What Is Economic Profit?
An economic profit is the difference between the revenue received from sales and the explicit costs of producing its goods and services, as well as any opportunity costs.
Opportunity costs are a type of implicit cost determined by management and will vary based on different scenarios and perspectives.
- Economic profit is the financial amount that remains after subtracting both explicit costs and opportunity costs from revenue.
- Opportunity costs are the profits that a business misses out on when choosing to pursue one business venture over another.
- Economic profit is used for internal analysis and is not required for transparent disclosure.
- Accounting profit is straightforward and precise: revenue minus explicit costs.
- While theoretical, economic profit computations can help a company size up and choose between potential business ventures.
Understanding Economic Profit
Economic profit is often analyzed in conjunction with accounting profit. Accounting profit is the profit that a company shows on its income statement. It is also known as "net income."
Accounting profit measures actual money inflows versus money outflows and is part of the required financial reporting and transparency of a company.
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 can be used in a "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.
How to Calculate Economic Profit
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
If you excluded the opportunity costs from this equation, you'd get simply the accounting profit. However, when you subtract the opportunity costs as well, the economic profit results. It can serve as a comparison to other options that could have been undertaken by a company, for better or worse.
Companies state 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.
Individuals starting their own business might use economic profit as a proxy for their first year of business (since they have given up some prior opportunity). 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.
Economic Profit vs. Accounting Profit
Accounting profit, or net income, is determined by subtracting all costs from revenue for a particular accounting period. Economic profit is determined by going a step further and subtracting opportunity costs, as well. The former represents an actual figure that's included on financial statements. The latter can be used by company management to determine how effective its business decisions were. It can also be used before actions are taken to decide on the best business strategy to put to work.
Here's a quick reference chart that summarizes the differences between economic profit and accounting profit.
|Economic Profit||Accounting Profit|
|A theoretical financial figure based on assumptions||Actual profit (net income) is determined|
|Isn't part of financial statements or reported||Calculated according to GAAP and reported to IRS|
|Used for internal analysis||Used by investors to analyze a potential investment|
|Illuminates for management the wisdom of various business options||Provides insight into how well management is running company|
|Can reveal how efficiently a company uses its resources||Is used to calculate investors' earnings per share|
Advantages and Disadvantages of Economic Profit
- Economic profit figures can be helpful for business decision-making. By studying the effect on net income of subtracting not just explicit costs but the estimated costs of giving up potential business opportunities, companies can size up the wisdom of business ventures from high to low before launching one or more.
- Economic profit can also be reviewed after the fact. Lessons can be learned about the choices that were made.
- Economic profit can show management how efficiently the company has been using its resources.
- The economic profit figure is theoretical because opportunity costs are based on assumptions. Since the opportunity wasn't taken, a company doesn't know the exact amount of revenue that might have been made.
- The calculation of economic profit over the short-term can lead to inappropriate conclusions about the business option chosen. That's because short-term losses can be inevitable before expected long-term profitability. It's smarter to analyze economic profits over long-term time periods.
Opportunity costs can be used for deeper analysis of 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 are 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 by 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 it could have produced shorts with revenue of $10 and costs of $2 then there would 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 to decide 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.
What Are Economic Profits?
Economic profits are the theoretical profits that result when company management subtracts all expenses plus the costs of lost opportunities from revenue earned in a particular period of time.
Why Is Economic Profit Important?
It can be important because it can help a company's management understand potential flaws in its choices for business strategies or ventures, missed financial opportunities, and how efficiently it uses company resources.
What Is an Opportunity Cost?
It's the cost to an individual or company of not pursuing a particular business option. The cost isn't related to something they spend. It refers to money they forego.
The Bottom Line
Economic profit represents a company's revenue less its explicit costs as well as its opportunity costs. It's used for internal analysis. Accounting profit (net income) is a company's revenue less its direct, indirect, and capital costs. It's reported on financial statements and to the IRS.
Economic profit is important for the insight that it can give the management of a company about potential or past business opportunities. Accounting profit is an important measure of profitability and management capability for investors.