How to Calculate Accounting and Economic Profit

Profit is the lifeblood of any business, but understanding the different types of profit is crucial for financial decision-making. This guide explains how to calculate accounting profit and economic profit, their key differences, and when each is relevant.

What is Profit?

Profit represents the financial gain a business achieves after accounting for all costs and expenses. It's calculated by subtracting total costs from total revenue. There are two primary types of profit: accounting profit and economic profit.

Basic Profit Formula

Profit = Total Revenue - Total Costs

Understanding these profit types helps businesses make informed decisions about pricing, investment, and operational efficiency.

Accounting Profit

Accounting profit is the most commonly used measure of profitability in financial statements. It represents the net income available to shareholders after all expenses have been deducted from revenue.

Accounting Profit Formula

Accounting Profit = Total Revenue - Total Explicit Costs

Where explicit costs are all costs that can be directly measured and assigned to a product or service.

Accounting profit is important for external reporting and financial analysis because it provides a standardized measure of a company's profitability that can be compared across different businesses and industries.

Economic Profit

Economic profit is a more comprehensive measure of profitability that includes both explicit and implicit costs. Implicit costs are the opportunity costs of using resources that could have been used elsewhere.

Economic Profit Formula

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

Where implicit costs include the value of owner's time, the cost of capital, and other opportunity costs.

Economic profit is particularly useful for evaluating the long-term viability of a business and making decisions about whether to continue operating or shut down.

Key Differences Between Accounting and Economic Profit

Aspect	Accounting Profit	Economic Profit
Costs Included	Explicit costs only	Explicit and implicit costs
Purpose	External reporting	Internal decision-making
Time Horizon	Short-term	Long-term
Opportunity Costs	Not included	Included

Understanding these differences is crucial for businesses to make informed financial decisions and effectively communicate their financial health to stakeholders.

How to Calculate Accounting and Economic Profit

Calculating profit involves several steps that differ slightly between accounting and economic profit. Here's a step-by-step guide:

Step 1: Calculate Total Revenue

Determine the total amount of money your business has earned from sales during a specific period. This includes all income from products, services, and other activities.

Step 2: Calculate Total Explicit Costs

Identify and sum up all the direct and indirect costs associated with producing your goods or services. This includes wages, rent, materials, utilities, and other operating expenses.

Step 3: Calculate Accounting Profit

Subtract total explicit costs from total revenue to get accounting profit.

Step 4: Calculate Implicit Costs (for Economic Profit)

Determine the opportunity costs of using your resources. This includes the value of owner's time, the cost of capital, and other alternative uses of your resources.

Step 5: Calculate Economic Profit

Subtract both explicit and implicit costs from total revenue to get economic profit.

Important Note

Economic profit can sometimes be negative, indicating that a business is not covering its opportunity costs. This might suggest that the business should consider shutting down or reallocating resources.

Practical Example

Let's look at a practical example to illustrate the difference between accounting and economic profit.

Scenario

A small bakery has the following financial data for the month of June:

Item	Amount ($)
Total Revenue	15,000
Total Explicit Costs	10,000
Implicit Costs (Owner's Salary)	3,000
Implicit Costs (Opportunity Cost of Equipment)	1,500
Total Implicit Costs	4,500

Calculations

Accounting Profit = Total Revenue - Total Explicit Costs

Accounting Profit = $15,000 - $10,000 = $5,000

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

Economic Profit = $15,000 - $10,000 - $4,500 = $500

In this example, the bakery has an accounting profit of $5,000, but its economic profit is only $500. This suggests that while the business is profitable in accounting terms, it's not covering its opportunity costs, which might indicate that the business should consider alternative uses of its resources.

FAQ

What is the difference between accounting and economic profit?

Accounting profit only includes explicit costs, while economic profit includes both explicit and implicit costs. Economic profit is more comprehensive and considers opportunity costs, making it useful for long-term decision-making.

When should I use accounting profit versus economic profit?

Use accounting profit for external reporting and financial analysis. Use economic profit for internal decision-making, especially when evaluating the long-term viability of a business.

Can economic profit be negative?

Yes, economic profit can be negative, indicating that a business is not covering its opportunity costs. This might suggest that the business should consider shutting down or reallocating resources.

Are implicit costs always included in economic profit calculations?

Yes, implicit costs are an essential part of economic profit calculations as they represent the opportunity costs of using resources that could have been used elsewhere.