Cost for own labour

arrowman

Part of my day job involves assessing the profitability of individual businesses in a particular sector. All of these businesses operate slightly differently - with differences over products sold, systems of production, raw materials purchased and whether they are making use of their own capital or are leasing or borrowing capital.
Most of the businesses are operating as sole traders but there are some that are using a company structure.
They are mostly family owned and operated with a significant labour input by the owner and this is often supplemented by family labour.
I report back to these businesses on their financial performance (based on information supplied on revenue and costs) on an individual basis but I also analyse all the businesses as a batch and show the average, top and bottom performers for comparison purposes.
The main figures reported back are business output, total costs and net margin (profit) with the underlying detail also disclosed.

Now to my question...
In the calculation of total costs (to offset against revenue) I DO NOT include any charge for either the farmers or the families own labour. I do however include a labour cost for any PAID labour This is in line with general accountancy principles.
Some of the businesses query this and say that by not including a cost for own labour I am not showing the true cost of running the business. They point to the following facts in support of this
- where a larger scale business takes on additional labour this IS included as a cost
- smaller scale businesses choose not to take on paid labour but the farmer is supplying this labour (at zero cost in my calculation)
- businesses that are incorporated have a charge included for the directors salary (I generally DO NOT include this as a labour cost to make these incorporated business comparable with their sole trader compatriots)

I am sticking to my guns that the NET PROFIT figure is the return to the business owner for his labour and managerial input as well as providing a return on the capital employed in the business.

Am I right in this? Is there an angle to this which I cannot see?

andrew

It seems like you're running into the difference between implicit cost and explicit cost - and in turn, the difference between accounting profit and economic profit. The second example on this page seems to speak directly to your problem, and Googling 'implicit cost accounting profit' seems to have a good few useful results.

arrowman

Thanks for the reply Andrew.

Yes I get the idea of implicit (opportunity) costs and explicit. What I am struggling with is which is more important for a business owner to know? - accounting profit (revenue - explicit costs) OR economic profit (Revenue - (explicit + implicit costs)).

The notion of using an implicit costs gets me thinking about a "top of the head" calculation of a cost figure which may or may not be based on reality. The notion of putting a cost of someone's labour based on what they could earn elsewhere is something that I find it hard to stand over at times. The reality often is that they are committed to the business and will be there in the business and have no aspirations to work anywhere else - is this a true opportunity cost?
The other argument is that the fact that the owner does the work means that he/she doesn't bear the cost of employing and paying someone to do it therefor this is the imputed labour cost. But the reality is that the scale of some of these businesses would not justify hiring labour anyway.

arrowman

Thanks for the reply Andrew.

Yes I get the idea of implicit (opportunity) costs and explicit costs. What I am struggling with is which is more important for a business owner to know? - accounting profit (revenue - explicit costs) OR economic profit (Revenue - (explicit + implicit costs))?

The notion of using an implicit cost gets me worried about a "top of the head" calculation of a cost figure which may or may not be based on reality. The notion of putting a cost of someone's labour based on what they could earn elsewhere is something that I find it hard to stand over at times. The reality often is that they are committed to the business and will be there in the business and have no aspirations to work anywhere else - is this a true opportunity cost?
The other argument is that the fact that the owner does the work means that he/she doesn't bear the cost of employing and paying someone to do it therefor this is the imputed labour cost. But the reality is that the scale of some of these businesses would not justify hiring labour anyway.

andrew

I think I'll move this thread over to the accountancy forum, hopefully you can get better answers there!

My 2c would be that the answer appears to be 'it depends'. For some businesses it clearly does matter, since they query you when you don't include it and might be in a position to work elsewhere. For others, like you say the opportunity cost isn't really a 'true' one and so it's not so relevant.

OttoPilot

arrowman wrote: »

Thanks for the reply Andrew.

Yes I get the idea of implicit (opportunity) costs and explicit. What I am struggling with is which is more important for a business owner to know? - accounting profit (revenue - explicit costs) OR economic profit (Revenue - (explicit + implicit costs)).

The notion of using an implicit costs gets me thinking about a "top of the head" calculation of a cost figure which may or may not be based on reality. The notion of putting a cost of someone's labour based on what they could earn elsewhere is something that I find it hard to stand over at times. The reality often is that they are committed to the business and will be there in the business and have no aspirations to work anywhere else - is this a true opportunity cost?
The other argument is that the fact that the owner does the work means that he/she doesn't bear the cost of employing and paying someone to do it therefor this is the imputed labour cost. But the reality is that the scale of some of these businesses would not justify hiring labour anyway.

I think it could be argued either way, two sides of looking at the same thing. An economic profit of 0 should be equal to an accounting profit of 40k assuming the cost of labour is 40k. I would not get into opportunity cost (I.e. what the owner/manager could potentially earn), I would just base their cost of labour on the cost of hiring someone else to do the job as good as they do.