Economic Profit

Economic Profit Definition

Economic profit is the difference between accounting profit and opportunity cost the business has foregone as the business has invested in its existing project.

Whenever, a firm talks about profit, it’s usually an accounting profit. Accounting profit, in simple terms, is the difference between total revenue and the explicit costs the company is incurring. Now, in economics, accounting profit doesn’t make much sense because it doesn’t ensure whether the business is making real profits or not. So, that’s the reason, economists turn to economic profit.

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Source: Economic Profit (wallstreetmojo.com)

Economic Profit Example

Let’s say Mr. A has left his job to start a restaurant business. Mr. A was a lawyer and was making $100,000 per year. He felt that he is more inclined toward food and fun; so he started his business were in the first year, he has made an accounting profit of $50,000. But if we notice closely, we would see that to be able to make an accounting profit of $50,000; Mr. A has to forego his job as a lawyer and the salary (which is the opportunity cost) i.e. $100,000.

  • So, even if he has made an accounting profit in his restaurant business; economically, he has made an economic profit of ($50,000 – $100,000) = – $50,000.
  • As a rational decision-maker, if Mr. A keeps on earning an accounting profit of $50,000; then going back to the job as a lawyer may seem to be the right decision.
  • If it is not negative or at least equal, he may choose a restaurant business over his job as a lawyer.

Formula

  • Economic Profit = Accounting Profit – Opportunity Cost Foregone

Now, you may wonder what accounting profit is?

  • Accounting Profit = Total Revenue – Explicit Costs

In simple terms, when we call our firm has made “profit” we indicate that our firm has made “accounting profit”.

Here’s what relevant.

  • Total Revenue = Sale Price / Unit * Number of Products Sold

And explicit costs include –

  • Explicit Costs = Wages + Rent + Equipment Rent + Electricity + Telephone Expenses + Advertising Expenses.

Every business has to incur some of the expenses that they need to pay out of their own pocket to keep the business running and to keep producing the products they would be selling. These expenses are called 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.read more.

So, let us now look at the formula of economic profitFormula Of Economic 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 calculation.

  • Economic Profit = Total Revenue – Explicit Costs – Opportunity Costs Foregone

How to Interpret?

Why is it important because it is based on a concept called trade-off.

Let’s take a simple example to understand the concept of “trade-off”. Let’s say you decide to read this article, instead of playing a game on your mobile. Here the same time could have been invested in different things. But you decided to invest your time in this article, so that, you can understand it.

Let’s take another example. Suppose, after completing your graduation, you decided to go for an MBA instead of doing a full-time job. Now you have invested around $60,000 in MBA. And also, let’s say, if you would have joined a job after graduation, you could have earned a decent $40,000 per annum.

So what would be your cost of MBA?  Do you think it is $60,000?

No.

It would be the amount you have foregone (being employed) by choosing to do an MBA plus the cost of an MBA. So here’s what your MBA costs – $60,000 + ($40,000*2) = $140,000

Now, if you get a job after MBA and it’s not more than $140,000, you have incurred a loss by doing the trade-off of choosing an MBA over full-time employment.

Now, think about business. If a business only thinks about the profit they are making and not the trade-off the business has made because of choosing to invest in one project (and not in another), then it would not be an appropriate calculation. For example, Company MNP has invested $100,000 in project G. And they think they would be able to make around $30,000 as a return on investment. As Company MNP has invested in project G, they have foregone the opportunity to invest the same amount other projects which might have yielded better returns for Company MNP.

If you don’t take the “trade-off” into account, you are actually doing the wrong calculation.

Economic Profit Examples

Example # 1

Ramen left his job as a doctor and started a restaurant business. He used to earn $200,000 per annum which he left because he didn’t find medicine interesting anymore. In the first year, he has made revenue of $550,000 in revenue.

Since he is new in this business, he had to rent a place and all of the equipment. He rented a small place where he can start off his small food business and he also rented out all the equipment like stoves, utensils, chairs, tables and other things.

He made a scribbled note which looks as follows –

  • Wages paid to employees – $100,000
  • Food items – $200,000
  • Rented place – $50,000
  • Rented Equipment – $50,000

Using the information above, you need to find out the accounting profit of Ramen in the first year of his restaurant business. And also calculate economic profit (or loss) due to his decision to start this business.

From the information mentioned above, first, let’s find out the accounting profit –

Here’s the formula of accounting profit –

Accounting Profit = Total Revenue – Explicit Costs

So, we know the total revenue here, i.e. $550,000.

We need to compute the explicit costs –

Explicit CostsIn $
Wages paid to employees100,000
Food items200,000
Rented Place50,000
Rented Equipment50,000
Total Explicit Costs400,000

Now, let’s calculate the accounting profit –

Revenue (A)$550,000
(-) Total Explicit Costs (B)($400,000)
Accounting Profit (A – B)$150,000

To calculate economic profit (or loss), we need to go back to his salary as a doctor. We assume that if he would have not started his business in this year, he could have earned $200,000 as a doctor. That means $200,000 is his opportunity cost for starting off with this business.

Here’s the formula  –

  • Economic Profit = Accounting Profit – Opportunity Cost Foregone

Putting the value of 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 and opportunity cost, we would get –

  • Economic Loss = $150,000 – $200,000 = – $50,000.

So it’s clear that if Ramen wants to continue this business, he has to earn more profit to make sense of foregoing the job as a doctor. If he is not able to earn at least $200,000 accounting profit, it’s better for him to go back to his job.

Example # 2

Let’s look at the Income Statement of ABC Company for the year 2016 –

Details2016 (In US $)2015 (In US $)
Sales30,00,00028,00,000
(-) Cost of Goods Sold (COGS)(21,00,000)(20,00,000)
Gross Profit900,000800,000
General Expenses180,000120,000
Selling ExpensesSelling ExpensesThe amount of money spent by the sales department on selling a product is referred to as selling expenses. This includes expenses incurred on advertising, distribution and marketing. Because it is indirectly related to the production and delivery of goods and services, it is classified as an indirect cost.read more220,000230,000
Total Operating Expenses(400,000)(350,000)
Operating Income500,000450,000
Interest expenses(50,000)(50,000)
Profit before Income Tax450,000400,000
Income Tax(125,000)(100,000)
Net Income325,000300,000

ABC Company was started by 3 gentlemen A, B & C who have left their lucrative jobs, earning $140,000, $110,000 & $95,000 respectively each year to start ABC Company. We need calculate economic profit (or loss) ABC Company has made and also find it individually for A, B, & C.

In this example, we will not take Net Income as “accounting profit”, because usually accounting profit is profit before taxes. So, here, the accounting profit is Profit before tax of ABC Company, i.e. $450,000 in 2016 and $400,000 in 2015.

Let’s assume that the accounting profit for each year will be divided among the owners in equal proportion. We also assume that A, B, & C didn’t have any other source of income and as they had invested into the business, their opportunity cost is similar to the salary they have foregone.

Total Opportunity Cost foregone = ($140,000 + $110,000 + $95,000) = $345,000 per year.

So, here’s the calculation (or loss) –

Details2016 (In US $)2015 (In US $)
Profit before Income Tax450,000400,000
(-)Total Opportunity Cost Foregone(345,000)(345,000)
Economic Profit Calculation105,00055,000

From the above calculation, it’s clear that ABC Company earned $50,000 more economic profit in 2016 than what it made in 2015. But what is about individual profit?

Let’s have a look –

As the accounting profit is shared equally, in 2015, each of them would earn = ($400,000 / 3) = $133,333.

A, B and C in 2015 is as per below

  • For A,  in the year 2015 it would be = ($133,333 – $140,000) = – $6,667.
  • For B,  in the year 2015 it would be = ($133,333 – $110,000) = $23,333.
  • For C,  in the year 2015 it would be = ($133,334 – $95,000) = $38,334.

As the accounting profit is shared equally, in 2016, each of them would earn = ($450,000 / 3) = $150,000.

A, B and C in 2016 is as per below

  • For A, in the year 2016 it would be = ($150,000 – $140,000) = $10,000.
  • For B, in the year 2016 it would be = ($150,000 – $110,000) = $40,000.
  • For C, in the year 2016 it would be = ($150,000 – $95,000) = $55,000.

Limitations of Economic Profit

Even if it is used to take the opportunity cost into account, it has some weaknesses that we can’t ignore.

  • It is only applicable for a year. If we calculate the last year’s profit, it doesn’t always necessarily give any due advantage.
  • Any value obtained by the employees or the company is not considered in the calculation.
  • Many economists mention that it is all that you need to have, depending on one metric that is not free from risk. The investor should look at a bunch of other ratios along with this profit.

Conclusion

There are two things you need to consider. First, accounting profit is not always exhaustive. You need to think through the opportunity cost as well. Second, before investing in any new project or company, you need to look at the market first and find out whether this is the best investment you are making or not.

Economic Profit Video

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