Darrell is the owner of a furniture store. Last year, his total revenue was $525,000 and his total labor costs were $200,000. His overhead expenses, including insurance and legal fees, were...
Darrell is the owner of a furniture store. Last year, his total revenue was $525,000 and his total labor costs were $200,000. His overhead expenses, including insurance and legal fees, were $175,000. The rent on his building was $45,000. Darrell could earn $105,000 per year working at a nearby furniture distributor. From this information, how do we know what his accounting profit was?
The key to understanding this question is knowing the definition of accounting profit. If you know what this term means, you will know that one of the numbers in this question is irrelevant and is only put there to see if you know the difference between accounting profit and economic profit.
Accounting profit is what most people think of when they think of profit. It is the difference between how much money you bring in and how much money you spend. It has nothing to do with your opportunity cost. This means that the amount of money that Darrell could make if he worked at the distributor’s does not matter. That would only matter if this were a question about economic profit.
So, to find his accounting profit, we need to add up his expenses and subtract them from his revenue. His expenses are $200,000 for labor, $175,000 for overhead, and $45,000 for rent. Those add up to $420,000. His revenue was $525,000. Therefore, his accounting profit was $105,000.
Darrell's accounting profit is calculated in terms of revenue and losses. The money he could make going elsewhere has nothing to do with it, since we are solely looking at his business at this point. You can think of accounting profit in terms of a ledger that lists money taken in and money sent out--this is similar to how one balances a checkbook. For the year, Darrell's business made $525,000. Now subtract $200,000 for labor, $175,000 for overhead (which I'm assuming means utilities), and $45,000 for rent. After you subtract what he has to spend from his total revenue, Darrell is left with $105,000. According to the question, this is what Darrell could be making somewhere else; however, we are not asked to make any judgments on Darrell's career decisions--we only calculate profits and losses when looking at accounting profit.