Economic Profit vs. Accounting Profit: What's the Difference?
A Quick Overview
Profit is one of the most common financial measurements used to assess a company's financial health. Any business or investment venture generates a significant financial gain or income that exceeds all expenses, taxes, and other costs.
However, there are two sorts of profits: economic and accounting. Economic profit is total sales income, excluding all opportunity expenses. Accounting profit, on the other hand, is a company's total earnings after deducting explicit expenses. Let us find out both the types of profits and the major differences between them:
What is Economic Profit?
Economic profit refers to the profit produced from goods and services after all other uses or expenses of a company's resources have been deducted. It deducts explicit expenses from revenue and accounts for opportunity costs incurred during the time. The calculation also considers the hidden charges or expenses of a company's resources, which are usually referred to as implicit costs.
Economic profit is calculated using the following formula if someone knows the whole amount of revenue earned and the total expense involved:
Total Revenue - (Total Explicit Costs + Total Implicit Costs) = Economic Profit
The implicit costs may be the market price at which a corporation could sell a natural resource rather than consuming that resource. A paper company owns a grove of trees and uses wood to produce paper goods. Their implicit cost is the timber that it may sell at market value.
Here's another angle to consider. Project A may be preferred by a corporation above Project B. The accounting profit is the profit from Project A after deducting expenses and costs. However, the economic profit would include the opportunity cost of selecting Project A over Project B. In other words, economic profit would examine how much more or less profit would have been produced with the same resources of the company if management had picked Project B.
When equilibrium is achieved for economic profit, the business's implicit costs equal explicit costs, and debt holders and equity holders receive their required rate of return.
What is Accounting Profit?
It is sometimes referred to as a company's earned profit, net income, or bottom line. Accounting profit, as opposed to economic profit, is reported on a company's income statement. According to GAAP (generally accepted accounting principles), profit is gained after deducting different costs and expenses from total revenue or sales. These expenses usually include the following:
Accounting profit can be calculated using the following formula shown below:
Total Revenue - Explicit Costs = Accounting Profit
Accounting profit is the money that remains after deducting the business's explicit costs. Explicit costs are the precise amounts a firm pays for certain expenses, such as labor, during that period. Accounting profit, also known as net income, is frequently reported quarterly and yearly and is used to analyze a company's financial success.
What are some key differences between them?
A Comparison Table expressing the differences between Economic Profit and Accounting Profit
Example of Economic Profit vs. Accounting Profit
Let us use a hypothetical scenario to demonstrate how economic and accounting profit concepts function in business. It is important to understand that economic profit is determined by estimates and assumptions. In contrast, accounting profit is the amount companies disclose to tax authorities and investors.
Accounting profits are simple to calculate since we know they may be found on a company's income statement. As previously stated, it is reported as a company's net income. For example, NVIDIA (NVDA) announced a total net income or accounting profit of $9.75 billion for the financial year 2022, up from $4.33 billion in 2021.
Now consider an example of economic profit. This amount, unlike accounting profit, cannot be obtained from a business financial or income statement. Instead, some calculation is often required. Assume a corporation gets $10,000 in revenue from selling plush animals. Explicit costs total $5,000.
Furthermore, the corporation might have manufactured an alternative product; by passing up that option, it lost $2,000 in revenue. We can calculate the economic profit of creating these toys using the calculation above as equal to $3,000 ($10,000 - $5,000 - $2,000). In this case, the $2,000 is an implicit expense that would not otherwise be mentioned in the financial statements.
How to evaluate Economic Profit?
To compute economic profit, one needs to first add together both explicit and hidden expenses. Then, deduct that resultant amount from the total revenue earned. Salaries, leases, utilities, and raw material expenses are all explicit costs. In contrast, implicit costs include possible expenses such as the loss of interest on an investment.
How to evaluate Accounting Profit?
Accounting profit may be calculated by deducting explicit costs or expenses from the overall revenue collected. Raw materials, labor, leasing payments, and utilities are explicit expenses. Accounting profit is calculated by management as part of its financial reporting. At the same time, it may employ various methodologies for internal analysis.
Is Accounting Profit better than Economic Profit?
In most circumstances, accounting profit will exceed economic profit. This is because organizations frequently incur opportunity costs for operations eschewed in favor of other activities. Assume a corporation has $100,000 to invest, and suppose it foregoes one chance in favor of another. In that case, the potential money from the foregone opportunity is incorporated into economic profit but not accounting profit. Accounting profit, in other words, has less expenditure. On the other hand, an opportunity cost might be a cost avoidance assessment that results in a smaller accounting profit.
What is the advantage of Economic Profit over Accounting Profit?
Economic profit may be considered superior to accounting profit since it is not bound by accounting regulations. Economic profit represents a company's actions, regardless of whether they follow GAAP or IFRS. Economic profit encompasses actions not taken or options foregone. Therefore, it provides a larger, more comprehensive portrayal of a company's situation.
What is the distinction between Zero Accounting Profit and Zero Economic Profit?
Normal profit is another term for zero economic profit. Its value, like economic profit, considers both explicit and implicit costs. A typical normal profit occurs when a company's expenditures match its revenue, leading to no economic profit. Businesses that have total costs that surpass total income produce no economic profit or zero economic profit. In contrast, zero accounting profit shows that a company is losing money, indicating that its expenses outweigh its revenues.
The Bottom Line
The entire future of every organization is defined by its ability to make a profit and its performance in the past. Accounting profit is crucial for a shareholder/investor since it provides a genuine picture of financial performance. Economic profit can be used for internal analysis or by specific individuals to investigate the opportunity costs that allow current activities to occur.
Profit may also be calculated in a range of ways. Most analysts prefer accounting profit, which shows a company's revenue minus costs based on accounting regulations. These expenses are frequently stated openly. On the other hand, economic profit includes hidden expenses that are not often reflected on a general ledger but influence a decision's net profitability.