Want to learn more about economic profit? In this post, we will deep dive into what is economic profit, how to calculate it, economic profit example & more.
Economic profit is referred to as the difference between the revenue received by a commercial entity from its outputs and the opportunity costs of its inputs. Opportunity cost can be explained as the opportunity foregone, i.e., an opportunity that is given up in the pursuit of another one.
What is economic profit?
Economic profit is a theoretical measurement of opportunity costs in conjunction with actual revenue cost. In simpler words, it is the excess revenue a company generated from one course of action over another had they picked the other option.
Economists and business owners use these implicit costs to analyse the decisions made in the past and figure out if they could have taken a better course of action. The economic profit formula is the way for economists and business owners to check if they made the right choice between the chosen project and the one they had to let go of.
Economic profit formula
The formula for economic profit can be calculated by deducting the sum of implicit and explicit costs from the total revenue earned by the business.
Mathematical representation of economic profit formula,
Economic Profit = Total revenue – (explicit cost + implicit cost)
When economic profit is positive, it means a company is making above average profits and attracts new companies to enter the market. The company can recoup lost opportunity costs.
However, if the economic profit is zero, the company has no reason to exit or enter the market.
What is accounting profit?
Accounting profit is the net income for a company and is calculated by deducting all explicit costs and expenses from the revenues. Common revenue sources can include the sale of goods and services, receipt of dividend or interest, rental income, etc. While common expense type generally includes the cost of goods sold, travel, rent, entertainment, interest, taxes, and more.
Accounting profit is generally found at the button of a company’s income statement. Typically accounting profit or net income is used to measure the financial performance of a company. It is reported on a quarterly and annual basis.
Accounting profit vs economic profit
Accounting profit is the net income after deducting total expenses from the total revenue. Whereas, economic profit is the surplus after deducting the opportunity cost and implicit cost as well. Accounting profit gives a true picture of the financial health of a company, while economic profit may not give an accurate picture as certain parameters are estimated.
Accounting profit is generally used for short term phenomena. Economic profit is taken into consideration for long term decisions/ purposes. Accounting profit is known to be a more practical approach when compared to economic profit as it is based on actual happenings.
Economic profit formula calculations
Now that we have established an understanding of economic profit and accounting profit, let us take a look at the different economic profit formulas. These formulas are helpful in calculating different business costs and optimizing profits based on the results. Here are 5 formulas that you should know,
1. How to calculate explicit cost?
Explicit costs are out-of-pocket costs, the payments that are actually made by the firm towards wage, rent, materials, etc. To understand how explicit cost is calculated, let’s take an example.
Mark currently works for a company as a digital marketer. He is considering opening his own company where he expects to earn $300,000 per year. To run his own company he would need office space ($50,000 per annum) and an employee ($35,000 per annum). Keeping these figures in consideration, let’s see if Mark’s company will be profitable.
Explicit cost = Office rental + law clerk’s salary
Explicit cost = $50,000 + $35,000
Explicit cost = $85,000
Also read: Tax Accounting | A complete guide
2. How to calculate total revenue?
A simple way of calculating your company’s total revenue is by determining the number of units sold by your company and the average price per unit sold. Now to calculate total revenue, multiply the number of total units sold by the average price per good. Any interest or dividend should also be added to determine total revenue.
Here’s a formula for calculating total revenue:
Total revenue = (average price per unit sold) * (total number of units sold)
In the case of a service-based company, the total number of units sold will be replaced by the total number of services sold.
3. How to calculate accounting profit?
Accounting profit is the total money left after deducting the explicit costs from the total revenue. Here is an example to calculate accounting profit:
A firm earns $300,000 per year. They spend $50,000 per annum for rent and $50,000 per annum on their employee’s salary. Let us see firm profitability:
Step 1: Calculate explicit cost by adding wages and rent amount
Explicit cost = Rent + Wages
= $50,000 + $50,000
Step 2: Calculate accounting profit by deducting explicit cost from the total revenue generated
Accounting profit = Revenues – Explicit cost
= $300,000 – $100,000
4. How to calculate implicit cost?
The problem with calculating implicit costs of a company is that such costs are generally hard to quantify. Here is an example to learn implicit cost calculation better,
Fred invested $50,000 on a business prospect intending to earn a profitable income of $10,000. Now to earn this profit he had to forego the interest that could have been otherwise earned on this sum. Let us assume that the interest rate he had to forego was 10%, which would be $5,000 in a year. This $5,000 represents the implicit cost of investing the sum elsewhere.
5. How to calculate economic profit?
Here is an example to calculate the implicit cost:
A firm earns $500,000 per year. They spend $50,000 per annum for rent and $150,000 per annum on their employee’s salary. Let us see firm profitability:
Step 1: Calculate explicit cost
Explicit cost = Rent + Wages
= $50,000 + $150,000
Step 2: Calculate accounting profit
Accounting profit = Revenues – Explicit cost
= $500,000 – $200,000
Step 3: Let’s consider implicit cost as $100,000. Calculate economic profit
Economic profit = Total revenues – explicit cost – implicit cost
= $500,000 – $200,000 – $100,000
Implicit cost vs explicit cost
Explicit cost is the cost that is actually incurred by the organization during production. On the other hand, implicit costs are just opposite to explicit costs. These are the costs that are not directly incurred by the organization but are implied in nature and do not involve a cash payment.
Explicit cost is an out of pocket cost while implicit cost is an opportunity cost.It is helpful in calculating accounting profit and economic profit whereas implicit cost is useful for only economic profit calculations. Explicit costs may include salaries, rent, wages, etc. Implicit cost includes salary to the owner, rent of owner’s building, etc.
Also read: 10 Best accounting calculators
Accounting profit and economic profit example
Accounting Profit: Let’s say a business earns total revenue of $200,000. They make an annual expenditure of $100,000 towards explicit costs such as rent, wages, materials, etc. To calculate accounting profit, the explicit cost is deducted from the total revenue. This means the business has an accounting profit of $100,000.
Economic Profit: Let’s assume, a business or firm has an accounting profit of $50,000. This profit is obtained after making the payments towards materials, labour, rent, wages, etc. However, this profit ignores the implicit cost (foregone income on own financial capital, building, etc). It is achieved by subtracting implicit cost from accounting profit.
What is economic loss?
Economic loss is a term used to describe situations wherein a firm or an individual suffers money loss. The term covers financial losses that are usually covered as part of financial statements or balance sheets. Economic loss can be caused by natural calamity, or by the negligence of another party.
There are two major categories in which economic losses are divided: pure economic loss and consequential economic loss. Pure economic loss is essentially direct loss of money whereas inconsequential loss, loss is caused by another event such as property damage or unsatisfactory goods performance.
Explaining zero economic profit
A business in a normal profit state will have economic profit as zero, which is why normal profit is also known as zero economic profit. A firm making normal profits will continue staying in the industry. A firm will only have a reason to exist if it is making losses in the long run. In the long run, all firms which are part of a competitive firm will earn zero economic profits.
A firm making zero economic profit can still be earning positive accounting profits. The presence of economic profits attracts entry, economic losses will lead to an exit, and in long-term equilibrium, firms in a perfectly competitive environment will earn zero economic profit.
What is negative economic profit?
Negative economic profit is generated when the cost of equity capital exceeds the accounting profit. This means that it is possible for a firm to have both negative economic profit and positive accounting profit simultaneously. A firm can earn a positive accounting profit but negative profit if there is a possibility of earning greater returns in some other line of business. A firm tries to maximize its profits in a competitive market, making it possible for it to have positive, negative, and zero economic profits. However, in the long-run economic profits will always be zero.
Normal vs economic profit
Economic profit is the remaining surplus left after deducting total costs from total revenue. Normal profit is the least amount of profit required for the survival of the business. While the former shows how well the company is allocating its resources the latter helps in knowing the future prospects of the company.
When profit equals zero as a result of the difference between total revenue and total cost, the normal profit arises. If the amount turns out to be positive, economic profit arises. On the flip side, if the amount turns out to be negative, the economic loss comes into the picture.