Accounting Profit vs. Economic Profit: Beach Umbrella Rental Case Study

Overview of the Beach Umbrella Business Venture

  • Entrepreneur: William Howey, a college student, who is also referred to as Harry.

  • Business Model: Renting out beach umbrellas at an ocean resort.

  • Operational Period: The business is planned for next summer, specifically the three months of June, July, and August.

  • Lease Inventory: William intends to lease 5050 umbrellas for this three-month duration.

  • Revenue Model: He believes each umbrella can be rented to vacationers at a price of $5\$5 per day.

  • Location and Fixed Fees:

    • Umbrella Leasing Cost: The cost to lease the 5050 umbrellas for the three-month period is a one-time fixed payment of $3,000\$3,000.

    • Business Location Fee: The fee to rent the operational location is $3,000\$3,000 per month.

  • Labor: William will operate the business entirely by himself; no additional employees will be hired.

  • Alternative Employment Opportunity (Opportunity Cost): If he decides not to start this business, he has the option to perform construction work, which would earn him $4,000\$4,000 for the same three-month period.

Accounting Profit Calculation

  • Profit Definition: Accounting profit is defined as the total revenue (total earnings) minus the total explicit costs.

  • Calculation of Total Revenue:

    • Total Days Demanded: There are 8080 days during the summer when beach umbrellas are demanded.

    • Capacity: Harry rents all 5050 of his umbrellas on each of these days.

    • Price: The rental price is $5\$5 per umbrella per day.

    • Formula: Total Revenue=80 days×50 umbrellas×$5 per day\text{Total Revenue} = 80\, \text{days} \times 50\, \text{umbrellas} \times \$5\, \text{per day}

    • Result: The total revenue for the summer period is $20,000\$20,000.

  • Calculation of Total Explicit Cost:

    • Location Rent Cost: The fee is $3,000\$3,000 per month for three months.

    • Location Subtotal: 3\, \text{months} \times \3,000\, \text{per month} = \9,0009,000

    • Umbrella Lease Cost: A one-time fixed payment of $3,000\$3,000 for the entire duration.

    • Formula: Total Cost=$9,000+$3,000\text{Total Cost} = \$9,000 + \$3,000

    • Result: The total explicit cost is $12,000\$12,000.

  • Final Accounting Profit:

    • Formula: Accounting Profit=Total Revenue−Total Explicit Cost\text{Accounting Profit} = \text{Total Revenue} - \text{Total Explicit Cost}

    • Calculation: $20,000−$12,000=$8,000\$20,000 - \$12,000 = \$8,000

    • Result: The total accounting profit that would be recorded on financial books for the summer is $8,000\$8,000.

Economic Profit and Decision-Making

  • Economic Profit Definition: Economic profit goes beyond accounting profit by accounting for opportunity costs (the value of the next best alternative sacrificed to pursue a specific choice).

  • Opportunity Cost Identification: The alternative for William is construction work, where he would have earned $4,000\$4,000.

  • Equation for Economic Profit:

    • Economic Profit=Accounting Profit−Opportunity Cost\text{Economic Profit} = \text{Accounting Profit} - \text{Opportunity Cost}

  • Calculation of Economic Profit:

    • Calculation: $8,000−$4,000=$4,000\$8,000 - \$4,000 = \$4,000

    • Result: The economic profit generated by the umbrella business is $4,000\$4,000.

  • Analysis and Comparison:

    • An economic profit of $4,000\$4,000 indicates that by choosing the umbrella rental business, William is making an additional $4,000\$4,000 in income over the three-month period compared to what he would have earned in construction.

    • Because the economic profit is positive, it signifies that the umbrella rental business is the wiser choice between the two available options.

    • Economic profit serves as a guide for decision-makers, helping them identify which option among multiple alternatives will generate the greatest additional profit and determine the most efficient use of resources.