The Midnight Hour, a local nightclub, earned $100,000…

Question:

The Midnight Hour, a local nightclub, earned $100,000 in accounting profit last year. This year the owner, who had invested $1 million in the club, decided to close the club. What can you say about economic profit (and the rate of return) in the nightclub business?

Answer:

Economic profit is the difference between revenue and (explicit costs + implicit costs).

According to the information,

Accounting profit = $100,000

Owner’s investment = $1 million.

Now, calculate the accounting rate of return on investment.

Hence, the accounting profit does not include implicit costs. In this problem, implicit cost is the income where the owner of the nightclub can earn on the investment, if he invests it somewhere else.

The owner can run the nightclub, if he invests the $1 million on any other best available project, where the accounting rate of return on investment is less than 10%.

Owner of the nightclub wants to close the club because, in accounting terms, he can earn more than 10% on investment by investing in some other project. If he considers the opportunity cost, then his economic profit will be negative. Due to negative economic profit, the economic rate of return will also be negative.

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