What is Economic Profit?

Economic Profit is defined as the difference between total revenue and total cost of inputs. Revenue is the amount derived from the sale of goods or the delivery services. The total costs of inputs include all expenses and all profits forgone to undertake the activity.

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How to Calculate Economic Profit

To calculate economic profit the accounting costs and opportunity costs are deducted from total revenue. An opportunity cost is a benefit or value that must be given up to take advantage of something else. More simply, its an alternative cost.

Economic Profit versus Accounting Profit

Most of us are familiar with the concept of accounting profit. Accounting profit is the monetary profit that includes only explicit cost. Accounting profit can be measured as: 

Profit = Sales- Total explicit cost 

As such, there is a fundamental difference between economic profit and accounting profit. When measuring economic profit, both explicit and implicit costs are deducted from sales. It can be measured as: 

Profit = Sales - (Explicit cost + Implicit cost) 

As discussed, an opportunity cost is an alternative that is forgone to achieve something else in the decision making. For example, one can enroll at the university to earn a higher degree. During this time you will incur lots of expenses. Also, you will forgo the ability to work and earn profits while undertaking classes. The lost revenue, as well as the expenses of attending, are opportunity costs.

How to Use Economic profit and Accounting Profit

Firms use accounting profit to measure the performance of firm in the given period. It is the measure of financial success of the company. These are the metrics that owners and investors employ when determine whether the firm is profitable. Public firms are obligated to disclose accounting profit in their financial statements. A firm may have accounting profit but it may have economic loss. This occurs when the assets could have been better utilized which could earn higher profit. If an individual could have invested their efforts elsewhere or earned interest from assets employed in the business, this must be counted as an economic cost. Generally, economic profit is not recorded nor disclose to anyone. Nonetheless, it is certainly relevant to those involved in the business venture.

An Example of Economic Profit

An individual quits his job to start a business. In his job, he is making $50,000 per year. To set up the business, the initial startup cost is $ 30,000. We will assume that these are all immediate expenses that do not include acquired assets. In the first year, the firm earned $40,000. If the individual had maintained his job he would have made $10,000 more than his earnings. In the example accounting profit is $10,000 ($40K - 30K). In real terms, he incurred an economic loss of $40,000 ($10,000 + $30,000). This is a simple example, but it goes to illustrate the point that assets employed in one project cannot be employed in another. As such, you must calculate any forgone profits associated with selecting one project over another. This concept will be explored further in our material on the cost of capital.

Relate Topics

• Theory of the Firm
• Capital Formation
• Rent Seeking
• Structure Conduct Performance Model
• Integration
• Co-Insurance Effect
• Conglomerates
• Cost vs Profit Center
• Accelerator Theory
• Market Structure
• Fixed Cost vs Variable Cost
• Actual vs Implicit Costs
• Explicit Costs
• True Cost Economics
• Accounting Profit
• Economic Profit
• What are Factors of Production?
• Factor Income
• Production Function
• Fixed and Variable Inputs
• Short-Run and Long-Run Production
• Short Run
• Total Product
• Marginal Product
• Value of Marginal Product
• Law of Marginal Diminishing Product
• Production Function
• Production Possibilities Frontier
• Capital 
• Labor Theory of Value
• How the Production Function Estimates Inputs
• Factor Payment
• Economic Rent
• Cost Function
• Incremental Cost
• Marginal Input Cost  
• Fixed and Variable Costs
• Diminishing Marginal Productivity
• Costs Relate to Diminishing Marginal Productivity
• Law of Diminishing Marginal Returns
• Average Total Cost
• Average Variable Cost
• Marginal Cost
• Average Profit or Profit Margin
• Accounting Profit
• Economic Profit
• Normal Profit
• Short and Long-Run Production
• Cost Curves
• Long-Run Average Cost (LRAC)
• Production Technologies
• Economies of Scope
• Economies of Scale
• Diseconomies of Scale
• Minimum Efficient Scale
• Increasing, Constant, and Decreasing Returns to Scale
• Shape of the Average Long-Run and Short-Run Cost Curves
• Returns to Scale
• Diseconomies of Scale
• Long-Run Average Cost Curve Affect Industry Competitors
• Technology Shifts the Long-Run Average Cost Curve
• Law of Diminishing Marginal Returns