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Video transcript

let's think about how we would account we would have accounted for things if instead of renting our building for $200,000 instead we bought the building for two million dollars how would have that showed up how would that have shown up on from an accounting profit point of view and an economic profit point of view so we're going to buy we're going to buy our building for two million dollars so that is the market value of our building at the beginning of our period at the beginning of year one and let's say at the end of year one so this this is year one right over here that occurs and maybe to a large degree this is because I use the building there was a lot of traffic in there became maybe was a brand new building before and now it's essentially kind of the building itself has taken some wear and tear and because of that the market value of the building is now 1.9 million dollars so essentially through this year the building's value has depreciated by $100,000 so we'll say the depreciation is $100,000 notice I didn't pay anyone that hundred thousand dollars it was not an explicit it was not an explicit opportunity cost but this really is an opportunity cost because I've this I spent that this hundred thousand dollars is the opportunity cost of not selling the building a year ago and instead using that building I have essentially lost out on a hundred thousand dollars now that's not all that I have lost out on I have also lost out on the ability to invest this two million dollars in other things maybe I could have got maybe I could have invested the two million dollars at a five percent rate and gotten some interest on it so I also have the opportunity cost opportunity cost of capital of capital of not investing that two million dollars someplace else and so the opportunity cost of capital let's say I could have gotten I could have gotten five percent on my two million dollars so five percent of two million is $100,000 so my opportunity cost of capital right over $100,000 another way to think about it is let's just say that I buy the building and I sell it at the end of the year then I would have literally lost a hundred thousand dollars on that transaction and although I might have used it so I got some value out of it and I would have lost another hundred thousand dollars by not having that money invested in some other use during that period so these are the two non explicit costs that will come in - that would show up in our profit statements now this depreciation depreciation is something that is accounted for by accountants when you look at a company's financials you will see something called depreciation which is a measure of how are you you're kind of using up your capital goods you are using up your building you are using up your equipment you are using up your your vehicles or whatever else you might have economists are very pure about depreciation they say what was the market value at the beginning of the period what is the market value at the end and so the difference is how much it has depreciated and this is kind of it's actually almost a more natural way in accounting and I won't go into the details there are many ways to depreciate something you might be able to say well if the thing is worth two million dollars and if it's going to last me ten years I can depreciate a hundred thousand dollars a year or actually two hundred thousand dollars here two million divided by ten years and there's different incentives based on if you are if you are the owner of a firm of how you depreciate you might want to actually have a lot of depreciation for tax purposes so that you can somehow hide a high day hide a profit or whatever but for the sake of this video we're going to assume that both the accountants and the economists will will mark off a hundred thousand dollars of depreciation if we'd about if we were to buy the building so let's redo our two financial statements the accounting version and the economic version so in the accounting version so let me copy and paste all of this so copy and let me go down here and paste it let me paste it and so now now we don't have any rent expense instead of renting the building we've gone off and we've bought the building so let me get rid of that so our rent expense is now going to be zero is now going to be easy but we do have a depreciation expense and I'll write that in another color we do have a depreciation expense of one hundred of one hundred thousand dollars and we don't think about the opportunity cost of capital what we could have done what we could this is opportunity cost of capital what we could have done with that two million dollars that we used to buy the building and so our pre-tax profit our pre-tax accounting profit pre-tax profit from an accounting point of view is going to be is going to be let's see 50 minus 200 is 300 minus another - another let me make sure I get this right so I have I have actually it's gotten better because my rent was 200 and now I only have a depreciation of 100 so it's 50 minus 350 gives me a pre-tax profit of 150 thousand dollars now let's and that was because I was renting it for more and now my depreciation based on how what happened with the market rate actually changed less than what my rent would have been but the economic profit at least based on the way we've done the numbers here it'll actually come out neutral which it should because we really economic profit we're just trying to decide does it make sense for us to run this business in this way and so when we look at the economic profit let's copy and paste this again so we're going to let me copy just this part so copy and paste and maybe if things actually did improve when we actually changed how we how we whether we owned or rent then that would say well that's the more economic way to do it so let's say this year to year or this is year one again but now we're doing this is economic profit year one so our food is the same our labor is the same our rent disappears we get rid of that let me get rid of the rent the rent is now going to be zero we now on our building rent is zero these are all our explicit costs these are direct outlet outlet these are direct payments of money to someone else but now let's think about our implicit costs implicit implicit costs well we still have the same implicit cost that we had up here we have the wages foregone we talked about maybe I was a doctor and I'm not working as a doctor to run this restaurant so my wages foregone or $150,000 wages foregone for God are 150,000 never actually I think wages wages lost are 150,000 dollars and now we have the depreciation on top of that I'll do this in magenta to show what is new we have the depreciation of $100,000 and on top of that we have the opportunity cost of capital the return we could have gotten on that two million dollars that instead we used to buy the building so I'll call it I'll call it OCC opportunity cost of capital in this situation was the 5% of two million dollars another $100,000 $100,000 so the way that I've worked out the numbers here we we didn't have to spend two hundred thousand on rent but we increased our implicit costs by owning the building by two hundred thousand so it all comes out the same we still get what we got in the previous one of an economic profit of negative one hundred thousand dollars negative one hundred thousand of economic economic profit economic profit and this of course was accounting accounting profit and so what I wanted to really just highlight in this is that you don't get kind of a freebie on the economic profit when you decide to buy instead of rent or a rent versus buy you there are still ways of accounting for essentially the opportunity cost of doing any of these actions