What Is Economic Profit (or Loss)?
An economic profit or loss is the difference between the revenue received from the sale of an output and the costs of all inputs used as well as any opportunity costs. In calculating economic profit, opportunity costs and explicit costs are deducted from revenues earned.
Opportunity costs are a type of implicit cost determined by management and will vary based on different scenarios and perspectives.
- Economic profit is the result of subtracting both explicit and opportunity costs from revenue.
- Opportunity costs are the benefit that a business misses out on when choosing between alternatives.
- Economic profit is used for internal analysis and is not required for transparent disclosure.
Understanding Economic Profit (or Loss)
Economic profit is often analyzed in conjunction with accounting profit. Accounting profit is the profit a company shows on its income statement. Accounting profit measures actual inflows versus outflows and is part of required financial transparency.
Economic profit, on the other hand, is not recorded on a company’s financial statements, nor is it required to be disclosed to regulators, investors, or financial institutions. Economic profit is a type of "what if" analysis. Companies and individuals may choose to consider economic profit when they are faced with choices involving production levels or other business alternatives. Economic profit can provide a proxy for foregone profit considerations.
The calculation for economic profit can vary by entity and scenario. In general, it can be captured as follows:
Economic profit = revenues - explicit costs - opportunity costs
In this equation, excluding the opportunity costs results in just the accounting profit, but subtracting the opportunity costs as well can provide a proxy for comparison to other options that could have been undertaken.
Companies transparently show their explicit costs on the income statement. The accounting profit on the bottom line of the income statement is the net income after subtracting for direct, indirect, and capital costs. The cost of goods sold is the most basic explicit cost used in analyzing per-unit costs. Thus, in the equation above, a company could also break down its opportunity costs by units to arrive at a per-unit economic profit.
Economic profit may be used when seeking a comparison to income that potentially would have been gained from choosing a different option. Individuals starting their own business may use economic profit as a proxy for their first year of business. With large entities, business managers can potentially look more intricately at gross, operating, and net profit versus economic profit at different phases of the business operations.
Opportunity costs can be used for deeper analysis into business decisions, specifically when alternatives are available. Companies may look at opportunity costs when considering production levels for different types of products that they produce collectively but in varying quantities.
Opportunity costs are somewhat arbitrary and can be known as a type of implicit cost. They can vary depending on management’s estimations and market circumstances. Generally, opportunity cost will be the accounting profit that could have been achieved from making an alternative choice.
Examples of Economic Profit
An individual starts a business and incurs startup costs of $100,000. During the first year of operation, the business earns revenue of $120,000. This results in an accounting profit of $20,000. However, if the individual had stayed at her previous job, she would have made $45,000. In this example, the individual’s economic profit is equal to:
$120,000 - $100,000 - $45,000 = -$25,000
This calculation only considers the first year of business. If after the first year, costs decrease to 10,000 then the economic profit outlook would improve for future years. If economic profit comes out to zero, the company is said to be in a state of "normal profit."
In using economic profit in comparison to gross profit, a company may look at different types of scenarios. In this case, gross profit is the focus, and a company would subtract the opportunity cost per unit:
Economic profit = revenue per unit - COGS per unit - unit opportunity cost
If a company generates $10 per unit from selling t-shirts with a $5 cost per unit, then its gross profit per unit for t-shirts is $5. However, if they could have potentially produced shorts with revenue of $10 and costs of $2 then there could be an opportunity cost of $8 as well:
$10 - $5 - $8 = -$3
All things being equal, the company could have earned $3 more per unit if they had produced shorts instead of t-shirts. Thus, the -$3 per unit is considered an economic loss.
Companies can use this type of analysis in deciding on production levels. More complex scenario analysis of profits may also factor in indirect costs or other types of implicit costs, depending on the expenditures involved in doing business as well as different phases of a business cycle.