What is the Difference between Accounting and Economic Profit?

Accounting profit and economic profit are two important metrics used in financial analysis, each offering information about a company's financial health. Understanding the differences between these two types of profit is crucial for making informed business decisions and optimizing financial performance. In this article, we will be exploring what is the difference between accounting and economic profit.

 

Table of Contents

• Difference between Accounting and Economic Profit
• What is Accounting Profit?
• Calculation of Accounting Profit
• What is Economic Profit?
• Calculation of Economic Profit
• Importance of Accounting Profit Analysis
• Importance of Economic Profit Analysis

Difference between Accounting and Economic Profit

Accounting profit is the net income calculated by subtracting total explicit costs from total revenues. On the other hand, economic profit is the surplus after subtracting both explicit and implicit costs from total revenues. Let us now take a look at more difference between accounting profit and economic profit:

Feature	Accounting Profit	Economic Profit
Definition	The net income calculated by subtracting total explicit costs from total revenues.	The surplus after subtracting both explicit and implicit costs from total revenues.
Costs Included	Includes only explicit costs such as cost of goods sold, operating expenses, etc.	Includes both explicit costs and implicit costs, including opportunity costs.
Focus	Primarily focuses on the financial performance over a specific accounting period.	Focuses on overall profitability, considering the cost of alternative choices and the potential missed opportunities.
Purpose	Used to assess the short-term financial health of a business and is often reported in financial statements.	Used for long-term strategic planning and evaluating the true profitability of business decisions.
Calculation	Total Revenues - Total Explicit Costs = Accounting Profit	Total Revenues - (Explicit Costs + Implicit Costs) = Economic Profit
Importance in Business	Essential for evaluating the immediate financial performance and operational efficiency.	Important for assessing the allocation of resources and the long-term sustainability of business decisions.
Example	A company earns $1 million in revenue and has $600,000 in explicit costs. Its accounting profit is $400,000.	The same company has an opportunity cost of $100,000 for not investing in an alternative project. Its economic profit is $300,000.
Visibility	Easily derived from financial statements and widely used in reporting.	Requires deeper analysis to identify and calculate, focusing on theoretical profitability.
Use	Often used by external stakeholders to gauge a company's profitability and financial health.	Used by management for internal decision-making and strategic planning.

What is Accounting Profit?

Accounting profit or net income, is an important financial metric that measures the business profitability over a specific accounting period, such as a quarter or a year. It is calculated by subtracting total explicit costs from total revenues generated from business operations. Explicit costs, also known as operating expenses, include all direct costs that are associated with the production and sale of goods or services, such as cost of goods sold (COGS), salaries, utilities, rent, and marketing expenses.

Calculation of Accounting Profit

Let us now learn how to calculate accounting profit. The following formula is used in accounting profit:

Accounting Profit = Total Revenues−Total Explicit Costs

Scenario-Based Example:

Imagine a company, ANC Corp, that manufactures eco-friendly packaging. In the fiscal year 2023, ANC Corp reported total revenues of $500,000. The explicit costs, including materials, labor, rent, utilities, and other operational expenses, amounted to $350,000.

Using the formula:

Accounting Profit = $500,000 − $350,000 = $150,000

So, ANC Corp's accounting profit for the fiscal year 2023 is $150,000. This figure will be reported on their income statement and used to assess the company's financial performance over that period.

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What is Economic Profit?

Economic profit is a measure of performance that captures the true profitability of an enterprise by considering both explicit and implicit costs, including opportunity costs. It goes beyond the traditional accounting profit by incorporating the cost of choosing one action over another potentially more profitable one. 

Calculation of Economic Profit

Let us now learn how to calculate economic profit. The following formula is used in economic profit:

Economic Profit = Total Revenues − (Explicit Costs + Implicit Costs)

Scenario-Based Example:

Continuing with ANC Corp, besides the explicit costs of $350,000, assume the company had an opportunity to invest in a project that would have generated $50,000 in revenue. This foregone revenue is considered an implicit cost (opportunity cost) because it is the cost of not pursuing the next best alternative.

Using the formula:

Economic Profit = $500,000 − ($350,000 + $50,000) = $100,000

Therefore,  ANC Corp's economic profit for the fiscal year 2023 is $100,000. This calculation takes into account not just the actual expenses incurred but also the opportunity cost of not investing in another potentially profitable venture.

Importance of Accounting Profit Analysis

Following are the key reasons why accounting profit analysis is important:

• Accounting profit helps in making short-term operational decisions by providing a snapshot of financial performance.
• Accounting profit analysis is essential for assessing the company's ability to generate profit from its own operations.
• Accounting profit figures are crucial for investors assessing the company's profitability and potential for dividend payouts.
• Both profit metrics are used to evaluate management performance, with accounting profit focusing on operational efficiency and economic profit on strategic effectiveness.
• Accounting profit helps in benchmarking against industry standards and competitors.

Importance of Economic Profit

Following are the key reasons why economic profit analysis is important:

• Economic profit aids in strategic planning by considering the opportunity costs of decisions, ensuring resources are allocated to the most beneficial projects.
• Economic profit analysis offers a deeper insight into the company's sustainability and its capacity to create value over the long term.
• Understanding economic profit helps businesses allocate resources more efficiently by highlighting the cost of missed opportunities.
• Economic profit can signal to investors the company’s potential for long-term growth and competitive advantage.
• Economic profit analysis can help a company understand its position in the market relative to competitors by considering not just revenues and costs but also alternative investments.