Managerial Economics - Christopher R. Thomas-S. Charles Maurice

CHAPTER 1 Managers, Profits, and Markets 13
Depending on the type of financial statement and where it appears in a statement,
accounting profit goes by a variety of names such as income, net income, operating
income, net profit, earnings, or net earnings.
As you can see, when firms employ owner-supplied resources, the resulting
implicit costs are not subtracted from total revenue and the accounting profits
reported in financial statements overstate business profitability. All three types
of implicit costs discussed earlier are ignored by accountants. 3 We want to stress,
however, that when financial accountants omit these implicit costs from financial
reports, they are following generally accepted rules set forth by the FASB and
SEC. The practice of omitting most kinds of implicit costs, which can be quite large
for many firms, is widely recognized by managers, shareholders, government officials,
and financial analysts, who make lucrative careers converting the information
in financial accounting statements into measures more closely resembling
economic profit (see Illustration 1.2).
Business owners, of course, must bear all costs of using resources, both explicit
and implicit, regardless of which costs may be deducted for accounting purposes.
Because all costs matter to owners of a firm, you should now clearly understand
why maximizing economic profit, rather than accounting profit, is the objective of
the firm’s owners. And, as we explain in the following section, the value of a firm
is determined by the amount of economic profit, rather than accounting profit
the firm is expected to earn in the current period and all future periods. As you
now see, it is economic profit that matters in business decision making, so in the
rest of this chapter and in later chapters whenever we refer to “profit,” we will
mean economic profit. We will now summarize the relation between economic and
accounting profits in a principle:
Principle Economic profit is the difference between total revenue and total economic cost:
Now try Technical
Problem 2.
Economic profit 5 Total revenue 2 Total economic cost
5 Total revenue − Explicit costs 2 Implicit costs
Accounting profit differs from economic profit because accounting profit does not subtract from total
revenue the implicit costs of using resources:
Accounting profit 5 Total revenue 2 Explicit costs
Since the owners of firms must cover the costs of all resources used by the firm, maximizing economic profit,
rather than accounting profit, is the objective of the firm’s owners.
3
One of the implicit costs that accountants do deduct when computing accounting profit is
the cost of depreciation of capital assets, which is the reduction in the value of capital equipment
from the ordinary wear and tear of usage. As you may know from taking accounting courses,
businesses have several methods to choose from when computing depreciation costs, and some of
these methods tend to overstate the actual value of depreciation in the early years of equipment
ownership.