Accounting Profit vs. Economic Profit Explained
Having a tight grasp on your books is essential when doing accounting, and making a clear distinction between each figure and how it ties into your bottom line is vital. With profit being one of the essential metrics of economic activity, knowing the difference between accounting profit vs. economic profit is an absolute must for anyone involved in any business activity.
Accounting Profit vs. Economic Profit: Definitions
Let’s start by defining what they stand for to figure out the difference between the two.
Accounting Profit Definition
The accounting profit equals revenue minus expenses, appearing on a company’s income statement. It’s the profit a company has made from its operations calculated at the closing month of accounting year or over a period of time. It measures a company’s performance. It’s taxed and used to pay dividends.
Economic Profit Definition
Economic profit, on the other hand, takes into account opportunities. It’s the company’s revenue minus the total costs, including the opportunity cost. Opportunity cost is what you give up when making a decision. For example, if you’re deciding between going to the movies and staying home, your opportunity cost is the movie you didn’t see.
Economic Profit vs. Accounting Profit: What’s the Difference?
There are several key differences between accounting profit and economic profit;
- Accounting profit does not consider opportunity costs, while economic profit does;
- Accounting profit is recorded, while economic profit is a “what-if” type of analysis;
- Accounting profit is taxed, while economic profit is not.
For most firms, the significant difference between accounting profit and economic profit is that the former expresses nominal terms while the latter takes into account also unrealized potential. Both can easily be calculated using accounting software.
Accounting Profit vs. Economic Profit Example
One very simplified accounting vs. economic profit example would be a freelancer who makes $50,000 a year and has positive accounting profit after deducting their expenses. If, however, their peers working in an agency make $75,000 a year, this would mean that the freelancer is operating at an economic loss and should consider getting employment with an agency.
Accounting Profit vs. Economic Profit Formula
The difference between accounting profit and economic profit is expressed using the following formulas:
Accounting Profit = Total Revenue – Explicit Costs
Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
In other words, economic profit is the difference between accounting profit and the opportunity cost of doing business, so the formula would look like this:
Economic Profit = Accounting Profit – Opportunity Costs.
Zero Accounting Profit vs. Zero Economic Profit
As accounting statistics show, zero accounting profit means the company is working at a loss, i.e., revenue does not outweigh expenses.
Zero economic profit, meanwhile, means that the business has ‘normal’ profit. Normal profit happens when all resources are being efficiently applied and could not be put to better use elsewhere.
Positive & Negative Economic Profit
Positive economic profit might also become zero in the long run due to new entrants in the market, which would result in bigger competition. The positive economic definition, meanwhile, implies that a company is working in an uncompetitive market. Negative economic profit signals that the company should exit a given market.
Accounting Profit vs. Economic Profit FAQ
What is the difference between economic profit and accounting profit?
As for the accounting vs. economic profit dichotomy, the latter is the amount of money a company makes above and beyond its accounting profit. Accounting profit follows the golden rules of accounting and is the net income of a company, while economic profit is net income which also includes opportunity costs.
Can economic profit ever exceed accounting profit?
Economic profit generally should not exceed accounting profit since it is calculated as subtracting the opportunity costs from the accounting profit.
What is the best way to judge a company’s profitability?
The best way to judge a company’s profitability is to look at its accounting and economic profits. Accounting profit measures how much money a company has made in the past, while economic profit measures how much money a company is making now and in the future. Looking at economic vs. accounting profit, you can get a complete picture of a company’s current and projected financial health.
Why is economic profit important?
Economic profit is important because it measures the costs of taking one business action over an alternative, something that accounting profit does not count.
What is the difference between zero accounting profit and zero economic profit?
Zero accounting profit means that a company is not profitable, i.e., its revenue does not exceed its expenses. Meanwhile, zero economic profit means that the difference between a business’s revenue and its explicit and implicit costs equals zero.
Are there any situations where a company can have negative economic and positive accounting profit?
Yes, a company can have negative economic and positive accounting profit if its investments are doing poorly or if it is missing opportunities by not investing in a specific area while still being profitable.
Is it better for a company to have a positive economic profit or a positive accounting profit?
Regarding accounting profit vs. economic profit, a company should have the former since it means it is making money, i.e., its expenses are smaller than its revenue.