As someone who is in charge of a number of business expenses, the way I calculate expenses and profits is very different than the average person. It does not necessarily mean that I’m right, but there are many opportunity costs that the average person does not take into calculation.
This article by Jerzy Gangi transcribes my thoughts and my method incredibly effectively into words.
You and your friend Bob have a great idea for an iPhone app. You set up a little office in your basement, and code the app. It takes a few rounds of revisions to get everything right, but soon the app is selling really well. Your acountant presents you with the following profit/loss statement:
Apple Developer License -$100 Adsense campaign -$3,500 App sales +$250,000 ———————————————————— ———— Net accounting profit $246,400
“Great,” you say. “We made $246,400! That’s like a quarter million dollars! Eat that, App Store! Our app kicks ass!” Enjoy this moment, because next I’m going to show you how you actually made a $0 economic profit.
You forgot the opportunity cost
What you failed to account for are your opportunity costs. As you learned above, opportunity cost is “what you had to give up in order to get what you want.” So, what did you and Bob give up to make that iPhone app during the last six months?
Your lost salary, MS in CS -$45,000 Bob’s lost salary, BS in CS -$37,500 Basement apartment lost rentals -$3,600 iPhones for you and Bob -$1,200 Overtime to handle app support -$6,240 More eating out than usual -$1,000 Gas saved not driving to work +$2,700 Sole prop. insurance -$3,500 Apple Developer License -$100 Adsense campaign -$3,500 App sales +$250,000 ———————————————————— ———— Net profit w/opportunity costs $151,060
Now you and Bob can split the remaining money in half. You’ve each made a profit of $75,530. This could be worded as: “when accounting for opportunity costs, you and Bob made $151,060 more than if you both had been employed as salaried computer programmers.” Sounds pretty sweet, right?