Except you run a non-profit business, the primary purpose of every business is to make a profit. While your intentions might be to add value to the world and economy, without profit eventually your ability to offer that value will be handicapped. Now, besides adding value to society, every business wants to make a profit. Nothing is more exciting for a business owner than getting huge values after deducting total costs from total revenue. The higher the difference, the greater the company’s profitability. But, distinguishing between economic profit and accounting profit is an excellent way to measure the financial health of a business. Here is everything you need to know about economic profit and accounting profit.
Economic profit and Accounting profit
Economic profit and accounting profit are similar with a subtle difference between them. While they are both financial, one talks about the profit of an organization and the other of an economy. Understanding the difference between these two profits requires an understanding of two major cost types. They are; implicit costs and explicit costs. In a nutshell, economic profit involves both explicit and implicit costs; while accounting profit involves just explicit costs.
An Overview of Economic Profit vs. Accounting Profit
Profit is one of the most extensively followed financial criteria in assessing a company’s financial health. It is the financial gain or income earned by any commercial or investment activity that exceeds all expenses, taxes, and other costs. Simply put, profits are revenue less costs. Profits are classified into two types: economic profits and accounting profits. Economic profit is defined as total income from sales minus all opportunity expenses. Accounting profit, on the other hand, indicates a company’s overall earnings, including explicit costs.
Economic profit is a type of profit obtained from the production of goods and services while accounting for alternative uses of a company’s resources. It subtracts explicit expenditures from income and accounts for opportunity costs accrued during that time period. Implicit costs, or the expenses of a company’s resources, are also included in the calculation.
The implicit costs may, for example, be the market price at which a corporation could sell a natural resource rather than consuming that resource. A grove of trees is owned by a paper firm. They fell trees and made paper goods. Their implicit cost is the timber, which they may sell at market prices.
Here’s another way of looking at things. A corporation may pick Project A over Project B, and the profit from Project A after expenses and costs is the accounting profit. The economic profit would include the opportunity cost of selecting Project A against Project B, or how much more or less profit would have been made (by leveraging the company’s resources) had management chosen Project B.
Profit in Accounting
Accounting profit is also known as earned profit, net income, or the bottom line of a corporation. Accounting profit, as opposed to economic profit, is recorded on a company’s income statement. It is the profit gained after deducting different costs and expenses from total revenue or total sales in accordance with generally accepted accounting rules (GAAP). These expenses include:
- Wages and salaries are examples of labor expenses.
- Any manufacturing inventory required
- The raw ingredients
- Costs of transportation and storage
- Overhead and production expenses
- Sales and marketing expenses
Accounting profit is the amount of money left over after subtracting the business’s explicit costs. Explicit costs are simply the precise quantities paid by a corporation for certain expenditures during that period, such as wages. Accounting profit or net income is often reported quarterly and annually and is used to assess a company’s financial success.
What are the Explicit costs?
Explicit costs are costs that are expressly identified and easily calculable. They are the monetary costs that directly leave the business. When a company pays for using its factors of production, that cost is explicit. It is a subset of cash outflow and is usually expressed on the company’s accounts sheet or ledger. Explicit costs directly affect the company’s ability to generate profit since the business has to directly pay for them. Some examples include: paying wages, utilities, production materials, and any other direct, usually monetary costs.
What are Implicit costs?
Implicit costs are more subtle costs that are not easily calculable because of their implied nature. Oftentimes, they are referred to as opportunity costs, which are forgone alternatives. Because implicit costs tend to be unclear, they are not easily calculable. As a result, they do not serve accurate measures for accounting. Furthermore, they do not always have to be expressed on the company’s balance sheet. A clear example would be using the company’s auditorium for a presentation rather than renting it out to a social group. Implicit cost with explicit cost is used for calculating economic profit.
Difference between economic profit and accounting profit
What is Accounting Profit?
As the name suggests, it is a more accurate measure for the financial accounting of a business. It is the financial information that government organizations like the IRS are usually more interested in. And is very relevant to preparing taxes because it is in fact, the company’s net income.
Net income is calculated by deducting all monetary costs of running the firm from the total revenue generated. The value of accounting profit is always higher than that of economic profit. The calculation is achieved by only making use of explicit costs. In other words, the formula for calculating accounting profit is total revenue minus explicit costs. This means the total monetary value of a firm minus the total monetary costs of the firm. Since accounting profit is not all-encompassing, it reflects only the revenue and cost of one period in time. The timeline for computing accounting profit can be a fiscal year of the company or a fiscal quarter.
The formula for accounting profit
Total monetary revenue generated – Total monetary costs incurred
This formula makes use of the generally accepted accounting principles (GAAP)
What Is the Distinction Between a Zero Accounting Profit and a Zero Economic Profit?
Normal profit is synonymous with zero economic profit. This value, like economic profit, takes into account both explicit and implicit expenses. When a business generates a typical profit, its costs equal its revenue, leaving no economic benefit. Competitive businesses with total costs that exceed entire income generate no economic profit. However, zero accounting profit indicates that a corporation is losing money. This signifies that its costs exceed its revenue.
What is Economic profit?
Generally speaking, economic profit is obtained from the difference between the total company revenue and the total company costs. The sum of the company’s explicit and implicit costs gives the company’s total costs. In other words, we have to add up all explicit costs and implicit costs of the business. Then, subtract this sum or addition from the total revenue generated by the enterprise.
To assess economic profit for different projects or situations, follow these procedures.
- Determine your company’s estimated total revenue or income from sales of goods and services, which is effectively the number of units sold multiplied by the price per unit.
- Define your entire explicit expenses, which include raw supplies, payroll, rent, and so forth.
- Determine your implicit expenses (or total opportunity cost).
- Subtract the entire income from the sum of explicit and implicit costs; the resultant number is your economic profit for each possibility.
The formula for economic profit
Economic profit=Total revenue generated- Total costs incurred
Total costs incurred=[explicit costs incurred + implicit costs incurred]
Since economic profit is all-encompassing, it is usually lower than accounting costs. This is because the totality of company costs incurred also includes opportunity costs. As a result, it involves a longer timeline than accounting profit. Since opportunity costs can sometimes be difficult to calculate and span across both time and space. Therefore, economic profit is great for making predictions about the long-term survival of a business in the economic market.
Merits of Economic profit
1. Detection of business opportunities
Nothing serves as an excellent marker for detecting business opportunities than analyzing business economic profit. Because it can be positive, negative, or zero, it is useful for predicting market entry. When it is zero, there is no incentive for the business to enter or leave the market. Because, whether or not the business enters or leaves the market, it would still earn the same as when its resources are alternatively invested. If it is negative, then the business has an incentive to exit the market. Because its resources when invested alternatively would yield more benefit. If the economic profit is positive, then the business has an incentive to enter the market.
2. Measures business success relative to alternatives
Both economic profit and accounting profit are useful for measuring the success of a business. However, while accounting profit measures the success of a business relative to finances. Economic profit measures the success of a business relative to alternatives. This is so because it considers opportunity costs. This means the business can ascertain how well it is doing in contrast to how it would have done if it proceeded with the forgone alternative.
Demerits of economic profit
1. It is not an accurate metric for measuring business profitability
This is because it does not take every financial aspect of the business into account. And it is not time-specific since it is not possible to run an economic profit analysis over a short time. Like a quarter fiscal period or even a fiscal year. All these stem from the ambiguity associated with the opportunity costs of the business.
2. It is not easily measurable
Since economic profit deals with both implicit costs and explicit costs, the implicit cost makes it difficult to calculate. It has no true mathematical value; only an estimated value. This is why it is not represented on the balance sheet as it can be sometimes elusive.
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