Economic Profit Formula: Economic profit is the distinction between total financial revenue and total costs, but total costs include both specific and implicit costs. Economic profit involves the opportunity costs connected with production and is, therefore, cheaper than accounting profit. Economic profit also accounts for a longer extent of time than accounting profit. Economists usually think long-term economic profit to decide if a firm should enter or exit a market.
Accounting profit is the disparity between total financial revenue and total monetary costs and is computed by using commonly held accounting principles (GAAP). Put another way, accounting profit is identical to bookkeeping costs and consists of credits and debits on a firm’s balance sheet. These consist of the explicit costs a firm has to manage the production (for example, wages, rent, and material costs). The monetary revenue is what a firm gets after selling its product in the market.
Accounting profit is also restricted in its time scope; usually, accounting profit only reflects the costs and revenue of a single span of time, such as a financial quarter or year.
Economic Profit (or Loss)
An economic profit or loss is the discrepancy between the revenue derived from the sale of an output and the costs of all inputs used as well as any opportunity costs. In measuring economic profit, opportunity costs and explicit costs are subtracted from revenues earned.
Opportunity costs are a type of implicit cost prepared by management and will change based on different situations and scenes.
Key Points
- Economic profit is the result of subtracting both explicit and opportunity costs from revenue.
- Opportunity costs are the benefit that business drops out when choosing among alternatives.
- Economic profit is used for internal review and is not required for open disclosure.
Better Understanding of Economic Profit (or Loss)
Economic profit is often examined in connection with accounting profit. Accounting profit is the profit a company shows on its income statement. Accounting profit measures actual inflows versus outflows and is a portion of the expected financial transparency.
Economic profit, on the other hand, is not recorded on a company’s financial statements, nor is it needed to be exposed to regulators, investors, or financial institutions. Economic profit is a kind of “what if” analysis. Companies and individuals may prefer to consider economic profit when they are confronted with choices including production levels or other business alternatives. Economic profit can provide a substitute 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 equalization, excluding the opportunity costs results in just the accounting profit, but deducting the opportunity costs as well can give a substitute for comparison to other options that could have been undertaken.
Companies transparently present their explicit costs on the income receipt. The accounting profit on the bottom line of the income statement is the net income after deducting for direct, indirect, and capital costs. The cost of goods sold is the most basic explicit cost used in examining per-unit costs. Thus, in the equation above, a company could also cut down its opportunity costs by units to appear at a per-unit economic profit.
Economic profit may be used when attempting a comparison to income that probably would have been achieved from taking a different choice. Individuals beginning their own business may use economic profit as a substitute for their first year of business. With big entities, business managers can possibly look more intricately at gross, operating, and net profit versus economic profit at different stages of business operations.
Economic Profit Formula
The word “economic profit” refers to the profit that is received by a business after settling for the opportunity cost that the business has certain. In other words, it is the difference between the accounting profit and the opportunity cost. The formula for economic profit can be obtained by deducting the explicit costs (pertaining to the business expenses) and the implicit costs (opportunity cost) from the total revenue received by the business. Mathematically, Economic Profit is described as,
Economic Profit = Total Revenue – Explicit Costs – Implicit Costs
Explicit and Implicit Costs
Explicit costs are costs that affect direct monetary payment. Wages are given to workers, rent paid to a landowner, and material costs paid to a supplier are all examples of explicit costs.
In distinction, implicit costs are the opportunity costs of parts of production that a producer already has. The implicit cost is what the firm must give up in order to use its sources; in other words, an implicit cost is any cost that occurs from using an asset instead of renting, selling, or lending it.
For example, a paper production firm may own a grove of trees. The implicit cost of that natural resource is the potential market price the firm could get if it sold it as wood instead of using it for paper production.
Relevance and Uses of Economic Profit Formula
It is very important to recognize that economic profit and accounting profit are two entirely different things and one can’t be used as an alternative for the other in any case. Economic profit primarily varies from accounting profit in the case that the former also includes the effect of opportunity costs, which is the amount that a business or individual has given up to do something else.
Now, it is feasible for a business to have a positive accounting profit while the economic profit is negative, and it means that the individual could be financially better off by reducing the current business operation and engage in a different opportunity. On the other hand, if a business is able to perform a positive economic profit then it indicates the individual should seek the current business operation as it is allowing better returns than other opportunities.
Examples of Economic Profit
An individual begins a business and contracts startup costs of $100,000. During the first year of service, the business receives revenue of $120,000. This results in an accounting profit of $20,000. However, if the individual had waited at her previous job, she would have earned $45,000. In this example, the individual’s economic profit is equal to:
$120,000 – $100,000 – $45,000 = -$25,000
This calculation only examines the first year of business. If after the first year, costs lower to 10,000 then the economic profit outlook would better 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 correlation to gross profit, a company may look at different kinds of situations. In this case, gross profit is the center, and a company would deduct the opportunity cost per unit:
Economic profit = revenue per unit – COGS per unit – unit opportunity cost
If a company makes $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 provided 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 equivalent, the company could have made $3 more per unit if they had produced shorts instead of t-shirts. Thus, the -$3 per unit is estimated at an economic loss.
Companies can use this kind of review in determining production levels. A more complex situation review of profits may also factor in incidental costs or other types of implicit costs, depending on the expenditures involved in doing business as well as different phases of a business cycle.
Accounting Profit
Profit is a widely watched financial metric that is commonly used to judge the health of a company.
Firms often issue multiple versions of profit in their financial declarations. Some of these figures take into account all revenue and expense things, set out in the income statement. Others are original interpretations put together by management and their controllers.
Accounting profit also pointed to as bookkeeping profit or financial profit is net income (NI) made after deducting all dollar costs from total revenue. In conclusion, it shows the amount of money a firm has left over after subtracting the explicit costs of operating the business.
The costs that need to be studied include the following:
- Labor, such as wages
- Inventory required for production
- Raw elements
- Transportation costs
- Sales and marketing costs
- Production costs and expenses
Key Points
- Accounting profit displays the amount of money left over after subtracting the explicit costs of operating the business.
- Explicit costs cover labor, inventory required for production, and raw materials, together with transportation, production, and sales and marketing costs.
- Accounting profit varies from economic profit as it only describes the monetary expenses a firm pays and the monetary revenue it gets.
Accounting Profit Calculation/Formula
Let’s see an example of how accounting profit is determined. Company A runs in the manufacturing industry and trades widgets for $5. In January, it marketed 2,000 widgets for total monthly revenue of $10,000. This is the first number listed in its income statement.
The cost of goods sold (COGS) is then deducted from revenue to come at gross revenue. If it costs $1 to manufacture a widget, the company’s COGS would be $2,000, and its gross revenue would be $8,000, or ($10,000 – $2,000).
After determining the company’s gross revenue, all running costs are deducted to arrive at the company’s running profit, or earnings before interest, taxes, depreciation, and amortization (EBITDA). If the company’s only cost was a monthly employee expense of $5,000, its running profit would be $3,000, or ($8,000 – $5,000).
Once a company receives its operating profit, it then evaluates all non-operating expenses, such as interest, depreciation, amortization, and taxes. In this example, the company has no money but has depreciating assets at a straight-line depreciation of $1,000 a month. It also has a corporate tax rate of 35%.
The discount amount is first deducted to arrive at the company’s earnings before taxes (EBT) of $1,000, or ($2,000 – $1,000). Corporate taxes are then valued at $350, to give the company an accounting profit of $650, determined as ($1,000 – ($1,000 * 0.35).
Accounting Profit vs. Economic Profit
Like accounting profit, economic profit deducts explicit costs from revenue. Where they vary is that economic profit also uses implicit costs, the many opportunities cost company contracts when allocating resources elsewhere.
Examples of implicit costs cover:
- Company-owned structures
- Plant and tools
- Self-employment sources
For example, if a person spent $100,000 to begin 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 work. 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 happened and the measurable results for the period. Accounting profit has many uses, including for tax announcements. Economic profit, on the other hand, is mainly just calculated to help management to make a conclusion.
Conclusion
Economic profit is described as the difference between total revenue and total cost, including both explicit and implicit costs. The concept of economic profit is greatly important when it comes to examining decision-making processes in an economic context. To calculate it, we can follow a simple three-step process: (1) calculate total revenue, (2) calculate total costs, and (3) subtract total costs from total revenue.