Accounting vs Economic Profit

Did you know that accounting profit differs from economic profit? Read on to know more about accounting vs. economic profit.

Accounting profit for a company is simply its net profit, that is, the expenses deducted from the revenue. Economic profit is almost identical to accounting profit – the only difference being that economic profit also considers opportunity cost.

Accounting profit is the reflection of a company’s profitability. Economic profit, meanwhile, shows the degree of efficiency with which the company is using its resources to generate revenue. As such, accounting profits help assess a company’s financial performance. Economic profits, on the other hand, are useful for determining the optimal utilization of firm resources.

If you want to learn more about the difference between the two kinds of profits, this blog might well be the perfect one for you. We have taken into account the opinions of several accountants, economics, and business owners, to help you distinguish between accounting and economic profits.

‍Accounting Profit

A company’s accounting profit is also referred to as its net income. According to the GAAP (Generally Accepted Accounting Principles), it is the number that you obtain once you have deducted all your expenses or costs from your sales revenue.

Examples of those costs and expenses are labor costs (wages or salaries, for example), inventory required for production, transportation costs, raw materials, sales costs, marketing expenses and overhead costs.

Example of Accounting Profit

For instance, a shoe seller generates $15,000 each month by selling shoes – this is their sales revenue. The shoe seller’s total monthly costs are $12,000. The shoe seller’s profit is, therefore:

$15,000-$12,000 = $3000

Accounting profit is, therefore, the amount remaining after all explicit business costs have been deducted from the revenue.

A company’s explicit costs are simply all the costs that the company has endured during a period. The above costs are all examples of explicit costs. Generally, net income or accounting profit is reported on a quarterly and yearly (annual) basis.

Economic Profit

Just like accounting profit, economic profit also deducts a company’s explicit costs from its sales revenue. However, economic profits also take into account the opportunity cost. This cost is the cost of choosing one option over the other. For instance, let us suppose that you have $25,000. Now, you can either place this money into a bank to earn interest, or you can use it to expand your business. If you go for the expansion, the amount of interest money that you give up will be considered your opportunity cost.

Hence, economic profits are determined based on economic – and not accounting – principles.

Example of Economic Profit

Let us assume that a shoe seller has monthly sales revenue of $15,000. The shoe seller’s monthly explicit costs are $12,000. The shoe seller knows that if he stopped selling shoes and put up the shop for rent, they could generate $1,000 a month. The shoe seller’s economic profit is, therefore:

$10,000-($12,000 + $1,000) = $2,000.

Economic profit is, therefore, the sales revenue minus explicit and implicit costs. 

Why is Opportunity Cost Important?

Opportunity cost is a crucial concept in the finance and business world. It allows us to understand the logic behind our economic decisions, with regards to the available alternatives.

Our world has a finite amount of resources such as capital, labor, and land. Owing to this scarcity, it is important that we use every resource in the best possible manner. Through opportunity cost, we can weigh in all the available options and choose the best one. By using every resource optimally, we can maximize our economic profits.

For example, in terms of production, opportunity cost can help determine if a product is worth producing. This can be done by comparing the economic benefits of production against the economic benefits of the other options (such as investing the money elsewhere). It can also determine which product should be produced. A manufacturer can compare the benefits of producing A against the benefits of producing B. This will allow the manufacturer to produce the product with the higher economic benefit.

Calculating Opportunity Cost

Example 1

Let us assume that product A can be produced for $10. Conversely, the same product can be purchased from the market at $20. If the manufacturer decides to produce the product, they can obtain a profit of $10 ($20-$10). However, what if product A is available in the market for $10? In this case, the manufacturer can either continue producing the product, or simply buy it from the market and sell. If product A is available for $7 in the market, the manufacturer has a disincentive to continue producing. Instead, they can simply purchase the product from the market and sell it at a higher price.

Example 2

Let us assume that there are two stocks – A and B, both priced at $10. If an investor invests $10 in stock A, the opportunity cost will be the profit they could have earned by investing $10 in stock B. Now, imagine that the price of stock A went up to $15, but the price of stock B remained unchanged. In this case, the investor gains a profit of $5, thereby justifying his decision to invest in stock A.

Unlike accounting profits, economic profits also make use of implicit costs, which are the costs of a business’ resources. In addition, economists often use economic profits to determine if a business should enter, continue to operate or exit a market. For instance, in case of a positive economic profit, other firms would want to enter the market. However, if there is no economic profit, it shows that the firm is earning no more or less than it would if it had invested in the next best option. In case of negative economic profits, firms should leave the market since they can use their resources in a more profitable manner elsewhere. A firm’s economic profit is highly dependent on the level of market competition. In addition, it also depends on the timespan being considered.

Vital Differences between Accounting and Economic Profits

For an economist, there is a close relation between accounting and economic profits. However, there are some key differences between the two:

Formula

The first difference is in the formulas. Like we mentioned earlier, accounting profits only use explicit costs. Economic profits, on the other hand, also consider implicit costs.

Therefore:

Accounting profit = revenue- explicit costs.

Economic profit= revenue-(explicit costs + implicit costs).

Determined by

The accounting profit is determined by the GAAP. The economic profit, on the other hand, is determined according to established economic principles.

Relationship

Since the economic profit is just a subtype of accounting profit with an additional subtraction (implicit costs), it can never be higher than the accounting profit. In other words, a company’s economic profit will always be equal to or less than its accounting profit.

Economic profit <= Accounting profit.

Scope

Accounting profit, generally, has a relatively limited scope. It only takes into account the costs and revenue for a single period, such as a year or a quarter. On the other hand, economic profit provides a macroeconomic view. In other words, it allows economists to analyze an entire market, and make entry or exit decisions.

Application

As you must have realized, accounting profit is a simpler and more straightforward calculation. It allows companies to determine their financial status. It also enables them to determine if their profitability level is good enough for them to continue operations. Accounting profit is also utilized for taxation purposes. On the other hand, economic profits are more complex and nuanced. By factoring in the opportunity costs, economic profits help companies determine if they should enter a certain market or seek out a more profitable alternative.