What is Accounting Profit?
Accounting profit is a company's total earnings, calculated according to generally accepted accounting principles (GAAP). It includes the explicit costs of doing business, such as operating expenses, depreciation, interest and taxes.
How Accounting Profit Works
Firms often publish various versions of profit in their financial statements. Some of these figures take into account all revenue and expense items, laid out in the income statement. Others are creative interpretations put together by management and their accountants.
Accounting profit, also referred to as bookkeeping profit or financial profit, is net income (NI) earned after subtracting all dollar costs from total revenue. In effect, it shows the amount of money a firm has left over after deducting the explicit costs of running the business.
The costs that need to be considered include the following:
- Labor, such as wages
- Inventory needed for production
- Raw materials
- Transportation costs
- Sales and marketing costs
- Production costs and overhead
- Accounting profit shows the amount of money left over after deducting the explicit costs of running the business.
- Explicit costs include labor, inventory needed for production and raw materials, together with transportation, production and sales and marketing costs.
- Accounting profit differs from economic profit as it only represents the monetary expenses a firm pays and the monetary revenue it receives.
Accounting Profit Method
Let’s look at an example of how accounting profit is calculated. Company A operates in the manufacturing industry and sells widgets for $5. In January, it sold 2,000 widgets for a total monthly revenue of $10,000. This is the first number entered into its income statement.
The cost of goods sold (COGS) is then subtracted from revenue to arrive at gross revenue. If it costs $1 to produce a widget, the company's COGS would be $2,000, and its gross revenue would be $8,000, or ($10,000 - $2,000).
After calculating the company's gross revenue, all operating costs are subtracted to arrive at the company's operating profit, or earnings before interest, taxes, depreciation, and amortization (EBITDA). If the company's only overhead was a monthly employee expense of $5,000, its operating profit would be $3,000, or ($8,000 - $5,000).
Once a company derives its operating profit, it then assesses all non-operating expenses, such as interest, depreciation, amortization, and taxes. In this example, the company has no debt but has depreciating assets at a straight line depreciation of $1,000 a month. It also has a corporate tax rate of 35%.
The depreciation amount is first subtracted to arrive at the company's earnings before taxes (EBT) of $1,000, or ($2,000 - $1,000). Corporate taxes are then assessed at $350, to give the company an accounting profit of $650, calculated as ($1,000 - ($1,000 * 0.35).
Accounting Profit vs. Economic Profit
Like accounting profit, economic profit deducts explicit costs from revenue. Where they differ is that economic profit also uses implicit costs, the various opportunity costs a company incurs when allocating resources elsewhere.
Examples of implicit costs include:
- Company-owned buildings
- Plant and equipment
- Self-employment resources
For example, if a person invested $100,000 to start a business and earned $120,000 in profit, his accounting profit would be $20,000. Economic profit, however, would add implicit costs, such as the opportunity cost of $50,000, which represents the salary he would have earned if he kept his day job. As such, the business owner would have an economic loss of $30,000 ($120,000 - $100,000 - $50,000).
Economic profit is more of a theoretical calculation based on alternative actions that could have been taken, while accounting profit calculates what actually occurred and the measurable results for the period. Accounting profit has many uses, including for tax declarations. Economic profit, on the other hand, is mainly just calculated to help management to make a decision.
Accounting Profit vs. Underlying Profit
Companies often choose to supplement accounting profit with their own subjective take on their profit position. One such example is underlying profit. This popular, widely-used metric often excludes one-time charges or infrequent occurrences and is regularly flagged by management as a key number for investors to pay attention to.
The goal of underlying profit is to eliminate the impact that random events, such as a natural disaster, have on earnings. Losses or gains that do not regularly crop up, such as restructuring charges or the buying or selling of land or property, are usually not taken into account because they do not occur often and, as a result, are not deemed to reflect the everyday costs of running the business.