When it comes to profits, the major discussed one is Economic Profit vs Accounting Profit. In financial metrics, “Profit” signifies the condition of your business. Good profit means good business. How? Well, the profit refers to the money you make when you sell something for more than it costs you!
Now the question is- how the economic profit different from accounting profit? In this write-up, we will look into Economic Profit vs Accounting Profit in detail.
Keep reading!
(A) Economic Profit vs Accounting Profit
Before delving into the details, let’s have a brief look at economic profit vs accounting profit-
| Aspects | Economic Profit | Accounting Profit |
| Definition | Derived from producing goods and services, considering alternative resource uses (opportunity costs). | Net income for a company, including explicit costs. |
| Calculation Formula | Economic Profit = Total Revenue – (Total Explicit Costs + Total Implicit Costs) | Accounting Profit = Total Revenue – Explicit Costs |
| Explicit Costs | Includes actual business expenses (e.g., wages, raw materials). | Explicit costs only (no implicit costs). |
| Implicit Costs | Considers opportunity costs of using company resources (e.g., foregone market prices). | Not considered in accounting profit. |
| Basis | Theoretical principles and assumptions. | Based on accounting principles. |
| Purpose | Evaluate overall profitability, considering all costs. | Reported to investors and the IRS for tax purposes. |
| Real-world Example | Choosing between two projects: Economic profit accounts for opportunity cost. | Project A’s profit after expenses: Accounting profit. |
| Nature | Derived from assumptions and estimates. | True form of profitability based on actual financial data. |
| Long term Perspective | Considers long-term viability and sustainability | Focuses on short-term financial performance |
| Decision Making | Useful for making strategic business decisions | Useful for assessing financial performance on paper |
In short, economic profit provides a broader perspective by considering both explicit and implicit costs, including opportunity costs, offering insights into the long-term viability of a business.
Accounting profit, on the other hand, is more focused on short-term financial performance, considering only explicit, out-of-pocket costs.
(B) Explicit Cost vs Implicit Cost
In the above comparison analysis, you saw that the prime difference in economic profit vs accounting profit was explicit and implicit costs.
So, you need to understand what are explicit and implicit costs first and then dive into economic profit vs accounting profit.
So, let’s look into the difference between explicit and implicit costs-
| Differential Aspects | Explicit Cost | Implicit Cost |
| Definition | Direct, tangible expenses involving actual payment | Opportunity costs associated with resources not paid for |
| Visibility | Identifiable, recorded in accounting books | Not easily visible in accounting records |
| Nature of Expenses | Out-of-pocket expenditures | Opportunity sacrifices, potential income foregone |
| Calculation for Profit | Included in accounting profit calculations | Considered in economic profit assessments |
| Examples | Salaries, rent, raw materials, utility bills | Foregone income, self-owned resources used |
| Impact on Decision-Making | Influences short-term financial decisions | Influences long-term strategic decisions |
In essence, explicit costs are the straightforward, visible expenses that involve actual payment, while implicit costs represent the less tangible opportunity costs associated with resources not directly paid for. Both are essential in evaluating the overall cost structure and profitability of a business.
Sounds complicated?
Let me explain it in simpler terms. I hope you will understand the concept with the help of this example!
The explicit costs are the clear, tangible expenses you can easily track. Think of it as the money you’re spending out directly – buying ingredients, paying rent, or hiring help for your lemonade stand. These costs are right there in black and white, showing up on receipts and invoices. They’re the dollars and cents you can count.
On the other hand, implicit costs are the less obvious, opportunity-related expenses. Here’s where it gets a bit sneakier. It’s not about actual cash leaving your pocket; it’s about what you could have earned if you’d chosen a different path.
Imagine you decide to run the lemonade stand instead of babysitting for the neighbor’s kid, which could have earned you some extra cash. The money you could have made from the babysitting gig is your implicit cost.
So, in the lemonade business, while explicit costs are the straightforward bills you pay, implicit costs are the hidden gems of missed opportunities.
Both are crucial to consider when you’re tallying up the real cost of your lemonade empire. It’s not just about what you see leaving your wallet; it’s about what you could have gained if you took a different route.
Balancing these costs helps you make savvy decisions and ensures you’re not just counting the dollars but also the cents you could be making elsewhere. Thus, they help to understand Economic Profit vs Accounting Profit.
(C) What is Economic Profit?
Let’s begin with the definition of Economic Profit to understand economic profit vs accounting profit-
“Economic profit is a comprehensive financial metric that assesses the net profitability of an enterprise by subtracting both explicit and implicit costs from total revenue.”
Unlike accounting profit, economic profit incorporates the concept of opportunity cost, recognizing the foregone earnings associated with choices.
The formula for economic profit is articulated as the difference between total revenue and the sum of explicit and implicit costs, thereby providing a nuanced perspective on the long-term viability and efficiency of a business endeavor.
This metric serves as a strategic tool for decision-makers, guiding them toward a more holistic evaluation of the overall value generated by a business activity.
So, we can say that economic profit delves into the deeper layers of financial analysis, going beyond the surface-level numbers.
Imagine you’re running a business – let’s stick with the lemonade stand analogy.
- Total Revenue: Economic profit starts with the total revenue your lemonade stand generates. This is the money flowing in from selling your refreshing beverages.
- Explicit Costs: Now, subtract the explicit costs. These are the straightforward, tangible expenses like lemons, sugar, cups, and any wages you pay for help. It’s the money you can easily see going out.
- Implicit Costs: Here’s where economic profit gets interesting. It factors in implicit costs – the opportunities you’ve given up. Let’s say you have a talent for painting and could have earned some extra cash selling artwork. The potential income from your paintings is an implicit cost because, by running the lemonade stand, you’ve chosen one path over another.
- Opportunity Cost: Implicit costs contribute to the concept of opportunity cost. This is the value of the next best alternative forgone. In our lemonade stand scenario, it’s what you could have earned if you pursued an alternative opportunity, like selling paintings.
- Economic Profit Equation: Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
- Long-Term Perspective: Economic profit takes a holistic, long-term perspective. It’s not just about making a quick buck; it’s about assessing whether your lemonade stand is the most efficient use of your resources and time in the grand scheme of things.
- Strategic Decision-Making: This type of profit is a powerful tool for strategic decision-making. It helps you evaluate not only the financial gains but also the overall value of your choices. If your economic profit is positive, it suggests your business is doing well beyond covering basic expenses.
In essence, economic profit provides a comprehensive view of your business’s success by considering both explicit and implicit costs. It’s a strategic compass guiding you toward decisions that maximize your overall well-being and financial prosperity.
So, when you’re in the business game, economic profit is your backstage pass to understanding the full picture of your success journey!
Note: Sorry to interrupt you in the middle of your reading journey. Recently, there has been a buzz around the gig economy in India. So we have covered the topic “The rise of the Gig Economy in India & the future ahead.” Go through it for detailed information.
(D) What is Accounting Profit?
First, go through the definition of Accounting Profit-
“Accounting profit is defined as the financial surplus obtained by deducting explicit, out-of-pocket costs from total revenue.”
It represents the traditional measure of profitability, focusing solely on quantifiable and observable expenditures incurred in the course of business operations. Accounting profit, as a fundamental metric in financial reporting, excludes implicit costs and opportunity costs, providing a straightforward representation of the monetary gains derived from commercial activities.
Let me explain this complicated concept in layman’s language.
Accounting profit is a financial metric that measures the net earnings of a business by subtracting explicit, out-of-pocket costs from total revenue. It provides a straightforward assessment of a company’s financial performance, focusing on the monetary gains derived from its operational activities.
Now, look at some of the components of accounting profit-
- Total Revenue: Accounting profit initiates with the total revenue generated by a business. This encompasses all income derived from sales, services, or any other sources.
- Explicit Costs: The next step involves deducting explicit costs from total revenue. Explicit costs are tangible, quantifiable expenditures incurred in the course of business operations. These include expenses such as raw materials, labor wages, rent, utilities, and other direct costs.
- Accounting Profit Equation: Accounting Profit = Total Revenue – Explicit Costs
- Short-term Focus: Accounting profit primarily focuses on short-term financial performance. It provides a snapshot of the financial health of a business during a specific accounting period, typically quarterly or annually.
- Exclusion of Implicit Costs: Unlike economic profit, accounting profit does not account for implicit costs or opportunity costs. It solely considers the explicit, out-of-pocket expenses incurred in the production and operation of the business.
- Regulatory Compliance: Accounting profit aligns with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), ensuring consistency and comparability in financial reporting across businesses.
- External Reporting: Accounting profit is essential for external reporting to stakeholders, including investors, creditors, and regulatory bodies. It provides a standardized measure for assessing a company’s financial performance.
- Limitations: While accounting profit provides a clear snapshot of immediate financial gains, it has limitations. It doesn’t consider implicit costs like the value of your time or the potential earnings from alternative uses of your resources. That’s where economic profit steps in for a more comprehensive evaluation.
- Example: Let’s say you operate a bakery. Last year, your total revenue from selling cakes, pastries, and bread was Rs.1,00,000. Your explicit costs, including ingredients, labor, and overhead, summed up to Rs.60,000. The accounting profit will be calculated by subtracting Rs.60,000 from Rs.1 lakh. So, the accounting profit will be Rs.40,000.
In essence, accounting profit is your go-to metric for a straightforward assessment of how well your business is doing in terms of generating revenue and covering explicit costs. It’s the bread and butter of financial reporting, providing a foundation for understanding the financial health of your enterprise. Now, you must have understood economic profit vs accounting profit.
(E) Summing Up Economic Profit vs Accounting Profit
To sum it up, knowing the difference between Economic Profit and Accounting Profit is crucial for smart business choices. Accounting Profit shows the money you’ve made after subtracting clear costs. But Economic Profit digs deeper – it looks at hidden costs like missed opportunities.
Imagine you could have made money doing something else instead of your current business. Economic Profit considers that too.
So, while Accounting Profit is like a quick financial snapshot, Economic Profit gives you a full album. It helps you see if you’re not just making money but also if there are better ways to use your time and resources.
Both are important – Accounting Profit for basic money talk and Economic Profit for the big picture, guiding you to make decisions that lead to overall success!
