Difference Between Economic And Accounting Profit

Economic profit and accounting profit are two distinct concepts in the world of finance and business, each offering a unique perspective on a company's financial performance. While both are used to assess profitability, they differ significantly in their calculation and interpretation. Understanding the nuances between them is crucial for making informed business decisions, evaluating investment opportunities, and gaining a comprehensive understanding of a company's true profitability.

What is Accounting Profit?

Accounting profit, also known as net income or net profit, is the most commonly used measure of profitability. It represents the actual revenue a company earns over a specific period, minus its explicit costs.

• Explicit costs are the direct, out-of-pocket expenses a business incurs, such as:

  • Salaries and wages
  • Rent
  • Utilities
  • Cost of goods sold (COGS)
  • Interest payments
  • Depreciation

The formula for calculating accounting profit is straightforward:

Accounting Profit = Total Revenue - Explicit Costs

Accounting profit provides a clear and concise picture of a company's financial performance based on recorded transactions and is primarily used for reporting purposes, such as preparing financial statements and tax returns.

What is Economic Profit?

Economic profit, on the other hand, takes a more holistic view of profitability by considering not only explicit costs but also implicit costs.

• Implicit costs are the opportunity costs of using a company's resources in a particular way. They represent the potential benefits a company forgoes by not using those resources in their next best alternative. Examples of implicit costs include:

  • Foregone salary: The salary an entrepreneur could have earned working for someone else.
  • Foregone rent: The rental income a company could have earned by leasing out space it owns.
  • Foregone interest: The interest income a company could have earned by investing its capital elsewhere.

The formula for calculating economic profit is:

Economic Profit = Total Revenue - Explicit Costs - Implicit Costs

Alternatively, it can be expressed as:

Economic Profit = Accounting Profit - Implicit Costs

Economic profit is a more comprehensive measure of profitability because it accounts for the true cost of resources used by a company. It helps businesses determine whether they are truly earning a profit above and beyond what they could achieve by allocating their resources to other opportunities.

Key Differences Between Economic and Accounting Profit

Examples to Illustrate the Difference

Example 1: Small Business Owner

Sarah runs a bakery. In one year, her bakery generates $200,000 in revenue. Her explicit costs (ingredients, rent, salaries, etc.) are $120,000. Sarah could have earned $60,000 working as a pastry chef at another bakery.

• Accounting Profit: $200,000 (Total Revenue) - $120,000 (Explicit Costs) = $80,000
• Economic Profit: $200,000 (Total Revenue) - $120,000 (Explicit Costs) - $60,000 (Implicit Cost - Foregone Salary) = $20,000

In this case, while Sarah's bakery is generating an accounting profit of $80,000, her economic profit is only $20,000. This suggests that she is not significantly outperforming her next best alternative (working as a pastry chef).

Example 2: Manufacturing Company

A manufacturing company has total revenues of $1,000,000. Its explicit costs, including cost of goods sold, salaries, and rent, amount to $600,000. The company owns a building that it uses for its operations. If the company were to lease the building to another business, it could earn $150,000 per year in rent.

• Accounting Profit: $1,000,000 (Total Revenue) - $600,000 (Explicit Costs) = $400,000
• Economic Profit: $1,000,000 (Total Revenue) - $600,000 (Explicit Costs) - $150,000 (Implicit Cost - Foregone Rent) = $250,000

The company's accounting profit is $400,000, but its economic profit is $250,000. This means that the company's operations are generating a profit above the opportunity cost of using its building, but it's important to consider this forgone income in the overall profitability assessment.

Why Economic Profit Matters: Applications in Decision-Making

While accounting profit is essential for financial reporting, economic profit plays a crucial role in internal decision-making, resource allocation, and strategic planning:

• Investment Decisions: Economic profit helps companies evaluate whether an investment is truly worthwhile. If the expected economic profit of a project is positive, it means the project is expected to generate a return greater than the opportunity cost of investing in it. If the economic profit is negative, it suggests that the company would be better off investing its resources elsewhere.
• Resource Allocation: By considering implicit costs, economic profit helps companies allocate resources to their most productive uses. For example, if a company has multiple divisions, it can use economic profit to determine which divisions are generating the most value relative to their opportunity costs. Resources can then be shifted to the divisions with the highest economic profit potential.
• Pricing Strategies: Economic profit can inform pricing decisions by highlighting the true cost of production, including opportunity costs. Companies can use this information to set prices that ensure they are earning a profit above their economic costs.
• Strategic Planning: Economic profit helps companies assess the long-term viability of their business strategies. If a company is consistently generating negative economic profits, it may need to re-evaluate its business model or consider exiting the market.
• Performance Evaluation: Economic profit can be used to evaluate the performance of managers and business units. It provides a more comprehensive measure of performance than accounting profit by considering the opportunity costs associated with their decisions.

Limitations of Economic Profit

Despite its usefulness, economic profit also has certain limitations:

• Difficulty in Measurement: Implicit costs can be difficult to quantify accurately. Estimating the value of foregone opportunities often requires subjective judgment and can be prone to error.
• Reliance on Assumptions: Economic profit calculations often rely on assumptions about future revenues, costs, and market conditions. These assumptions can be uncertain and may not hold true, leading to inaccurate results.
• Short-Term Focus: Economic profit is typically calculated for a specific period, such as a year or a quarter. It may not capture the long-term implications of certain decisions or investments.
• Not Required for Financial Reporting: Economic profit is not a required metric for financial reporting purposes. This means that companies may not have readily available data on implicit costs, making it more challenging to calculate economic profit.

The Relationship Between Economic Profit and Accounting Profit

The relationship between economic profit and accounting profit can be summarized as follows:

• Accounting profit is always greater than or equal to economic profit. This is because economic profit includes implicit costs, which are not considered in accounting profit.
• If economic profit is positive, accounting profit will also be positive. However, a positive accounting profit does not necessarily mean that economic profit is positive.
• If economic profit is negative, accounting profit may still be positive. This indicates that the company is earning a profit in the traditional accounting sense, but it is not earning enough to cover its opportunity costs.

Normal Profit: The Breakeven Point

Another important concept related to economic profit is normal profit.

• Normal profit is the minimum level of profit required to keep a company in business. It represents the opportunity cost of the resources invested in the company. In other words, it's the level of profit at which a company is indifferent between continuing its current operations and investing its resources elsewhere.

Economically, normal profit occurs when economic profit is equal to zero. This means that the company is earning just enough to cover all its explicit and implicit costs, including the opportunity cost of capital.

How to Calculate Economic Profit: A Step-by-Step Guide

Calculating economic profit involves several steps:

1. Calculate Total Revenue: Determine the total revenue generated by the company over the period.
2. Calculate Explicit Costs: Identify and sum up all the explicit costs incurred by the company.
3. Calculate Accounting Profit: Subtract the explicit costs from the total revenue to arrive at the accounting profit.
4. Identify Implicit Costs: Identify all the implicit costs associated with the company's operations. This may include foregone salary, foregone rent, foregone interest, and other opportunity costs.
5. Quantify Implicit Costs: Assign a monetary value to each of the implicit costs. This may require making estimates or using market data.
6. Calculate Economic Profit: Subtract the implicit costs from the accounting profit to arrive at the economic profit.

Example:

Let's say a company has the following financial information:

• Total Revenue: $500,000
• Explicit Costs: $300,000
• Foregone Salary (Implicit Cost): $80,000
• Foregone Rent (Implicit Cost): $40,000

Here's how to calculate the economic profit:

1. Accounting Profit: $500,000 (Total Revenue) - $300,000 (Explicit Costs) = $200,000
2. Total Implicit Costs: $80,000 (Foregone Salary) + $40,000 (Foregone Rent) = $120,000
3. Economic Profit: $200,000 (Accounting Profit) - $120,000 (Implicit Costs) = $80,000

In this case, the company's economic profit is $80,000.

The Importance of Understanding Both Metrics

While economic profit offers a more comprehensive view of profitability, it's important to understand both economic and accounting profit.

• Accounting profit provides a clear and objective picture of a company's financial performance based on recorded transactions. It's essential for financial reporting, tax compliance, and investor analysis.
• Economic profit offers a more nuanced and forward-looking perspective by considering opportunity costs and resource allocation. It's valuable for internal decision-making, strategic planning, and performance evaluation.

By considering both metrics, businesses can gain a more complete understanding of their financial performance and make more informed decisions.

Economic Profit vs. Other Profitability Metrics

Besides accounting profit, several other profitability metrics are commonly used in finance and business. Here's how economic profit compares to some of them:

• Gross Profit: Gross profit is calculated as total revenue minus the cost of goods sold (COGS). It represents the profit a company makes from its core operations before considering other expenses. Economic profit provides a broader view of profitability by including all explicit and implicit costs.
• Operating Profit: Operating profit, also known as earnings before interest and taxes (EBIT), is calculated as gross profit minus operating expenses. It represents the profit a company makes from its operations before considering interest and taxes. Economic profit takes an even wider view by including implicit costs.
• Net Profit Margin: Net profit margin is calculated as net profit divided by total revenue. It represents the percentage of revenue that remains after all expenses have been paid. While net profit margin is a useful measure of profitability, it doesn't consider opportunity costs like economic profit does.
• Return on Equity (ROE): ROE is calculated as net profit divided by shareholders' equity. It measures the return a company generates on the investment made by its shareholders. Economic profit can provide additional insights by considering the opportunity cost of capital.
• Return on Assets (ROA): ROA is calculated as net profit divided by total assets. It measures the return a company generates on its assets. Similar to ROE, economic profit can complement ROA by considering the opportunity cost of using those assets.

Conclusion

Economic profit and accounting profit are both important measures of profitability, but they offer different perspectives. Accounting profit focuses on explicit costs and provides a clear picture of a company's financial performance based on recorded transactions. Economic profit, on the other hand, considers both explicit and implicit costs, providing a more comprehensive view of profitability that takes into account opportunity costs and resource allocation.

Understanding the difference between these two metrics is crucial for making informed business decisions, evaluating investment opportunities, and gaining a deeper understanding of a company's true financial performance. By considering both accounting profit and economic profit, businesses can make better decisions about resource allocation, pricing strategies, and strategic planning, ultimately leading to improved profitability and long-term success.