Question

Tom runs a brew pub in a large city. The brewing equipment he owns has a current market value of $700,000. Tom owes his local bank $300,000. Tom expects revenue for the upcoming year to be $300,000, and his variable costs to be $100,000. Depreciation of his machines is $30,000 yearly. Also, yearly interest on his bank loan is $3,500. If Tom worked as a lawyer (his former employment) instead of running his brew pub, his annual income would be about $125,000. If the brewing equipment were sold today, Tom would pay his bank loan and invest the difference ($400,000), earning 6% rate of return.

a. What is Tom’s accounting profit from the brew pub if he operates it this year?

b. What is Tom’s economic profit from the brew pub if he operates it this year? Should he run the brew pub this year?

Answer 1

Answer:

First of all we need to calculate accounting profit if he operates pub or works as lawyer

Profit will be as below

A Tom’s accounting profit the brew pub

Accounting Profit			Accounting Profit
Brew pub			lawyer
Revenue	300000		Annual Income	125000
Variable Cost	(- 100000)		Return @ 6%	24000
Depreciation	(- 30000)
Loan Interest	( - 3500 )
Accounting profit	166500		Accounting profit	149000

B Economic Profit  the brew pub

Economic profit = Accounting profit - Opportunity cost

Here opportunity cost = 149000 the income received from profession of lawyer and return of 6% on 6 Lacs, because he will not get this income if he has chosen business of Pub

=166500 - 149000

= $17,500‬

Economic profit from the brew pub is $17,500‬.

As economic profit is positive after incurring the opportunity cost of lawyer income and return on investment of 6 lacs, he should operate business.