Accounting Profit vs Economic Profit

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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 direct costs 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 two different types of profits.

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  • Accounting profit refers to the Gross revenue minus the explicit costs (deductible expenses). E.g., Mrs. ‘B’ is running a pastry shop and must maintain 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.

Accounting Profit vs. Economic Profit Infographics

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Accounting Profit vs. Economic Profit Explained in Video

Key Differences

  1. 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.read more is the real profit/realized by a firm during an accounting year. It includes opportunity costs. In contrast, Economic profit refers to the abnormal profit, i.e., gains above what is required to cover the expenses.
  2. Accounting profit is normally more than Economic profit since economic profit can involve multiple categories of income and expenses accompanied by relevant assumptions.
  3. The aspects included in calculating 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.read more/DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more, 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.read more, inflation level changes, rate of taxation, and interest rates on cash flows.
  4. 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.
  5. 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 economists describe costs, they are interested in how the company has decided to implement any strategy. It will also analyze how those strategies can impact the firm and the economy.

A firm aims to earn positive economic profits. If accounting profits exceed 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 businesses 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 Rateread more.

Comparative Table

Basis of ComparisonAccounting ProfitEconomic Profit
MeaningNet income earned during an accounting year;Surplus remaining after deduction of total costs from total revenue;
RelevancePractical from a financial perspective.May was not the precise picture since certain aspects are estimated.
BenefitReflects the profitability of the firm;Highlights efficiency of the company in resource allocations.
FormulaTotal Revenue – Explicit costTotal Revenue – (Explicit costs + Implicit costs)

Important

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 is impossible since a business can always choose not to act on available opportunities, thus in a situation of neither earning nor spending anything.

Final Thoughts

The entire future of any company depends on the profit earning potential shortly and how it has performed in the recent past. As a shareholder/investor, the accounting profit is important 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.read more may be used for internal analysis or by specific individuals to assess the opportunity costs that make way for current activities. Though economic profits can involve a lot of assumptions, they can give an approximate answer to the desired direction.

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