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developed the following estimates of annual revenues and costs (on average)

over the first three years of business:

Management fees $140,000

Miscellaneous revenues 12,000

Office rent 36,000

Other office expenses 18,000

Staff wages (excluding self) 24,000

From this list, the new venture’s accounting profit, the difference between rev-

enues and explicit expenses, would be reckoned at $74,000.

Is going into business on one’s own truly profitable? The correct answer

depends on recognizing all relevant opportunity costs. Suppose the money

manager expects to tie up $80,000 of her personal wealth in working capital as

part of starting the new business. Although she expects to have this money back

after the initial three years, a real opportunity cost exists: the interest the funds

would earn if they were not tied up. If the interest rate is 8 percent, this capi-

tal cost amounts to $6,400 per year. This cost should be included in the man-

ager’s estimate. Furthermore, suppose the manager’s compensation (annual

salary plus benefits) in her current position is valued at $56,000. Presumably

this current position is her best alternative. Thus, $56,000 is the appropriate

cost to assign to her human capital.

After subtracting these two costs, economic profit is reduced to $11,600.

This profit measures the projected monetary gain of starting one’s own busi-

ness. Since the profit is positive, the manager’s best decision is to strike out

on her own. Note that the manager’s decision would be very different if her

current compensation were greater—say, $80,000. The accounting profit

looks attractive in isolation. But $74,000 obviously fails to measure up to the

manager’s current compensation ($80,000) even before accounting for the

cost of capital.

In general, we say that economic profit is zero if total revenues are exactly

matched by total costs, where total costs include a normal return to any capi-

tal invested in the decision and other income forgone. Here normal return

means the return required to compensate the suppliers of capital for bearing

the risk (if any) of the investment; that is, capital market participants demand

higher normal rates of return for riskier investments. As a simple example,

consider a project that requires a $150,000 capital investment and returns an

accounting profit of $9,000. Is this initiative profitable? If the normal return on

such an investment (one of comparable risk) is 10 percent, the answer is no. If

the firm must pay investors a 10 percent return, its capital cost is $15,000.

Therefore, its economic profit is $9,000$15,000 $6,000. The invest-

ment is a losing proposition. Equivalently, the project’s rate of return is

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