Difference between accounting profit and economic profit
Accounting profit and economic profit are two distinct measures used to evaluate the financial performance of a business. While both metrics are essential for understanding a company’s profitability, they differ in their approach and what they represent. This article aims to highlight the key differences between accounting profit and economic profit.
Accounting Profit
Accounting profit is a straightforward measure that focuses on the financial aspects of a business. It is calculated by subtracting the explicit costs from the total revenue. Explicit costs are the direct expenses that a company incurs, such as wages, rent, utilities, and materials. In other words, accounting profit considers only the out-of-pocket expenses that can be easily identified and measured.
The formula for accounting profit is:
Accounting Profit = Total Revenue – Explicit Costs
Accounting profit provides a clear picture of the financial performance of a business, as it shows how much revenue is left after covering the direct expenses. This measure is widely used by businesses and investors to assess the profitability and financial health of a company.
Economic Profit
In contrast, economic profit takes into account both explicit and implicit costs. Implicit costs, also known as opportunity costs, represent the value of the next best alternative that is forgone when a particular decision is made. These costs are not directly measurable but are crucial in understanding the true economic performance of a business.
The formula for economic profit is:
Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
Economic profit provides a more comprehensive view of a company’s profitability, as it considers the opportunity costs associated with the resources used in the business. By incorporating implicit costs, economic profit reveals the true economic value generated by the business.
Key Differences
1. Components of Cost: Accounting profit only considers explicit costs, while economic profit includes both explicit and implicit costs.
2. Opportunity Costs: Economic profit takes into account the opportunity costs, whereas accounting profit does not.
3. Profitability Measure: Accounting profit is a more conservative measure of profitability, as it does not account for the opportunity costs. Economic profit, on the other hand, provides a more accurate representation of the true economic value generated by the business.
4. Investment Decisions: Investors and managers often use economic profit to make informed decisions, as it provides a clearer picture of the business’s performance in relation to its resources.
In conclusion, the difference between accounting profit and economic profit lies in the approach to cost calculation and the inclusion of opportunity costs. While accounting profit is a simpler measure that focuses on financial aspects, economic profit offers a more comprehensive view of a company’s profitability by considering both explicit and implicit costs. Understanding these differences is crucial for making informed financial decisions and evaluating the true economic performance of a business.
