Finance Formulas / May 8, 2018 / Briana Leonard
An individual starts a business and incurs startup costs of $50,000. During the first year of operation, the business earns a profit of $75,000. If the individual had stayed at his previous job, he would have made $30,000. In this example, the accounting profit is $25,000, or $75,000 - $50,000. However, because the individual had the potential to earn income at another location while retaining the startup costs of the business, an economic loss of $5,000, or $25,000 - $30,000, is incurred. Although an accounting profit occurred, the individual would have made a larger profit if he had stayed in his previous position.
The personal debtequity ratio is often used in financing, as when an individual or small business is applying for a loan. This form of DE essentially measures the dollar amount of debt an individual has for each dollar of equity they have. DE is very important to a lender when considering a candidate for a loan, as it can greatly contribute to the lender’s confidence (or lack thereof) in the candidate’s financial stability.
Contribution margin is used by management when making pricing decisions. This is especially true in special pricing or special order situations where fixed costs are sunk costs and should not be factored into the decision whether to accept or reject. Negative or low contribution margins indicate a product line or business segment may not be profitable.
Economic profit is determined by economic principles, not GAAP. Just like accounting profit, costs are deducted from revenues. Economic profit uses implicit costs, not just explicit costs. Implicit costs are considered opportunity costs and are normally the company's own resources. Examples of implicit costs include company-owned buildings, equipment and self-employment resources. Economic profit computations are not normally limited to time periods like accounting profit computations are. Economic profit is used more to judge total value of the company somewhat like the performance metric economic value added (EVA) would and is helpful in calculating total production costs.
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