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.
References for Economic Profit:
Academic Research on Economic Profit
- ● Economic profit and performance measurement in banking, Kimball, R. C. (1998). New England Economic Review, 35-53. This article analyzes the use of economic profit for measuring the performance of banks, focusing on the allocation of equity capital to products, customers, and businesses. It reviews the use of economic profit to evaluate performance, to analyse price transactions, and to reward managers.
- ● How to fix accounting—measure and report economic profit, Stewart III, G. B. (2003). Journal of Applied Corporate Finance, 15(3), 63-82. This article focuses on the different problems faced by managers on keeping proper account of earnings. It also investigates the different activities of business managers aimed at growing returns on investments. The author provides different advices on fixing accounting errors.
- ● Concentration, barriers to entry, and long run economic profit margins, Qualls, D. (1972). The Journal of Industrial Economics, 146-158. This paper investigates the distinct conclusions from two of Joe Bain’s studies. The main objective of this paper is to show the various conclusions drawn from Bain’s second study on the impact of concentration and the impact of barrier entry.
- ● Stability and persistence of economic profit margins in highly concentrated industries, Qualls, D. (1974). Southern Economic Journal, 604-612. Earlier studies [1; 3; 12] have concluded that high concentration and high barriers are important market structural characteristics leading to monopolistic resource misallocation. This research aims to support the hypothesis of concentration by different studies, thus making the allegations against it null and void.
- ● Toward a synthesis of the resource‐based and dynamic‐capability views of rent creation, Makadok, R. (2001). Strategic management journal, 22(5), 387-401. This paper develops a basic theoretical model to address questions generated from the resource-picking and capability-building mechanism, and derives testable hypotheses from the model.
- ● Using economic profit to assess performance: A metric for modern firms, Aggarwal, R. (2001). Business Horizons, 44(1), 55-55. This paper analyses the use of Economic Profit (EP), Economic Value Added (EVA) and, Economic or Shareholder Value Increase (EVI/SVI) in assessing economic performance.
- ● Firm and industry effects in accounting versus economic profit data, Holian, M. J., & Reza, A. M. (2011). Applied Economics Letters, 18(6), 527-529. This article presents estimates of firm and industry fixed effects on profit rates for large US corporations, using Economic Value Added (EVA) tax and simple (unadjusted) accounting measures as the dependent variables. We find that the improvement in explanatory power of the fixed-effect model is substantially greater when using EVA than has been documented with alternative measures.
- ● Profit regulation of defense contractors and prizes for innovation, Rogerson, W. P. (1989). Journal of Political Economy, 97(6), 1284-1305. This paper argues that regulatory institutions in defense procurement are (and necessarily must be) organized to create prizes for innovation in the form of positive economic profit on production contracts. This has a number of important policy implications. The values of the prizes on 12 major aerospace projects are estimated using stock market data and shown to be large.
- ● Approaches of enhancing economic profit of land development and consolidation item [J], Min, L., Xiaomin, Z., & Shaoqi, G. (2004). Transactions of The Chinese Society of Agricultural Engineering, 3, 062. It was particularly discussed that approaches of enhancing land economic profit in the project “land consolidation”, taking Yangxin County, Shandong Province as an example. Two approaches including single land consolidation and the combination of land consolidation with rational planting system were lucubrated using different factors. The result shows that the two approaches can enhance land economic profit, but the second one is better.
- ● Savanna management for ecological sustainability, economic profit and social equity, Young, M. D., & Solbrig, O. T. (1992).
- ● Theory in Action: Economic Profit: An Old Concept Gains New Significance, Bell III, L. W. (1998). Journal of Business Strategy, 19(5), 13-15. This paper analyses the need of the public and entrepreneurs to know more information about the profits generated by a firm/company. The main objective is to show the rate at which the main focus of investors is shifting from the general profit generated by firms, to the monetary value created for shareholders.