What Is The Difference Between Accounting Profit And Economic Profit

The business world thrives on understanding financial performance, and at the heart of this understanding lies the concept of profit. However, profit isn't a one-size-fits-all measure. Two crucial types of profit, accounting profit and economic profit, offer distinct perspectives on a company's profitability. While both are essential, they differ significantly in their calculation and interpretation, impacting how businesses make decisions and how investors evaluate their performance.

Accounting Profit: The Traditional View

Accounting profit, also known as net income or net profit, is the most commonly used measure of profitability. It represents the actual money a company has earned over a specific period, typically a month, quarter, or year.

How to Calculate Accounting Profit:

The calculation of accounting profit is straightforward and follows the basic accounting equation:

Accounting Profit = Total Revenue - Explicit Costs

Let's break down each component:

• Total Revenue: This is the total amount of money a company receives from selling its goods or services. It's the top line of the income statement.

• Explicit Costs: These are the out-of-pocket expenses a company incurs in running its business. They are tangible and easily quantifiable, including:

  • Cost of Goods Sold (COGS): Direct costs associated with producing goods or services, such as raw materials, direct labor, and manufacturing overhead.
  • Operating Expenses: Costs incurred in running the day-to-day operations of the business, such as salaries, rent, utilities, marketing expenses, and depreciation.
  • Interest Expense: The cost of borrowing money.
  • Taxes: Income taxes paid to the government.

Example of Accounting Profit:

Imagine a small bakery called "Sweet Delights." In a year, Sweet Delights generates $200,000 in revenue from selling cakes, pastries, and coffee. Their explicit costs are:

• Cost of Goods Sold (ingredients, packaging): $80,000
• Rent: $20,000
• Salaries: $40,000
• Utilities: $5,000
• Marketing: $5,000

Therefore, Sweet Delights' accounting profit is:

$200,000 (Total Revenue) - ($80,000 + $20,000 + $40,000 + $5,000 + $5,000) (Explicit Costs) = $50,000

This means Sweet Delights has earned $50,000 in accounting profit after covering all its explicit costs.

Advantages of Using Accounting Profit:

• Simplicity: It's easy to understand and calculate.
• Objectivity: It's based on verifiable historical data.
• Standardization: It follows generally accepted accounting principles (GAAP), ensuring consistency and comparability across companies.
• External Reporting: It's used for financial reporting to external stakeholders, such as investors, creditors, and regulators.

Disadvantages of Using Accounting Profit:

• Ignores Implicit Costs: It only considers explicit costs, overlooking the opportunity costs of resources used in the business.
• Can be Misleading: It may not accurately reflect the true economic profitability of a business, as it doesn't account for all costs.
• Susceptible to Manipulation: Accounting practices can sometimes be used to manipulate accounting profit, potentially misleading stakeholders.

Economic Profit: A More Comprehensive View

Economic profit provides a more holistic view of profitability by considering not only explicit costs but also implicit costs, also known as opportunity costs. It represents the difference between a company's total revenue and the sum of its explicit and implicit costs.

How to Calculate Economic Profit:

The calculation of economic profit is slightly more complex than accounting profit:

Economic Profit = Total Revenue - Explicit Costs - Implicit Costs

We already understand total revenue and explicit costs. Let's delve into implicit costs:

• Implicit Costs: These are the opportunity costs of using resources that the company already owns. They are not actual out-of-pocket expenses but represent the potential benefits forgone by using those resources in their current use instead of their next best alternative use. Examples of implicit costs include:

  • Foregone Salary: The salary an entrepreneur could have earned by working in another job instead of running their own business.
  • Foregone Interest: The interest income a company could have earned by investing its capital in a different investment instead of using it in the business.
  • Depreciation of Assets: The decrease in the value of assets over time, even if no actual cash outflow occurs.
  • Rent on Owned Property: If a company owns the building it operates in, the implicit cost is the rent it could have earned by leasing the building to another party.

Example of Economic Profit:

Let's revisit Sweet Delights. We know their accounting profit is $50,000. However, let's consider the following implicit costs:

• Foregone Salary for the Owner: The owner, Sarah, could have earned $60,000 per year working as a pastry chef at a high-end hotel.
• Foregone Interest: Sweet Delights used $20,000 of Sarah's personal savings to start the business. She could have earned a 5% return on that money if she had invested it, which equates to $1,000 in foregone interest.

Therefore, Sweet Delights' economic profit is:

$200,000 (Total Revenue) - ($80,000 + $20,000 + $40,000 + $5,000 + $5,000) (Explicit Costs) - ($60,000 + $1,000) (Implicit Costs) = -$11,000

This means Sweet Delights has an economic loss of $11,000. While the business is generating an accounting profit, it's not covering all its costs, including the opportunity cost of Sarah's time and capital.

Advantages of Using Economic Profit:

• More Realistic: It provides a more realistic picture of profitability by considering all costs, both explicit and implicit.
• Better Decision-Making: It helps businesses make better decisions about resource allocation and investment opportunities.
• Resource Efficiency: It encourages businesses to use resources more efficiently by considering the opportunity costs of their decisions.
• Investment Evaluation: It's a valuable tool for investors to evaluate the true profitability of a company and make informed investment decisions.

Disadvantages of Using Economic Profit:

• Subjectivity: Implicit costs can be difficult to measure accurately and often involve subjective estimations.
• Not GAAP Compliant: Economic profit is not recognized under GAAP and is not used for external financial reporting.
• Complex Calculation: It can be more complex to calculate than accounting profit, requiring careful consideration of opportunity costs.

Key Differences Between Accounting Profit and Economic Profit: A Summary Table

Why Are Both Measures Important?

While economic profit provides a more comprehensive view of profitability, both accounting profit and economic profit are valuable for different purposes.

• Accounting Profit: It's essential for financial reporting to external stakeholders, providing a standardized and objective measure of a company's financial performance. It's used to assess a company's ability to generate revenue, manage expenses, and pay taxes.
• Economic Profit: It's crucial for internal decision-making, helping businesses allocate resources efficiently and evaluate investment opportunities. It provides a more realistic picture of profitability, considering the opportunity costs of all resources used.

Practical Applications: How Businesses Use Accounting and Economic Profit

Businesses use accounting and economic profit in various ways to inform their decisions and strategies.

Accounting Profit Applications:

• Financial Reporting: Preparing financial statements, such as the income statement, balance sheet, and cash flow statement, for external stakeholders.
• Tax Compliance: Calculating income taxes payable to the government.
• Performance Evaluation: Assessing the company's financial performance over time and comparing it to competitors.
• Creditworthiness Assessment: Providing information to lenders and creditors to assess the company's ability to repay debts.
• Investment Decisions (External): Investors use accounting profit to evaluate a company's stock and make investment decisions.

Economic Profit Applications:

• Investment Decisions (Internal): Evaluating the profitability of potential investments and projects, considering the opportunity costs of capital.
• Resource Allocation: Deciding how to allocate resources among different business activities to maximize profitability.
• Pricing Strategies: Setting prices for goods and services that cover all costs, including opportunity costs.
• Make-or-Buy Decisions: Determining whether to produce goods or services internally or outsource them to external suppliers, considering the opportunity costs of using internal resources.
• Performance Measurement: Evaluating the performance of managers and business units based on their ability to generate economic profit.
• Strategic Planning: Developing long-term strategies that maximize economic profit.

Examples of Business Decisions Using Economic Profit:

• A Manufacturing Company: A manufacturing company is considering investing in a new piece of equipment. The equipment is projected to increase revenue by $100,000 per year and have explicit costs of $60,000 per year. However, the company would need to use $50,000 of its retained earnings to purchase the equipment, which could have been invested elsewhere to earn a 10% return. The company should calculate the economic profit of the investment:

  • Total Revenue Increase: $100,000
  • Explicit Costs: $60,000
  • Implicit Cost (Foregone Interest): $50,000 * 10% = $5,000
  • Economic Profit: $100,000 - $60,000 - $5,000 = $35,000

  Since the economic profit is positive, the company should invest in the new equipment.

• A Retail Store: A retail store is deciding whether to stay open for an extra hour each night. The extra hour is projected to generate $500 in additional revenue but would require an additional $200 in labor costs and $50 in utility costs. The owner of the store could also be using that hour to work on other aspects of the business, such as marketing or inventory management, which they estimate would generate $300 in value. The store should calculate the economic profit of staying open for the extra hour:

  • Total Revenue Increase: $500
  • Explicit Costs: $200 (Labor) + $50 (Utilities) = $250
  • Implicit Cost (Foregone Value): $300
  • Economic Profit: $500 - $250 - $300 = -$50

  Since the economic profit is negative, the store should not stay open for the extra hour.

Limitations and Considerations

While both accounting and economic profit are useful, it's important to be aware of their limitations:

• Accounting Profit: Can be manipulated by accounting practices, may not reflect the true economic profitability of a business, and ignores implicit costs.
• Economic Profit: Subjective estimations of implicit costs can be inaccurate, not GAAP compliant, and more complex to calculate.

The Importance of Understanding Both

In conclusion, both accounting profit and economic profit are valuable tools for understanding a company's financial performance. Accounting profit provides a standardized and objective measure of profitability for external reporting, while economic profit offers a more comprehensive view of profitability for internal decision-making. By understanding the differences between these two measures, businesses can make more informed decisions about resource allocation, investment opportunities, and strategic planning.

For investors, understanding both metrics helps in a more nuanced assessment of a company's financial health. A company might show a strong accounting profit, attracting investors. However, a deeper look at the economic profit might reveal that the business isn't truly generating value when considering all costs, potentially signaling a less attractive investment.

For entrepreneurs, especially, considering economic profit is crucial. It forces a realistic assessment of whether their business venture is truly worthwhile, taking into account the value of their time and capital that could be used elsewhere. It's not enough to simply be "making money"; the business needs to be generating more value than the alternatives.

By considering both accounting and economic profit, businesses and investors can gain a more complete and accurate understanding of a company's financial performance and make better decisions.