Economic Profit Explained
Economic Profit is defined as the difference between total revenue and total cost of inputs. Revenue is the amount derived from sale of goods or the delivery services. The total costs of inputs includes the all expenses and all profits forgone to undertake the activity.
A Little More about Economic Profit
To calculate economic profit the accounting costs and opportunity costs are deducted from total revenue. An opportunity cost is the benefit or value that must be given up to take advantage of something else. More simply, it’s an alternative cost.
Economic Profit versus Accounting Profit
Most of use 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 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)
A Little More on Opportunity Cost
As discussed, an opportunity cost is the alternative that is forgone to achieve something else in the decision making. For example, one can enroll at the university to earn higher degree. During this time you will incur a 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 costs. Generally, economic profit is not recorded nor disclose to anyone. Nonetheless, it is certainly relevant to those involved in the business venture.
An Examples 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.