Difference between accounting profit and economic profit
The goal of any business is to maximize profit. Profit is equal to total revenue minus cost. But there are different notions followed by accountants and economists when they refer to cost and how they calculate profit. In this blog, we discuss the differences between accounting profit and economic profit.
How do economists refer to cost?
When economists refer to cost, they mean total cost, whether explicit or implicit. The cost of production of a company includes explicit costs such as payroll, raw material costs, and other direct costs. Explicit costs are those that necessitate a monetary payment and are very easy to measure.
In addition, implicit costs are those that do not necessitate a monetary payment. Also known as the opportunity cost of an action, this is what you must forego when choosing between two options. It is also referred to as the value of the next best opportunity. Any decision that a business makes will always involve a trade-off. If one option is chosen, you lose out on the opportunity to reap benefits from another readily available option. For example, if a company deploys some cash reserves in running a new machine, it loses out on the chance to earn interest on such amount had it been invested elsewhere. Such lost interest income represents the implicit or opportunity cost.
When calculating profits, economists refer to both explicit and implicit costs of a business.
How do accountants refer to cost?
When accountants refer to cost, they are only concerned with explicit costs as they are easily recognizable and found in financial statements. Accountants usually do not include implicit costs as they are a little difficult to measure. Moreover, an accountant also does not always know which investment opportunity was given up by the owner to start his business. Or what alternatives are chosen by the management team over other options? But this doesn’t mean that implicit costs are unimportant. In fact, they are very much used by firms and individuals to make important decisions.
Accounting profits are computed using explicit costs only. However, a firm’s economic profit is computed using both explicit costs and opportunity costs. This is why accounting profits are higher than economic profits.
The accounting profit of a firm refers to the difference between sales revenue earned by the firm and the monetary cost incurred by the firm during any particular time period. Thus, the accounting profit of the firm, in a bookkeeping sense, depends on the explicit cost and revenue of the firm. It includes explicit costs of doing a business such as the cost of raw materials, wage cost, depreciation, interest and tax payments, etc.
Hence, accounting profit of a firm = Sales revenue of the firm – All explicit costs of the firm during a particular year.
This profit is calculated on the basis of some generally accepted accounting principles (GAAP).
Thus, the calculation of the accounting profit of a company is based on the realized or actual gains and losses. It shows an excess of revenue gains over and above the explicit costs incurred by the company during any particular accounting year.
However, there remains a difference between the fundamentals of accounting profit and economic profit.
The economic profit or the profit of a firm in an economic sense considers both explicit and implicit costs (or the opportunity costs) while determining the profit.
Therefore, Economic profit is given by = Sales revenue – [Explicit costs + Implicit costs].
As economic profit combines the effects of explicit and implicit costs, it gives a much deeper view of the overall return generated by a business owner on his venture. It also throws light on the efficiency with which resources are utilized in a business. By assessing the opportunity costs, it helps in taking various decisions regarding the efficient allocation of resources. It tells you whether it is worthwhile or not to use a group of resources in your business. This will be clearer with some examples.
Take, for example, Farmer George, who owns a 100-acre farm. Farmer George is also a very well chess player in the area, and he could earn $18 per hour teaching chess.
He can sell the wheat he grows on his farm for $380 if he plants $94 worth of seed which takes up to 10 hours.
Now, an accountant would calculate an accounting profit of $286 based on the cost of producing wheat of $94.
Accounting profit = $(380 – 94) = $286
An economist, on the other hand, would estimate the cost of producing wheat at $274. This $274 cost includes both the $94 explicit cost of seed and the $180 implicit cost of Farmer George giving up teaching chess lessons in order to plant wheat. By planting wheat, he misses out on the opportunity to earn $180 by giving chess lessons for 10 hours that are currently occupied on the plantation.
Therefore, Economic profit = $(380 – 94 – 180) = $106
Farmer George earns an economic profit of $106 ($380 minus $274), which is lesser than his accounting profit of $286 ($380 minus $94).
If Farmer George could hire a laborer to plant his wheat for $5 per hour, he should do so. In such a case, his economic profit from farming would rise to $236 even though his explicit costs would increase to $144 (i.e., $94+$50) because he would now be free to earn $18/hour giving chess lessons. Hence, there will be zero opportunity costs.
His overall earnings (both from farming and teaching) would be: $236 + $180 = $416.
Take another example. Suppose the sales revenue of a firm is $4,00,000 per year; the explicit costs include the material cost of $50,000, wage cost of $60,000, transport and advertisement cost of $30,000, and interest on a loan to the extent of $5,000 per year. The owner of the firm is an engineer and the production work is carried out in his own land and building.
In this case, the accounting profit of the firm would be $4,00,000 – [$50,000 + $60,000 + $30,000 + $5,000] = $2,55,000 per year.
Now, as a qualified engineer, the owner of this firm could earn a monthly salary of, say, $15,000, and he could also earn a rental income from his own land and building to the extent of, say, $5,000 per month. These are considered as the opportunity loss or the opportunity cost of the firm (or the implicit cost).
Thus, the implicit costs of the firm per year would be ($15,000 × 12) + ($5,000 × 12) = $2,40,000.
Now, if we remove this implicit cost or the opportunity cost from the accounting profit, we get the economic profit of the firm.
Therefore, economic profit = $4,00,000 – [$1,45,000 + $2,40,000] = $15,000.
So, as we see, economic profit becomes less than the accounting profit.
Another name used to explain the concept of opportunity cost is ‘normal profit’. Normal profit in the economic sense refers to that factor price that has to be paid to the entrepreneur for supplying his/her own labor and capital in operating the business firm. It is supposed to be the minimum expected price of an entrepreneur, say, an expected return of 12% per annum on own capital invested in the business firm. This minimum expected return is often determined by the opportunity cost of the firm. If an entrepreneur does not get this minimum expected price for his entrepreneurship, then he will refrain from undertaking such business.
This minimum expected price or the normal profit of the entrepreneur is nothing but the difference between accounting profit and economic profit.
Normal profit = Accounting profit – Economic profit
For example, in the aforesaid case of an engineer operating his own business, he shall not undertake the business unless he attains a minimum of $2,40,000 therefrom. This is so because had he not been into the business, he would have easily earned this much amount from renting out his resources and taking a job instead of doing business.
Moreover, this expected return or the opportunity cost varies from one entrepreneur to another and from one business to another.
Comparison table – Difference between accounting profit and economic profit
|Basis of difference||Accounting profit||Economic profit|
|Opportunity cost||Includes only explicit costs||Includes both explicit costs and implicit (or opportunity costs)|
|Determination||Determined by generally accepted accounting principles (GAAP).||Determined by economic principles|
|Formula||Accounting profit = Total revenue – Explicit costs Where explicit costs represent payments that a firm makes to purchase resources such as labor, land, etc.||Economic profit = Total revenue – (Explicit costs + Implicit costs) Where implicit cost is the opportunity cost of the resources supplied by a firm’s owner|
|Precision||More precise as it is based on real figures of costs incurred and revenues earned||Gives a less precise picture since some costs (i.e., implicit) are estimated|
|What does it show?||Reflects profit derived from business operations over a given period||Reflects the final returns generated by an entrepreneur by the employment of his own resources into a business|
|Used by||Often used by accountants||Used mostly by economists|
As a shareholder or investor, the accounting profit is critical since it provides a genuine picture of the company’s financial performance. Economic profit, on the other hand, can be used for internal analysis or by specific persons to examine the opportunity costs that are being sacrificed in order to make room for current activity.