David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 6 Introducing supply decisions
pays its workers only £7 an hour. During
2009 it rented 100 000 hours oflabour. Business
expenses, including leasing an office,
buying advertising space and paying telephone
bills, were £200 000. Table 6.1 shows
the income statement or profit-and-loss account
for 2009. Profits before tax were £100 000.
Tax was £25 000. R-a-P's after-tax profits
were £75 000. Now for the complications.
Unpaid bills
People do not always pay bills on time. At
the end of 2009, R-a-P has unpaid bills for
workers hired to other firms during the year.
Nor has it yet paid its own telephone bill for
December. From an economic viewpoint, the
right definition of revenues and costs relates
to the activities during the year whether or
not payments have yet been made.
Actual receipts and payments thus may differ
from economic revenue and cost. Profitable
firms may still have a poor cash flow, for
example when customers are slow to pay.
Table 6.1 R-a-P income statement, year to
31 December 2009
Revenue
100 000 hours @ £10 £1 000 000
Cost
Wages £700 000
Adverts £50 000
Office rent £50 000
--
Other expenses £100 000
-£900 000
Pre-tax profit £100 000
Tax £25 000
Post-tax profit £75 000
A firm's cash flow is the net
amount of money actually
received during the period.
Physical capital is
machinery, equipment and
buildings used in production.
Capital and depreciation
R-a-P owns little physical capital. Instead, it leases office space, typewriters and desks.
However, many firms do buy physical capital. Economists use 'capital' to denote
goods not entirely used up in the production process during the period. Buildings
and lorries are capital, to be used again in the next year. Electricity is not capital:
purchases in 2009 do not survive into 2010. Economists also use 'durable goods' or
'physical assets' to describe capital goods.
How is the cost of a capital good treated in calculating profit and cost? It is the cost of using rather than
buying capital equipment that is part of the firm's costs within the year. If R-a-P leases all its capital
equipment, its costs include merely the rentals paid in leasing capital goods.
Suppose R-a-P buys 8 computers in Januaryfor£1000 each. £8000 is not the cost of computers in calculating
costs and profits for that year. Rather, the cost is the fall in value of the computers over the year. Suppose
wear-and-tear and obsolescence reduce the value of a computer by £300 during the year. Part of the
economic cost using 8 computers over the year is the £2400 by which they depreciate during the year.
Depreciation is the loss in
value of a capital good during
the period.
Depreciation makes economic profit and cash flow differ. When a capital good is
first bought there is a large cash outflow, much larger than the depreciation cost of
using the good in the first year. Profits may be high but cash flow low. In later
years, the firm makes no further cash outlay, having already paid for the capital
goods, but must still calculate depreciation as an economic cost since the resale value of goods falls steadily.
Cash flow is now higher than economic profit.
Treating depreciation, not the purchase price, as the true economic cost spreads the initial cost over the life
of the capital goods but that is not why we calculate cost in this way. R-a-P could have sold its computers
for £5600 after a year, restricting its costs to £2400. Since it chose to keep them for reuse in the next year,
the latter strategy is even more profitable. Hence the true economic cost of using the computers in the first
year is at most £2400.
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