Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.
Learn what economic profit is and how it's different from standard accounting profit in this lesson. Find out the formula for calculating economic profit and why it's possible to have a positive accounting profit and a negative economic profit.
What Is Economic Profit?
How can you be certain that you make the best financial decision when evaluating whether to take a job or invest in a new business opportunity? Your friends might tell you to calculate the profit you think you can make in both opportunities and compare them to see which one is better. What they are most likely referring to is accounting profit. What they don't realize is that there is another way to analyze your situation that takes into consideration the alternatives you may be giving up. The other way is to calculate the economic profit of the two scenarios.
Economic profit is the difference between the total revenue received by a business and the total implicit and explicit costs of a firm. It's often the extra profit left over after considering the next best alternative investment, and can be either positive or negative in value.
Economic Profit vs. Accounting Profit
Economic profit should not be confused with accounting profit, which is a firm's revenue minus its explicit costs. Explicit costs are what most people think of as regular business expenses. These are actual payments made to others for running a business, such as paying rent, wages, utilities, and purchasing IT equipment.
Economic profit differs from accounting profit because it also includes implicit costs, which are the opportunity costs equal to what a business or individual gave up in order to do something else. These costs are deducted from revenues and are the alternative returns you decided not to pursue. Adding implicit costs to your profit calculation gives you another way to compare financial alternatives.
So, is it possible to have a positive accounting profit and a negative economic profit for a business? The answer is absolutely. A negative economic profit implies that you could be financially better off by engaging in a different opportunity. A positive economic profit implies that there is no available or comparable opportunities that are more financially profitable because you have already factored those in to your calculation. Let's look at the formula and an example of how to calculate economic profit to help clarify.
Here's how you can write the formulas for calculating accounting and economic profit:
Accounting Profit = Total Revenues - Explicit Costs
Say you invest $25,000 of your savings to start a tax preparation business. In the first year you bring in $70,000 in revenue. Your accounting profit would be $45,000, which is $70,000 revenue minus $25,000 in explicit costs.
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Now, let's assume that you could have taken a job at a tax preparation firm and earned an annual salary of $40,000. In our scenario, this $40,000 salary is your lost opportunity cost, or implicit cost. To compare options, see if you can figure out how to use the simple economic profit formula to find out if you were better or worse off opening your own business.
Your economic profit in this case would be $45,000 (accounting profit) - $40,000 (salary), which results in a $5,000 economic profit. You are $5,000 better off as a result of opening your own business!
If your salary would have been $50,000 instead, how do you think it would have turned out? Your economic profit would be $70,000 - ($25,000 + $50,000) = -$5,000, or $5,000 worse off as a result of going into business your first year.
Let's review. Economic profit is a great way to financially measure and compare alternative business decisions. Economic profit is the difference between the total revenue received by a business and the total explicit and implicit costs for a firm. Explicit costs are the everyday costs that you pay for to run a business, such as wages, rent, utilities, and raw materials. Implicit costs are the opportunity costs, or next best alternative that you could have chosen. Economic profit can be both positive and negative and is calculated as follows:
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