Difference Between Accounting Profit and Economic Profit
The key difference between accounting profit and economic profit is that accounting profit refers to profits that are recorded in the books of accounts which is calculated by deducting all the explicit cost incurred which refers to monetary cost from the revenue and other income generated from the business activities, whereas, Economic profit refers to the profit which is calculated taking into consideration both explicit as well as implicit cost where implicit cost refers to the opportunity cost of the resources of the organization.
In a general sense, profit refers to the surplus which remains out of the total income after deducting the necessary expenses. However, we will be analyzing 2 different types of profits.
- Accounting profit refers to the Gross revenue minus the explicit costs (deductible expenses). E.g., Mrs. ‘B’ is running a pastry shop and is required to maintain a track of their earnings.
- If the total revenue is $300,000 and the explicit costs are $50,000 then accounting profit will be $300,000 – $50,000 = $250,000.
- Economic Profit involves subtraction of both Implicit costsImplicit CostsImplicit cost is the opportunity cost of the organization's resources where the organization calculates what the business would have earned if the resource had been employed for some other purpose instead of the business activity. and Explicit costsExplicit CostsExplicit cost refers to the business expenses that impact the organization's profitability and are recorded in the general ledger. Such costs are the expenses that appear in the income statement. from the Total Revenue. Implicit costs are the opportunity costs that are not measurable and not seen in the books of accounts as well. Extending the example above, the implicit costs shall include the loss in case Mrs. ‘B’ was working for someone else or the potential interest one could earn if the money of the pastry shop is invested elsewhere. The concept of implicit revenue also comes in the frame, such as the value of having their own business.
- Say, if the implicit cost was $75,000 and the implicit revenue was $30,000, then economic profit will be: $300,000 + $30,000 – $50,000 – $75,000 = $205,000
Accounting Profit vs. Economic Profit Infographics
- Accounting profitAccounting ProfitAccounting profit is the net income available after deducting all explicit costs and expenses from total revenue, and it is calculated in accordance with generally accepted accounting principles (GAAP). Operating expenses, labour, transportation, and sales expenses are common examples of these costs. is the real profit/realized by a firm during an accounting year. In contrast, Economic profit refers to the abnormal profit, i.e., gains above what is required to cover the expenses. It includes opportunity costs.
- Accounting profit is normally more than Economic profit since economic profit can involve multiple categories of income and expenses accompanied by relevant assumptions as well.
- The aspects included in the calculation of accounting profits are Leased assets, Non-cash adjustmentsNon-cash AdjustmentsNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation./Depreciation, Allowances & Provisions, and capitalization of Development Costs. However, the calculation of Economic profits shall include opportunity costs, residual valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed., inflation level changes, rate of taxation, and interest rates on cash flows.
- Accounting profit can be referred to as the revenue obtained post-meeting all economic costs, and Economic profit is obtained when revenue exceeds the opportunity cost.
- The accountant shall consider accounting profit as they will consider production costs and their impact on profitability. It was considered as production costs. In contrast, when an economist describes costs, they are interested in how the company has decided to implement any strategy. It will also analyze how those strategies can have an impact on the firm and the economy.
A firm aims at earning positive economic profits. If accounting profits are greater than implicit costs, the firm would earn a positive economic profit and should continue the business. If accounting profits are less than implicit costs, the economic profit would be negative, and business should divest their business interest.
In equilibrium, we have zero economic profit, i.e., the firm is covering all implicit and explicit costs, and both debt holders and equity holders are earning their required rate of returnRequired Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rate.
|Basis of Comparison||Accounting Profit||Economic Profit|
|Meaning||Net income earned during an accounting year;||Surplus remaining after deduction of total costs from total revenue;|
|Relevance||Practical from a financial perspective.||May was not the precise picture since certain aspects are estimated.|
|Benefit||Reflects the profitability of the firm;||Highlights efficiency of the company in resource allocations.|
|Formula||Total Revenue – Explicit cost||Total Revenue – (Explicit costs + Implicit costs)|
Economic profit will have to be greater than accounting profit for the concept to exist. Since opportunity cost cannot be negative, economic profit will be lower than accounting profit. An opportunity cost being negative is not possible since a business can always choose not to act on available opportunities, thus in a situation of neither earning nor spending anything.
The entire future of any company depends on the profit earning potential in the near future and also how it has performed in the recent past. As a shareholder/investor, the accounting profit is of importance as that will give the true picture of the financial performance. Economic profitEconomic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits. may be used for internal analysis or by specific individuals to assess the opportunity costs, which are making way for current activities. Though economic profits can involve a lot of assumptions, it can give an approximate answer to the desired direction.
Accounting Profit vs. Economic Profit Video
This article has been a guide to Accounting Profit vs. Economic Profit. Here we discuss the top differences between accounting profit and economic profit along with infographics and comparison table. You may also have a look at the following articles –