Definitions and explanations:
Accounting profit:
The profit that a business entity calculates by deducting all the explicit costs incurred out of all the revenues earned is known as accounting profit. Accounting profit does not take into account any opportunity costs.
Economic profit:
The profit that a business entity calculates after deducting all the explicit as well as implicit costs incurred from all the revenues earned is known as economic profit. Economic profit takes into account the opportunity costs.
Formulas:
Accounting Profit = Revenue – all expenses (Explicit costs)
Economic Profit = Revenue – all expenses (Explicit costs) – opportunity costs (Implicit Costs)
Example:
For example, JB Motors Co., is a car manufacturing business. The company has an investment option to invest into the production for manufacturing of 10 cars of a new model of sports car. All the costs attached to this production venture will be:
| Types of cost | Cost ($) |
| Direct Labor | $600,000 |
| Direct Material | $950,000 |
| Production Overheads | $700,000 |
| Non-production Overheads | $560,000 |
So, assuming sales price of each car is $300,000, the JB Motors Co. will generate a profit of:
| Line Item | Calculation | Total |
| Revenue | $300,000 ×10 | $3,000,000 |
| Total Direct Labor Cost | ($600,000) |
|
| Total Direct Material | ($950,000) | |
| Total Production Overheads | ($700,000) | |
| Total Non-production Overheads | ($560,000) | |
| Total cost | – | ($2,810,000) |
| Total Profit | – | $190,000 |
This profit of $190,000 would be referred as accounting profit. This is because it incorporates all the necessary costs that were required for the production of cars. All these costs would be called as explicit costs.
Now continuing with the same example, for instance the business had an alternative opportunity to invest all the costs incurred into a saving certificate to earn an interest income at a rate of 5%. In economic terms, this interest income would be termed as opportunity cost as JB Motors Co. could have earned this interest income and by opting to manufacture cars, the company is technically losing this income. This lost income is termed as implicit cost. So, the economic profit for the JB Motors Co. would be:
Economic Profit = Accounting Profit – Implicit Costs
Economic Profit = $190,000 – ($2,810,000 × 5%)
Economic Profit = $190,000 – ($2,810,000 × 0.05)
Economic Profit = $190,000 – ($140,500)
Economic Profit = $49,500
Difference between accounting profit and economic profit:
The main points of difference between accounting profit and economic profit are given below:
Basic Idea:
The basic idea for the difference between the economic profit and accounting profit is the consideration of opportunity costs in the profit calculation. The accounting profit method basically shows the net earnings of a business for a given period of time. This is calculated by deducting all the expenses a business has incurred from the overall turnover. This profit can also be called as net operating profit. The economic point of view of profit is that the profit which is earned by economic activities of a business do not show the true return of the business rather the opportunity cost or income compromised to earn the existing profit is also a loss for the business and so this lost income must also be made part of the profit calculation.
Application:
The profit figure obtained from accounting profit calculation shows the amount of earning a business has earned in a financial year or in a specific tenure of time. This figure is used to calculate the percentages of tax liability, percentage of retained earnings, dividend distribution etc. Economic profit figure is used to evaluate the efficiency of business operations and the effectiveness of resource allocation of a business.
Reliability:
The accounting profit is a more reliable figure than that of economic profit. This is because this figure is calculated based on real expenses that a business has incurred. Accounting profit also includes estimates like depreciation and revaluation etc. but these are usually reliable estimates. The economic profit is not a reliable figure. The reason being this figure includes an estimated cost which may not necessarily be fair estimate for the business. This is because every business has a limited amount of capital and cannot invest in all possible investment opportunities; therefore assessment for the best opportunity cost may become difficult.
Implication:
Accounting profit is the real profit that a business has earned whereas economic profit is the level of profit a business is earning over and above the maximum profit it can earn by investing in any other business opportunity.
Accounting profit versus economic profit – tabular comparison
A tabular comparison of accounting profit and economic profit is given below:
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| Basic idea | ||||
| Only the explicit costs are considered while calculating profit figure. | Both explicit and implicit costs are considered while calculating profit figure. | |||
| Application | ||||
| Is used in normal practice of businesses to calculate different accounting figures. | Is used to appraise the robustness of business investments. | |||
| Reliability | ||||
| It is a more reliable figure. | It is a less reliable figure. | |||
| Implication | ||||
| It is a real profit figure. | Is calculated by deducting a notional cost/charge from the real profit figure | |||
Conclusion:
Accounting profit is the figure which is normally used in businesses. This figure is calculated based on accruals and matching concepts. Economic profit calculation shows level of abnormal profit a business is earning as compared to other businesses or investment opportunities. So, if a business is earning an accounting profit but is making an economic loss it means that this business could have invested somewhere else and could have earned more profit than it is currently earning. If the economic profit is at a break-even point the business is said to earn a normal profit.
