

Business cost 40,000

Profit $46,000

Economic profit:

Accounting profit $46,000

Opportunity cost 34,000

Profit $ 12,000

Step-by-step explanation:

a) Data and Calculations:

Annual Wages for helper = $14,500

Annual Rent = $7,500

Annual Direct materials = $18,000

Business cost = $40,000

Funds investment = $40,000

Opportunity cost (alternative option)

Interest on funds = $5,000

Wages 23,000

Consulting fees 6,000

Total opportunity costs = $34,000

Total annual sales revenue = $86,000

b) Gomez's economic profit equals the accounting profit minus the expenses incurred for lost opportunities (alternative uses) of resources. This means that the economic profit is always less than the accounting profit, which does not consider opportunity costs.