Definition
Accounting profit, in the simplest terms, is the total revenue minus explicit costs which include direct costs like supplies and wages. Economic profit, on the other hand, is the total revenue minus both explicit and implicit costs, the latter encompassing both observable and hidden costs such as opportunity costs. Thus, while accounting profit represents a company’s tangible profit, economic profit accounts for both tangible and potential profits and losses.
Key Takeaways
- Accounting Profit is the net income for a business while Economic Profit takes into account both explicit and implicit costs. Accounting profit calculates the direct costs and indirect costs such as materials, labor, and overhead costs, while the economic profit considers these as well as the opportunity cost.
- The accounting profit does not include opportunity costs. This is the main difference between accounting profit and economic profit. As a result, the economic profit will often be less than the accounting profit because it includes both visible and invisible costs.
- Both profits are relevant in different business contexts. Accounting profit is widely used in financial reporting to portray the firm’s actual financial health, it’s important for tax calculation and also to potential investors. Economic profit helps businesses in decision making by considering all possible opportunity costs and evaluating if the current operation is the best use of resources.
Importance
The distinction between accounting profit and economic profit is essential as it offers a comprehensive view of a company’s profitability and efficiency.
Accounting profit, calculated by subtracting total explicit costs from total revenue, gives a partial view by focusing on tangible monetary costs and gains.
Conversely, economic profit considers both explicit and opportunity costs (implicit costs), therefore encapsulating the true profitability by acknowledging the potential benefits foregone in selecting a certain path.
The insight from economic profit helps companies make strategic decisions to optimize resource allocation, thus potentially yielding higher profitability.
Hence, understanding both concepts aids businesses in effective decision-making and long-term financial sustainability.
Explanation
Accounting Profit and Economic Profit are two actionable financial metrics utilized by organizations to evaluate performance from different perspectives. Understanding both of these allows a company to gain a multi-dimensional view of profitability and ensures informed decision making regarding reinvestment, expansion, or cost reduction initiatives.
Accounting Profit – often referred to as book profit or net income – is a measure used primarily for tax calculations and public reporting. It provides a snapshot of financial performance by calculating revenues minus explicit costs (like the cost of goods sold, salaries, and rental expenses), giving shareholders and potential investors a simplified view of a company’s fiscal health.
On the other hand, Economic Profit deduces both the explicit (direct) costs and implicit (indirect or opportunity) costs, providing a deeper and more holistic understanding of business performance. The conceptualization of Economic Profit allows businesses to consider not just the tangible costs, but also what is being potentially sacrificed by choosing one operational route versus another.
This insight facilitates more strategic decision-making and promotes efficient resource allocation to optimize overall profitability and long-term sustainability.
Examples of Accounting Profit vs Economic Profit
Retail Business: In a retail business, the accounting profit is calculated by subtracting all explicit costs (such as inventory cost, employee wages, rent, utilities etc.) from the total revenue. However, the economic profit will take into consideration the opportunity costs as well – the income the owner could have made if they had invested their time and resources elsewhere. For instance, if the owner could have made a significant profit by investing in stocks instead of running the retail shop, the economic profit of the retail business becomes lower or even negative.
Consulting Firm: For a consulting firm, the accounting profit would include revenues earned from consulting contracts minus explicit costs like salaries, rent, marketing, and operational costs. Conversely, the economic profit would contemplate the implicit costs too, say, the revenue that the lead consultant could have earned working for a different firm or the returns on investment had the initial capital been invested elsewhere.
Restaurant Business: For a restaurant, the accounting profit is calculated as total revenues (from sales of food and beverages) minus explicit costs (like cost of ingredients, salaries of employees, utilities, rent etc.). However, the economic profit also considers implicit costs, such as, the alternative income the owner could have generated if they invested the capital in another business or venture. If the owner had the opportunity to invest the same capital in a different venture with a higher return, then the economic profit of the restaurant is smaller. In case, the opportunity cost (the next best alternative) of the invested capital and owner’s time is higher than the accounting profit, the restaurant could actually be making an economic loss.
FAQ: Accounting Profit vs Economic Profit
1. What is Accounting Profit?
Accounting profit is the net income for a business, which is calculated by subtracting total explicit costs from the total revenue. Explicit costs are direct, out-of-pocket expenses associated with running a business like wages, rent, and materials.
2. What is Economic Profit?
Economic profit factors in both explicit and implicit costs. Implicit costs are opportunity costs associated with a company’s resources. For example, the return which could have been earned by investing the company’s resources elsewhere. Economic profit provides a more comprehensive profitability analysis compared to accounting profit.
3. How are Accounting Profit and Economic Profit different?
The primary difference between accounting profit and economic profit is the consideration of opportunity costs. Accounting profit only considers explicit costs, while economic profit considers both explicit and implicit costs. Hence, accounting profit gives a narrower view of profitability compared to economic profit.
4. Why might a company have a positive Accounting Profit and a negative Economic Profit?
This can occur if the implicit costs (opportunity costs) of a business exceed its accounting profits. Even if a company is generating profit in accounting terms, it may still be under-performing according to the economic profit calculation because it might have been able to generate more returns had it invested its resources elsewhere.
5. Which is more crucial to a firm’s financial health: Accounting Profit or Economic Profit?
Both are important depending on the context. Accounting profit is essential for assessing the basic profitability of operations and is a statutory requirement. Economic profit, however, provides a perspective on whether the firm is utilizing its resources effectively and helps in decision making for alternative investments.
Related Entrepreneurship Terms
- Opportunity Cost
- Explicit and Implicit Costs
- Revenue
- Accounting Principles
- Factors of Production
Sources for More Information
- Investopedia: It is a comprehensive online financial dictionary featuring thousands of accounting, taxation, and financial terms.
- AccountingCoach: This site offers free accounting courses, which include accounting basics, managerial accounting, financial statements, and more.
- Corporate Finance Institute: It provides a wide variety of resources relating to finance and accounting, including courses, templates, articles, and glossaries.
- Khan Academy: Khan Academy offers practice exercises, instructional videos, and a personalized learning dashboard that empower learners to study at their own pace in and outside of the classroom.
