Accounting Costs vs. Economic Costs
Is it worth it? Most financial decisions come down to this one simple question. Determining the answer, however, is not so simple. Whether an investment is seen as a profit or as a loss may depend on the types of costs analyzed. While revenue minus expenses equals profit, not all expenses qualify. Generally, profitability is determined by examining two types of costs: accounting costs and economic costs.
Accounting costs, also known as explicit costs, are costs that involve money being spent. Examples include rent, interest payments and utility bills. Another example would involve the decision to become a full-time student. Suppose someone quits her job and becomes a full-time student. If this person pays $30,000 for tuition and textbooks, but finds a $40,000-a-year job after graduation, her profit after attending college and working for one year is $10,000 (40,000 - 30,000 = 10,000). In this scenario, the $30,000 represents accounting costs, and the $10,000 can be thought of as accounting profit.
Economic costs include accounting costs and implicit costs. Implicit costs, also known as opportunity costs, do not involve spending money; rather, they involve opportunities to earn money that are abandoned in a financial decision. Using the previous example with the college student, if the college student gave up a $20,000-a-year job to go to school for four years, the opportunity cost would be $80,000 (20,000 x 4 = 80,000). In this scenario, the college student would have a $70,000 economic loss one year after graduation, even with the $40,000 job (40,000 - 30,000 - 80,000 = - 70,000).
Sunk costs are costs that have already been incurred. In the scenario with the college student, the opportunity cost in the decision was the loss of a $20,000-a-year job. However, if the person was already planning on leaving that job, it would be a sunk cost. The $20,000 job would be lost whether the person went to college or not. Unlike accounting and economic costs, sunk costs should not be considered when making financial decisions.
Whether a project is deemed profitable can depend on which costs are analyzed. Accounting costs are most often used to determine profitability, but economic costs should not be ignored. If office or building space that could have been used for something else is used in a project, the opportunity cost should be taken into account. Ignoring economic costs or using sunk costs in a decision can artificially increase or decrease profit.