Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.
It's easy to identify costs associated with running a business - labor, materials, rent, and advertising. These are all accounting costs, and in this lesson, we'll discuss how they compare to economic costs, and why it matters.
The costs associated with running a business clearly depend on the type of business that you are running, but generally speaking, we can probably name a few of the costs any business has to deal with at some point in time. There is the cost of labor — someone has to get paid for doing work, after all, and even if it's just you running your business, you obviously need to make money. There's equipment or materials— since you are selling something, you either need materials to make your product or equipment to create the content you sell.
All of these costs are called accounting costs. Accounting costs are those costs that have a specific monetary value you need to pay in order to receive the associated benefit. Accounting costs are also called explicit costs. Explicit costs are those stated costs that occur in exchange for a defined good or service.
Economic costs include accounting costs, but they also include opportunity costs. Opportunity costs are the benefits you could have received if you had chosen one course of action, but that you didn't because you went with another option. An example is probably helpful here. Imagine that you own a building and you use it as a warehouse for materials and finished products. If you weren't using that building, you could lease it for $3,000 per month. By using it as storage, you are missing out on the $3,000 in opportunity costs.
You are probably thinking, 'Okay, but if I did that, where would I store my materials and products?' Great question, and this really highlights why it is really important to know the opportunity costs of your decisions. If you leased another building, say for $4,000 a month, then the opportunity cost of $3,000 is well worth the tradeoff; or, if you could limit the amount of material and product you needed to store and find a place to lease for $1,000 per month, you may want to consider doing that. Then you'd actually be making a $2,000 accounting profit.
Opportunity costs are also called implicit costs, since these are the costs of doing business, but not ones that ends up coming out of your bank account or on financial statements; they're just implicit in the simple act of doing business.
Let's look at another quick example of a decision to identify the difference between accounting costs, economic costs, and why we should pay attention to both. We'll keep it simple, and not even in the business context. It'll be in the context of a decision that most people in the United States should be making, or at least considering: attending college.
The case for attending college is far more than financial, but since we are talking about accounting and economic costs, let's focus on the accounting costs. A good estimate for a 4-year college degree in business is about $80,000. That includes books, cost-of-living, etc. So, from an accounting cost perspective, you'll spend $80,000. Those are your explicit costs, or your accounting costs.
Over 79,000 lessons in all major subjects
Get access risk-free for 30 days,
just create an account.
But, you should ask yourself: what else could you be doing with your time? Instead of going to school and paying while you do, you could be working full-time. Maybe you have a decent job in an apprentice position making $30,000 per year. Over the next four years, you could make $120,000. When you're calculating the cost of going to college, your accounting costs are $80,000, but your opportunity cost is $120,000. Remember, economic costs include accounting costs plus opportunity costs (or implicit costs), so the economic costs of going to college is $200,000 ($80,000 + $120,000).
Using Economic vs. Accounting Costs
Does this mean you shouldn't go to college because the economic cost is higher than the accounting cost? Of course not. In fact, just knowing the economic and accounting cost of your decision doesn't even provide enough information to make an informed decision. Remember, we are only talking about costs here.
Also, economic costs are ALWAYS higher than accounting costs. Economic costs are accounting costs, PLUS implicit costs, or opportunity costs. Since you could always be doing something else with your time or investment, there is always an opportunity cost. The goal of calculating economic cost isn't to compare it to accounting costs; it is to serve as a decision-making tool for management.
To use economic costs to make a decision, you could expand our example about attending college. In that example, we only looked at the cost, but we can also look at the benefit. Instead of just looking at the next four years, think of the next ten years. Would the total accounting profit - not just cost - be higher than the economic cost over the same time period if you spent the $80,000 on school, used scholarships and grants to pay for it, then got a higher paying job? Data says the answer is yes.
Let's take a few moments to review some of the main things that we learned in this lesson about accounting vs. economic costs. It's important to understand the difference between accounting costs, which are those costs that have a specific monetary value you need to pay in order to receive the associated benefit, and economic costs, which include accounting costs, but also include opportunity costs. Opportunity costs are the benefits you could have received if you had chosen one course of action, but that you didn't because you went with another option. Remember, accounting costs are also called explicit costs; explicit costs are those stated costs that occur in exchange for a defined good or service. Economic costs are focused on implicit costs, which are costs of doing business, but not ones that end up coming out of your bank account or on financial statements.
Accounting costs end up on financial statements and end up coming out of your bank account. Economic costs, on the other hand, are important considerations and pieces of data for decision making.
Did you know… We have over 200 college
courses that prepare you to earn
credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the
first two years of college and save thousands off your degree. Anyone can earn
credit-by-exam regardless of age or education level.