Accounting Profit vs Economic Profit
Profit, as known to many of us is the excess of income over the expenses incurred. When a sole trader sells a pair of shoes for $10 that cost $3 to produce, many would say that he earned a profit of $7. However, this may not be the case always, as there are different definitions for profit. Profit is defined differently in the field of economics and accounting, and even though the differences between the two are quite subtle, they each have a distinct impact on decision-making. The article that follows provides a clear distinction between economic profit and accounting profit and provides examples of how such profits are calculated.
What is Accounting Profit?
Accounting profit is the profit that many of us are familiar with, which is recorded in a company’s profit and loss statements. The calculation of accounting profit is done by using the formula, Accounting profit = total revenue – explicit costs. Taking an example of a firm that manufactures and sells toys, and has total sales of $100,000 a year. The total cost that the firm incurred in terms of the wages, utility bills, rent, materials cost, and interest on loan and other explicit costs are $40,000. The firm, in this case, would be able to obtain an accounting profit of $60,000. This profit denotes the excess income available once the explicit or as one may say, the quite obvious costs that are easy to determine have been reduced. Firms are required to disclose this accounting profit as per the regulations in the accounting standards that are followed.
What is Economic Profit?
Economic profit is calculated in a different manner than accounting profit and includes an additional cost known as implicit cost. The implicit costs that a firm incurs are opportunity costs that a firm is faced with in choosing one from the alternatives available. The formula for calculating economic profit is Economic profit = Total revenue – (explicit costs + implicit costs). For example, a toy company’s employee decides to become a sole trader of producing and selling toys. For that, he will be incurring higher opportunity costs in terms of the personal salary that he forgoes from working at the firm, the rent that he needs to pay for the shop selling toys, and the interest on capital that he has to incur on his own. In this case, the employee may be better off working for the company for a salary rather than opening up his own business, if his salary is more than the profit he makes from his business as a sole trader.
What is the difference between Accounting and Economic Profit?
Accounting profit and economic profit both denote a form of profit that a company makes, even though their calculation and interpretation are quite different. Accounting profit only considers the explicit costs that a firm incur while economic profit, in addition, considers the implicit opportunity cost that is incurred in choosing one alternative over the other. Another difference is that accounting profit will always be higher than economic profit as economic profit considers the additional opportunity costs borne by a firm. Accounting profit is recorded in a firm’s income statement, whereas economic profit is usually calculated for internal decision making purposes. It is a common opinion among economists that an accounting profit overestimates revenues because they do not consider opportunity costs, and economic profits are critical to choose the option that brings about the highest value.
In a nutshell:
Accounting vs Economic Profit
• The definitions of profit in the fields of accounting and economics are different to each other, and are calculated in a different manner.
• Accounting profit takes into consideration the excess revenue once the explicit costs are reduced, and economic profit considers the explicit costs, as well as the implicit opportunity costs.
• Accounting profit is always higher than the economic profit and is recorded in the company’s income statement.
• Economic profit is not recorded in the firm’s accounting statements and is usually calculated for internal decision making purposes.