# Calculate the economic profit of the new factory

Home, - Calculate the accounting profit of the new factory

Question:- Skyjets, an aircraft manufacturing company, invested £200 million five years ago to build a factory for producing wing parts. The factory is now ready. Over the next twenty years that it will be operational, it is expected to generate £200 million in revenues and £25 million in operating costs (including depreciation for the assets, the cost of financing the project, etc). However, the board of directors of the company is considering whether it is worth investing in a new factory, which will adopt the latest manufacturing technology. The new factory would yield £400 million in revenues, £50 million in operating costs, and it would cost £200 million to build. If the old factory is abandoned it would have £0 value to the company.

a. Calculate the accounting profit of the new factory. (5 points)

b. Calculate the economic profit of the new factory.

c. Should Skyjets go ahead with the new project and why/why not?

a. Accounting profit for any business can be derived as follows -

Accounting profit = total revenue minus total explicit costs.

This profit does not include implicit costs or any opportunity cost to be deducted from total revenue

Total revenue of the new factory is £400 million versus operating cost of £50 million.The accounting profit new factory hence would be £350 million.

b.  Economic profit for any business can be derived as under-

Economic profit = total revenue minus total explicit cost - total implicit costs

This profit includes implicit as well as explicit cost of business project to be deducted from the total revenue earned for that particular financial year

Total revenue of the new factory is £400 million versus operating cost of £50 million. Assuming that the new factory will also be operational for 20 years, the depreciation expense would be £10 million each year. This is an example of implicit cost of the business. Also If the organisation would not shift to new factory, it would earn a profit of £175 million from the old cards. They shall be considered as it is opportunity cost. Hence, this shall be termed as it is implicit cost.

Hence, its economic profit would be

Economic profit = £ (400,000,000-50,000,000-10,000,000-175,000,000) = £165 million

Sincethe economic profit is positive and includes the consideration of opportunity cost borne by the organisation, the management of the financial entity should go ahead with building the new factory

c. Since the company claims to increase the building cost from £200 million-£300 million, accounting profit would still remain the same. There would be a significant change in the economic profit of the new factory and its depreciation expense would increase to £15 million. The resultant new economic profit would be £160 million. This is still a positive figure and hence the company should go ahead with the decision of building the new factory.