Chapter 1 - Applied Problem 1 1. At the beginning of the year, an audio engineer

Question

Chapter 1 - Applied Problem 1 1. At the beginning of the year, an audio engineer quit his job and gave up a salary of $175,000 per year in order to start his own business, Sound Devices, Inc. The new company builds, installs, and maintains custom audio equipment for businesses that require high-quality audio systems. A partial income statement for Sound Devices, Inc., is shown below: 2010 Revenues Revenue from sales of product and services . . . . . . . . . . . . . . . . . $970,000 Operating costs and expenses Cost of products and services sold . . . . . . . . . . . . . . . . . . . . . . . 355,000 Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155,000 Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Total operating costs and expenses . . . . . . . . . . . . . . . . . . . . . $555,000 Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $415,000 Interest expense (bank loan) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 Legal expenses to start business . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $177,000 To get started, the owner of Sound Devices spent $100,000 of his personal savings to pay for some of the capital equipment used in the business. In 2010, the owner of Sound Devices could have earned a 15 percent return by investing in stocks of other new businesses with risk levels similar to the risk level at Sound Devices. a. What are the total explicit, total implicit, and total economic costs in 2010? b. What is accounting profit in 2010? c. What is economic profit in 2010? d. Given your answer in part c, evaluate the owner

Explanation / Answer

There is not enough information given to answer all of the questions using consistent information, without making some assumptions about the tax consequences of the decisions. Since income tax expense incurred is based on the accounting profit of the business, it is an explicit cost, and should be added to that total. But in order to compare the results of his decision, the income taxes that he would have paid if he had kept his job should be deducted from implicit costs, since it would offset what he gave up to start the business. That information is missing from the question. You have to assume something in order to get an answer that makes a, b, c, and d consistent with each other. I will give you the numbers on a pretax basis, which basically assumes that higher accounting earnings will always mean higher income taxes. That isn't really always going to be the case because different things involved could be taxed at different rates. You have to manipulate the numbers somehow to account for the unknown; I'm not sure how your teacher wants you to do that. Keep in mind with my answers, I am giving you numbers that mean that explicit costs should be increased by $165,000 over the numbers I give, and explicit costs should be decreased by the amount of income taxes that he would have had to pay if he had kept his job: a) explicit costs would be the accounting costs listed (minus income taxes for the reasons listed above), which total $628,000 implicit costs would be opportunity costs (what he gave up), which are the salary of $175,000, plus the $15,000 he could have earned on investing the $100,000 in stocks of other businesses instead of putting it in his own business, for a total of $190,000. economic costs would be the total of explicit plus implicit costs, or $818,000. b) accounting profit would be the profit listed on the income statement, or $177,000. On a pretax basis, that would be $342,000. c) economic profit would be accounting profit minus implicit costs. That would be: pretax: $342,000 minus $190,000, or $152,000 posttax: $177,000 minus $190,000, but you have to add back in the tax that he would have had to pay if he had kept his job, which is an unknown. If that tax amount is greater than the difference of $13,000 between accounting profit and other implicit costs, then note that his economic profit would be a positive number. d) as long as the decision is to be evaluated solely on the numbers for the current year, then a positive economic profit means that he made the right decision. A negative economic profit would mean that he made the wrong decision. This number (economic profit) will tell you whether he made enough to cover opportunity costs. This answer to d) requires additional assumptions. It is based solely on current year numbers. The opportunity (explicit) costs should be reduced by the added satisfaction (utility) that he gets from owning his own business instead of working for somebody else. It should also be adjusted for the difference in the present value of future potential earnings, since that is always a major factor in the start of any business (most businesses expect future earnings to be greater than startup, or first year earnings; wiegh that against whatever raises he would expect if he had kept his previous job). Your teacher may be expecting you to ignore the additional implicit costs that I list here as assumptions that you have to make, or he may not have considered these himself. It might make things clearer to you if you give him my explanation about changes in income tax between the two choices, the utility of the independence of owning the business instead of working for someone else, and the impact that future earnings should have on this decision. Ask your teacher about these things, and see what he says.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.