The profit-making of an organization is largely dependent on two major factors, which are cost and revenue. The cost degree relative to the revenue establishes the overall firm profitability. To optimize its profits, a firm needs to generate more revenue while limiting its expenditure (Woolridge & Gray, 2006). While market conditions affect the level of revenue generated to a large extent, costs can be minimized by using the lowest output costs combination, improving organizational efficiency, or enhancing factor productivity. However, it’s important to note that output is directly dependent on the costs incurred by the firm.
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Producers pay the production factors for the production services they provide. Such expenses incurred on the production factors constitute the cost of production. Various forces affect the pricing of products. However, they broadly fall under two categories, which are demand and supply (Woolridge & Gray, 2006). In the case of Lemonade stand, pricing is based on perceived demand, which is largely reliant on the weather. Weather controls the people who feel the need to have the Lemonade drink. However, the cost of producing a unit of Lemonade determines the Benchmark price beyond which the business will not be viable.
Explicit versus implicit costs
However, another important for as much as a business may generate profit; it may be important to evaluate whether it was investing the capital and time in the business at the expense of other opportunities that could have existed. Business situation analysis goes beyond financial statement analysis only (Buchanan, 2008). Economic analysis of business analysis also goes a long way in establishing a strong foundation for making decisions. The economic analysis incorporates implicit costs as well as explicit costs, which help a lot in business decision-making.
Among essential concepts of economics is that the value associated with an item is actually precisely what an individual has to surrender to be able to obtain if one is tired of doing his regular job, which pays an annual salary of $500, and opts to run the lemonade business stand. He has to give up the accounting job and hence gives up his accounting job income. This is the opportunity cost he loses the accounting job in order to run the lemonade stand. Two types of costs emerge in such a situation explicit costs and implicit costs. Explicit costs are incurred in terms of the cost of setting up the business, while implicit costs do not require any cash outlay, i.e., the income that could have been earned while working at the accounting firm (Buchanan, 2008). Explicit costs define the entire cost incurred in establishing and operating the business.
The opportunity cost of the lemonade stand is provided in the simplest kind. Whilst this particular specific description associated with expense may be the favored benchmark for economists within expounding on cost, not every expense in decision-generating circumstances tend to be entirely apparent; one particular expertise of an excellent administrator may be the capability to discover concealed costs (Buchanan, 2008). Typically, the accountants are principally related along with an assortment of historical cost information for use in revealing a business’s monetary conduct and situation and establishing its taxation. The document or report exactly what occurred, existing data which will certainly safeguard the interests of investors in the organization, and offer requirements alongside which efficiency can be evaluated. Most of these possess merely an indirect connection to decision-building.
In the case of Lemonade stand, it is presumed that prior to investment, there was an opportunity to work as a clerk, a job which could have earned $500 during three similar seasons like the one that the business has been conducted. The clerical job’s earnings are therefore treated as the opportunity cost incurred in order to open the Lemonade stand business. To establish whether the business was worth leaving the clerical job, both accounting and financial reporting are necessary.
Lemonade Stand business performance
|Season 1||Season 2||Season 3|
From the Net Income statement, there is no doubt that the business had increased income for the third season in a row. However, the profit percentage growth showed a significant decline. The change in profit was not as large as it was in the previous season.
|Assets:||Season 1||Season 2||Season 3|
|Total Liabilities & Owner’s Equity||196.13||332.28||328.45|
From the balance sheet, it is revealed that the asset value of the business declined from$332.28 to $328.45. Similarly, liabilities declined significantly from $44.25 to $28.13.
|Season 1||Season 2||Season 3|
|Return on equity||75%||79%||77%|
|Return on Assets||62%||69%||71%|
|Debt to equity ratios||1.21||1.15||1.09|
Ratio analysis of the three seasons yields significant results useful in decision making. There is a declined growth in ROE in their season, with shareholders earning 77 cents for every dollar they invested, unlike the previous season where they earned 79 cents. ROA, on the other hand, grew with every dollar worth of an asset earning 71 cents, contrary to the previous year, where 60 cents was earned for every dollar worth of an asset. The current ratio rose from7.24 to 11.42, showing the increased ability of the business to pay for its operations. The debt to equity ratio further dropped from 1.15 to 1.09, which is often preferable by the lenders (Erich, 2001). This ratio is used to measure how capital relates to the creditor’s contribution.
As earlier mentioned, it is presumed that the opportunity cost of having invested in the business is $500. The total revenue is summed as the overall revenue generated over the three-season period and similarly the explicit costs. Based on these facts, an economic profit of $81.86 is generated, and hence, just like the account would, economists acknowledge that it was worth sacrificing the clerical job in order to invest in the Lemonade stand.
The conclusion reveals that both from an economic as well as accounting perspective, the Lemonade stand business was able to generate profit and, as such worth investing in. similarly, the ratios indicate that the business is doing well as most of the ratios show positive results. The Lemonade stand business can therefore be concluded as having lived up to the expectation and generated good returns for its investors. The opportunity cost incurred to invest in the business was therefore worth incurring.
Buchanan, J. M. (2008). Opportunity cost. The New Palgrave Dictionary of Economics Online.
Erich, H. (2001). The Nature of Financial Statements: The Income Statement. Financial Analysis – Tools and Techniques – A Guide for Managers. London: McGraw-Hill. p. 40.
Woolridge, J. R. & Gray, G. (2006). Applied Principles of Finance. London: McGraw Hill.