Understanding Accounting Profits: Key Differences and Calculations

Accounting profits are typically defined as the profit after costs and expenses are subtracted from total revenue. This financial metric provides businesses with a clear picture of their financial performance and helps in decision-making processes.

Economic Profit vs. Accounting Profit: An Overview

While accounting profit focuses on the explicit costs and revenue, economic profit factors in the opportunity costs as well. Opportunity costs refer to the potential benefit that could have been gained from the next best alternative. By considering opportunity costs, economic profit provides a more comprehensive view of a business's performance.

Economic Profit

Economic profit is the total revenue minus both explicit costs and implicit costs, including opportunity costs. It takes into account all the expenses incurred and the potential value of the next best alternative.

Accounting Profit

Accounting profit, on the other hand, is calculated by subtracting explicit costs, such as rent, wages, and utilities, from total revenue. It focuses solely on the monetary expenses and income.

Key Differences

1. Scope: Economic profit considers both explicit and implicit costs, while accounting profit only looks at explicit costs.

2. Calculation: Economic profit subtracts both explicit and implicit costs from total revenue, whereas accounting profit only subtracts explicit costs.

3. Opportunity Costs: Economic profit factors in opportunity costs, which accounting profit does not account for.

Economic Profit vs. Accounting Profit Example

Let's consider a hypothetical scenario. A business earns $100,000 in total revenue and has explicit costs of $80,000, including rent, wages, and utilities. Additionally, the next best alternative would have generated $20,000 in revenue.

The accounting profit would be $20,000 ($100,000 - $80,000), while the economic profit would be $0 ($100,000 - $80,000 - $20,000). The economic profit takes into account the opportunity cost of choosing the current business over the next best alternative.

What Is the Difference Between Zero Accounting Profit and Zero Economic Profit?

Zero accounting profit means that a business has covered all its explicit costs but has not generated any additional income. Zero economic profit, on the other hand, indicates that a business is not earning any profit after accounting for both explicit and implicit costs, including opportunity costs.

How Do You Calculate Economic Profit?

To calculate economic profit, follow these steps:

1. Determine the total revenue of the business.
2. Subtract explicit costs (rent, wages, utilities, etc.) from the total revenue.
3. Identify the opportunity costs by considering the potential value of the next best alternative.
4. Subtract the opportunity costs from the result obtained in step 2.

How Do You Calculate Accounting Profit?

Accounting profit is calculated using the following formula:

Accounting Profit = Total Revenue - Explicit Costs

Is Accounting Profit More Than Economic Profit?

Accounting profit can be greater than, equal to, or less than economic profit, depending on the business's situation. If the explicit costs are higher than the explicit costs plus opportunity costs, the accounting profit will be higher. However, economic profit provides a more accurate measure of a business's performance as it considers all costs and potential alternative earnings.

Why Is Economic Profit Better Than Accounting Profit?

Economic profit is considered a better measure of business performance because it accounts for opportunity costs. By considering the potential value of the next best alternative, economic profit provides a more comprehensive understanding of a business's financial health and the impact of its decisions.

The Bottom Line

While accounting profit is a valuable metric for analyzing financial performance, economic profit offers a more complete picture by factoring in opportunity costs. By understanding the key differences and calculations of both accounting and economic profit, businesses can make more informed decisions and evaluate their performance accurately.