Wali is planning to buy a family owned restaurant in a very good location. When

Question

Wali is planning to buy a family owned restaurant in a very good location. When looking at the accounting books, he notices in the balance sheet that there are no labor costs. The answer he gets from the seller and owner of this family owned restaurant is: 'I was the manager, my husband was the cook, my two kids were passing dishes and cleaning tables. It is a family business, you know. We didn't charge ourselves any money to reduce costs and make this restaurant profitable. And as you can see, we have profits since we started the business 5 years ago. It is very profitable, you can do the same and be successful.'

What would you advice Wali to consider before buying the restaurant? Explain.

Explanation / Answer

I would advice Wali to include the imputed value of their labor into computation of profit.

Accounting (book) profit equals the difference between revenue and accounting (explicit) costs, which are the costs that are actually incurred and paid. But economic profit equals the difference between accounting profit and implicit (opportunity) costs, which is the benefit foregone by choosing one alternative over another, which in this case is the value of labor included in the business. A positive accounting profit does not necessarily ensure a positive economic profit. If total implicit costs are higher than accounting profit, then economic profit would be negative.

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