Friday, September 15, 2006

Economic vs. accounting profit

Suppose that you are currently job hunting. Being a kind chap, your friend offers to give you his sock monkey business. He tells you that each month the business earns $3,000 in sales and costs $3,000 in wages for one worker. Suspicious, you ask your friend, “Why would I want to have a business that earns no profits?” Your friend says, “Look, you can dismiss the worker and make the sock monkeys yourself. Then, your profits will be $3,000 because you won’t have to pay any wages.”

Do you take the offer? If you do, you will earn $3,000 in what is called accounting profit. Your friend thinks that he’s helping you out. But your friend, by using accounting profit as a guide, is ignoring any salary you could earn working for someone else. Economic profit, on the other hand, does factor in the foregone salary as a cost. (The foregone salary is an example of opportunity cost, a fundamental concept in economics.) Suppose you could earn a salary of $4,000. Because the economic profit, $3,000 - $4,000 = -$1,000, is less than 0, you shouldn’t make sock monkeys. You should work for someone else.

Your friend may have your best interests at heart but you shouldn’t trust his financial advice. Would you heed financial advice from a newspaper that makes the same mistake?

Have cash to spare? Invest in a coffeeshop
The Straits Times
By Fiona Chan Sep 10, 2006

IF YOU are among the lucky ones to have made a small fortune selling your home in a collective sale, you may be wondering what to do with your newfound wealth.

Instead of taking the conventional route and reinvesting the money in another new residential property or two, you may do well to consider the unusual alternative of putting your money in a coffeeshop instead…

Homes generally fetch rental yields of 3 per cent to 4 per cent, but some coffeeshops can boast yields of as much as 14 per cent…

Many coffeeshop owners also manage the drink stalls themselves, thus adding to their income as these stalls usually have the highest profit margins. (my emphasis)
Maybe we shouldn’t be too hard on journalists (on second thought, they deserve it). Although the above example is straightforward, economists sometimes disagree on the proper application of opportunity cost.

9 Comments:

Blogger zyn said...

The article is just pointing out a fact - many coffeeshop owners manage the drink stall - rather than recommending that people who buy coffeeshops give up their other jobs to manage the drink stall. I seriously doubt anyone with common sense would read it that way.

11:33 AM  
Blogger a singapore economist said...

Zyn,

I don't agree that it is common sense. Many things that seem obvious to some, particularly when it comes to financial matters, aren't obvious to others.

My general point is that an article saying that it is good to invest in a coffeeshop is frivolous and should be taken with a grain of salt, particularly since the journalist has made a fundamental mistake in how to evaluate choice.

2:30 AM  
Blogger zyn said...

Apologies for belabouring the point, but I don't really understand your argument. You seem to think that the choice central to the article is whether you should quit your job to operate the drinks stall in a coffeeshop when it's actually about higher rental yields from a coffeeshop vs a residential unit. Or am I reading this completely wrong?

4:10 PM  
Blogger a singapore economist said...

My point is that this type of article provides financial advice that is not credible. (I aso wanted to explain an important economic concept.) Typically, this type of article is written by journalists that are financially ignorant. I chose to write about opportunity cost to point out that she made a fundamental mistake and therefore we should be suspicious of the entire article. Here is a longer critique.

We shouldn't find this article credible because returns tend to “even out” across investments. For example, if coffeeshops really offer a relatively high return, it would be short-lived because people would recognize that coffeeshops are a good investment, they would open coffeeshops, the prices at the coffeeshops would go down, and the return would go down. This will continue until the return on coffeeshops is the same as the return on other investments. For this reason, the numbers in the article can’t be right. Why would anyone invest in housing if they could get a 10 point higher return by investing in a coffeeshop?

A little long-winded but that’s why I didn’t get into it in the post. My opportunity cost of blogging has been very high the past couple of weeks. ;)

1:34 AM  
Blogger zyn said...

your argument makes too many assumptions: that of perfect information and instant adjustments. are you seriously suggesting that no articles should be written about good property investments, because the returns will eventually all even out anyway?

i also take issue with your sweeping statement that "Typically, this type of article is written by journalists that are financially ignorant". do you actually know the journalist who wrote this article and can you say that she knows nothing about finance? examples of coffeeshop sales and rental figures are all explicitly mentioned in the article; if you calculate the yields yourself it's pretty clear that these examples surpass residential rental yields.

also, your desire to explain economic vs accounting profit is, as i've pointed out earlier, quite irrelevant to the article in the first place. at this point i'm tempted to ask - what's your own financial background?

4:28 PM  
Blogger a singapore economist said...

are you seriously suggesting that no articles should be written about good property investments, because the returns will eventually all even out anyway?

No, I am "seriously" suggesting that the numbers in the article aren't representative of the industry. They are anecdotal, not data. A 10 percentage point difference in returns is not credible, IMO. It doesn't pass the sniff test for the reasons I mentioned in my previous comment.

I judged the journalist as financially ignorant based on what she wrote. You can judge me by the same standards. I won't try to persuade you by listing my credentials.

4:08 AM  
Anonymous abol said...

Noted. But it is a pretty snapshot argument.You to account NPV of both sides as well. NPVs of doing the business and the NPVs of working. You way end up noting that NPV of doing busines is far greater than continuously working, ot otherwise. But, what I am positing here is that economic profit is purely not enough for long term decision. Economic profit is normallt use to evaluate current performance and not future long term decision.

6:01 PM  
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