Beatrice Wants to Calculate The Accounting and Economic Profits

Beatrice wants to understand the difference between accounting and economic profits. This guide explains how to calculate both types of profits, when each is used, and how they help business decision-making.

What are accounting and economic profits?

Profits are the difference between a business's revenue and its costs. There are two main types of profits:

Accounting profits - The net income reported on a company's income statement, calculated as revenue minus explicit costs.
Economic profits - The net income after accounting for all costs, including implicit costs like opportunity costs.

Accounting profits are used for financial reporting and tax purposes, while economic profits help assess a business's true profitability and efficiency.

The difference between accounting and economic profits

The key difference lies in what costs are included:

Accounting Profits	Economic Profits
Only explicit costs (direct costs)	All costs (explicit + implicit)
Used for financial statements	Used for business evaluation
Doesn't account for opportunity costs	Accounts for opportunity costs

Economic profits are more comprehensive and help determine whether a business is truly profitable or just covering its costs.

How to calculate accounting profits

Accounting profits are calculated using the basic accounting formula:

Accounting Profit = Total Revenue - Total Explicit Costs

Where explicit costs include:

Direct costs (materials, labor)
Variable costs (commissions, utilities)
Fixed costs (rent, salaries)

This is the profit reported on income statements and used for financial reporting.

How to calculate economic profits

Economic profits are calculated by subtracting all costs from revenue, including implicit costs:

Economic Profit = Total Revenue - Total Explicit Costs - Total Implicit Costs

Implicit costs include:

Opportunity costs of capital
Opportunity costs of labor
Opportunity costs of time

Economic profits help determine if a business is truly profitable or just covering its costs.

Worked example

Let's calculate both types of profits for a small coffee shop:

Item	Amount
Total Revenue	$10,000
Explicit Costs	$7,000
Implicit Costs	$2,500

Calculations:

Accounting Profit = $10,000 - $7,000 = $3,000

Economic Profit = $10,000 - $7,000 - $2,500 = $500

This shows the coffee shop has $3,000 in accounting profits but only $500 in economic profits, indicating it's not truly profitable when considering all costs.

FAQ

What is the difference between accounting and economic profits?: Accounting profits only include explicit costs, while economic profits include both explicit and implicit costs like opportunity costs.
Which type of profit is more important for business decisions?: Economic profits are more important as they consider all costs, helping determine true profitability and efficiency.
Can economic profits be negative?: Yes, if total costs exceed total revenue, economic profits can be negative, indicating the business is not covering its costs.
Are implicit costs always higher than explicit costs?: Not necessarily. The relationship depends on the specific business and its operating environment.
How often should I calculate these profits?: At least quarterly to monitor financial health and make informed business decisions.