Accounting Profit vs Economic Profit: Key Differences

In business finance, profitability analysis is crucial in assessing a company's financial health and performance. While accounting profit is a widely recognized metric, economic profit dives deeper, providing a more comprehensive understanding of a company's true profitability. 

This blog post breaks down the distinctions between accounting profit and economic profit, empowering businesses and accounting professionals to utilize both concepts for informed decision-making effectively.

Table of Contents

What is Accounting Profit?

Accounting profit, or net income, represents a company's financial gain after deducting all explicit costs associated with its operations from its total revenue. Explicit costs encompass readily identifiable expenses reflected in a company's financial statements, such as:

• Cost of goods sold (COGS)
• Operating expenses (rent, salaries, utilities, marketing)
• Interest expense
• Depreciation expense

Evaluating a company's financial performance over a period requires consideration of various metrics, one of which is accounting profit. 

What is Economic Profit?

Economic profit, on the other hand, takes accounting profit a step further by factoring in implicit costs. The costs that are not explicitly stated but reflect the value of the best alternative use of resources are known as implicit costs. These costs are linked to the company's choices regarding its business operations. These costs aren't explicitly recorded in the financial statements but represent the value of forgone alternatives. Examples of implicit costs include:

• The owner's forgone salary if they were to work elsewhere.
• The cost of equity capital reflects the return investors could have earned by investing elsewhere.
• The opportunity cost of using company-owned assets instead of leasing them to generate rental income.

Economic profit measures a company's actual economic profit – the amount of money it earns above all explicit and implicit costs. It reflects whether a company generates a return that exceeds the minimum required to compensate its owners for their investment and the risks involved.

Accounting Profit vs Economic Profit: Formula

The formulas for accounting profit and economic profit highlight their key differences:

Accounting Profit:

Accounting Profit = Total Revenue - Explicit Costs

Economic Profit:

Economic Profit = Accounting Profit - Implicit Costs

As the formulas show, economic profit is always equal to or less than accounting profit. When implicit costs are zero, accounting profit and economic profit become identical.

Accounting Profit vs Economic Profit: Calculate

Calculating explicit costs for accounting profit is a straightforward process involving analyzing a company's income statement. Implicit costs, however, require estimations and may involve subjective considerations. Here's a breakdown of how to calculate each type of profit:

Accounting Profit:

1. Gather data on the company's total revenue from sales and other income sources.

2. Identify and total all explicit costs incurred during the accounting period, including COGS, operating, interest, and depreciation expenses.

3. Subtract the total explicit costs from the total revenue to determine the accounting profit.

Economic Profit:

1. Calculate the accounting profit using the steps mentioned above.

2. Estimate the implicit costs associated with the business. This may involve:

• Determining the market salary the owner could earn if employed elsewhere.
• Calculating the cost of equity capital using financial models or industry benchmarks.
• Estimating the potential rental income generated if company-owned assets were leased to others.

3. Subtract the total implicit costs from the accounting profit to determine the economic profit.

Accounting Profit vs Economic Profit: Examples

Let's consider two scenarios to illustrate the differences between accounting profit and economic profit:

Scenario 1: Bakery with Owner as Head Chef

• A bakery generates total revenue of $100,000 in a month.
• Explicit costs (COGS, operating expenses, etc.) total $70,000.
• The owner, a skilled chef, could earn $5,000 per month elsewhere.

Accounting Profit:

Accounting Profit = $100,000 (Revenue) - $70,000 (Explicit Costs) = $30,000

Economic Profit:

Economic Profit = $30,000 (Accounting Profit) - $5,000 (Implicit Cost) = $25,000

In this scenario, the bakery generates a positive accounting profit of $30,000. However, considering the owner's forgone salary as an implicit cost, the economic profit reduces to $25,000.

Accounting Profit vs Economic Profit: Differences

While both accounting profit and economic profit offer valuable insights into a company's financial performance, fundamental differences exist:

Focus:

• Accounting Profit: Focuses on historical costs and readily identifiable expenses.

• Economic Profit: Considers historical costs and the opportunity costs associated with business decisions.

Information Source:

• Accounting Profit: Derived from a company's financial statements, primarily the income statement.

• Economic Profit: Requires estimations and may involve subjective considerations beyond the data readily available in financial statements.

Decision-Making:

• Accounting Profit: Provides a fundamental measure of profitability for financial reporting and tax purposes. It helps assess a company's ability to generate revenue and cover operating expenses.

• Economic Profit: A comprehensive view of a company's true profitability, considering both explicit and implicit costs. This information is crucial for strategic decision-making, such as evaluating investment opportunities, resource allocation, and business expansion plans.

Limitations:

• Accounting Profit: This doesn't account for implicit costs and may not reflect the true economic profitability of a company.

• Economic Profit: This relies on estimations for implicit costs, which can be subjective and vary depending on the assumptions.

Additional Considerations:

• Short-Term vs. Long-Term Analysis: Accounting profit is often used for short-term financial analysis, while economic profit is more relevant for long-term strategic decision-making.

• Industry Benchmarks: Analyzing a company's accounting and economic profit concerning industry benchmarks can yield helpful information about its comparative performance.

Conclusion

Understanding the distinctions between accounting profit and economic profit empowers businesses and accounting professionals to make informed financial decisions. Accounting profit is a baseline measure of financial performance, while economic profit provides a more comprehensive view of a company's profitability. Businesses can better understand their financial health to make strategic choices that maximize long-term value by utilizing metrics and considering their limitations.