How to Calculate and Use Accounting Cost and Economic Cost

Is accounting cost sufficient for small businesses, or should you also incorporate economic cost? The Blueprint takes a look at which you should use.

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While there are a variety of types of accounting, they all use one common characteristic: accounting costs.

In simple terms, any expense that comes out of your bank account is considered an accounting cost.

While calculating accounting cost is a necessity for any business, small and large, calculating economic cost, while not a necessity, can be a valuable tool when looking to make an informed decision regarding your business.

Economic cost allows you to look at a variety of “what-if” scenarios and see exactly how those scenarios might affect your business and your bottom line.

At a glance: How economic cost and accounting cost work

  • Accounting costs represent anything your business has paid for.
  • You can calculate accounting cost by subtracting your expenses from your revenue.
  • Economic costs represent any “what-if” scenarios for your business.
  • You can calculate economic cost by subtracting implicit costs from your accounting cost.

What is accounting cost?

Accounting cost, like accounting profit, follows the basic principles of accounting 101. In simpler terms, accounting cost is the overall cost of anything your business has paid for.

These costs include the following:

  • Rent
  • Utility expenses
  • Food and entertainment expenses
  • Travel expenses, including transportation and hotels
  • Payroll expenses, including salaries and related payroll taxes
  • Supplies
  • Insurance
  • Any other expenses incurred during the normal course of business

All of the expenses listed above are considered explicit costs, which means they are direct costs associated with your business. These costs are automatically accounted for each time an expense is recorded in your accounting software or ledgers.

As long as you know how to track business expenses, and all of your financial transactions are properly recorded, there is no additional work necessary in order to calculate accounting cost.

What is economic cost?

Economic cost is a step further than typical bookkeeping basics and is often used by economists to compare two separate courses of action. It also looks at the impact each action would have on your business. Economic cost is calculated by taking your accounting cost, which has already been calculated, and also subtracting any implicit costs.

Implicit costs are calculated by analyzing your current resources and estimating the cost of those resources, as well as their impact to your business, should you decide to utilize them in a different way.

Accounting cost vs. economic cost: What’s the difference?

To understand accounting cost and economic cost, you must first understand the difference between explicit and implicit costs.

Explicit costs

Explicit costs are the total costs of doing business throughout the year. Explicit costs are everything from the cost of the office you rent to the salary you pay your employees.

Accountants use accounting cost to determine the profitability and financial health of your business since you will need to determine accounting costs prior to determining accounting profit.

Implicit costs

Implicit costs are designed to be used when making decisions. Implicit costs are often used by businesses looking to make strategic decisions, or to determine the true cost of a business decision they are considering.

Accounting Cost Economic Cost
Uses standard costs incurred in business Uses a “what if” scenario
Uses explicit costs only Looks at a long-term time frame
Determines profit or loss for a specific period of time Considers both explicit and implicit costs
Used for tax purposes or to determine financial health of your business Used to make long-term strategic decisions

Accounting cost and economic cost use different factors in their calculations

Should you use accounting cost or economic cost for your small business?

You use accounting cost in your business every day. Bank managers and investors will always look at your accounting cost to determine the financial health of your business.

Accounting cost is also used in the preparation of income taxes. The real question is whether it’s feasible to introduce economic cost as well.

It may be useful for a small business owner to use economic cost when making decisions regarding the future of her business, such as when creating financial projections. Using economic cost calculations can also be valuable if you’re looking to start a new business or expand your current one.

How to calculate accounting cost

Jane Brown is an attorney who wants to start her own small law firm. Jane expects to earn $150,000 in revenue her first year of operation. She will also pay a part-time legal assistant $30,000, with an additional $3,000 in payroll taxes for the year. Jane will initially be working from home and has estimated her other expenses.

Here’s what Jane’s projected profit and loss would be for her first year in business.

Total revenue (projected) $150,000
Gross profit $150,000
Expenses (projected)
Salaries $  30,000
Payroll taxes $    3,000
Utilities $    2,500
Insurance $    1,500
Office supplies $    3,500
Other expenses $    2,500
Total expenses $  55,000
Net profit $  95,000

The accounting cost of Jane opening her own firm

When we look at Jane’s projected gross profit, we can see that it’s $150,000, while her net profit, or accounting profit, is $95,000, which is why it’s important to look at revenue vs. profit when creating a profit and loss estimate for any business.

If Jane proceeds and opens her business based on the above figures, it’s projected to be successful, with expenses totaling $55,000. Those expenses are then subtracted from her gross profit to obtain her net profit of $95,000.

That is Jane’s explicit, or accounting cost of opening her small firm.

How to calculate economic cost

However, there are several details Jane may want to consider before making her final decision. This is where calculating economic cost can be helpful.

For instance, when Jane leaves her current job to open her own firm, she will be losing her $95,000 salary and medical benefits worth $5,000 when she leaves. When calculating economic cost, this $100,000 loss is subtracted from Jane’s current net profit of $95,000, leaving her with a projected $5,000 loss should she go ahead with her plans.

Total revenue (projected) $150,000
Gross profit $150,000
Expenses (projected)
Salaries $  30,000
Payroll taxes $    3,000
Utilities $    2,500
Insurance $    1,500
Office supplies $    3,500
Other expenses $    2,500
Total expenses $  55,000
Net profit $  95,000
Implicit cost $100,000
Net profit $  (5,000)

The economic cost of Jane opening her own firm

When Jane calculates the loss of her salary into her decision to open her own law firm, she will need to acknowledge that she is projected to earn less on her own than she currently earns.

Does that mean Jane shouldn’t open her own firm? No, but it does give her a more complete financial picture than accounting cost alone.

Economic cost looks at assets you already own and how they may be used in a different way. In Jane’s case, she is considered an asset. In another example, you may own the building where your business is housed, but the implicit cost of using that building is what you give up in return, such as potential rental income.

Again, this doesn’t mean you shouldn’t purchase a building for your business operations, but it does let you know that you may be able to earn a much bigger profit if you choose to rent the building instead.

Using both economic and accounting costs for your business

While most small business owners will continue to use only accounting cost to determine the financial health of their business, there’s a strong case to be made for introducing economic cost into the mix.

The next time you face a decision such as whether to open another location, whether to hire more staff, or whether you should look for other employment and work at your business part time, calculating the economic cost of those decisions can go a long way toward helping you make more informed choices.

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