What Is Accounting Profit and How Do You Calculate It?
Understand the core financial metric businesses use to measure reported performance and gain insight into its full implications.
Accounting profit is a fundamental measure of a company’s financial performance. It shows how much money a business earns after covering its direct, out-of-pocket expenses. This metric is widely used by stakeholders such as investors, creditors, and the Internal Revenue Service (IRS) to evaluate a company’s past performance and tax obligations.
Understanding Accounting Profit
Accounting profit is the net income a business generates, calculated by subtracting explicit costs from its total revenue. Total revenue is the sum of all income a business earns from its primary operations and other activities. This includes money from selling goods or services, recurring revenue streams like subscriptions, and non-recurring income such as consulting fees or one-time project payments. For example, a software company’s total revenue might include monthly subscription fees, usage-based charges, and revenue from professional services.
Explicit costs are the direct, tangible expenses a business incurs during its operations. These are out-of-pocket payments recorded in a company’s financial statements. Examples include employee wages and salaries, rent or lease payments for facilities, utility bills (e.g., electricity, water), raw materials used in production, advertising expenses, and supplies. Depreciation, which accounts for the reduction in value of assets over time, is also considered an explicit cost.
Calculating Accounting Profit
The calculation of accounting profit follows a straightforward formula: Total Revenue – Explicit Costs = Accounting Profit. This formula focuses on the actual cash inflows and outflows of a business over a specific period. It shows the profit remaining after all direct operational expenses have been paid.
Consider a small bakery that generated $150,000 in total revenue from selling pastries and coffee over a year. Its explicit costs included $40,000 for ingredients, $24,000 for employee wages, $12,000 for rent, and $5,000 for utilities and other supplies. The total explicit costs for the bakery were $81,000. Therefore, the accounting profit was $150,000 (Total Revenue) – $81,000 (Explicit Costs) = $69,000.
A freelance graphic designer earned $75,000 in total revenue from client projects in a year. Their explicit costs included $3,000 for software subscriptions, $1,500 for office supplies, $600 for internet, and $2,000 for marketing and advertising. The total explicit costs for the designer were $7,100. The accounting profit for the graphic designer was $75,000 (Total Revenue) – $7,100 (Explicit Costs) = $67,900.
Differentiating Accounting Profit from Economic Profit
While accounting profit provides a financial snapshot, economic profit offers a more comprehensive view of a business’s profitability by considering both explicit and implicit costs. Economic profit is calculated as total revenue minus the sum of explicit and implicit costs. This broader perspective helps business owners assess the return on their resources.
Implicit costs are the opportunity costs associated with using resources already owned by the firm, for which no direct monetary payment is made. These costs represent the value of the next best alternative that was foregone when a business decision was made. For instance, if a business owner uses a personal vehicle for business purposes, the implicit cost is the income they could have earned by renting out that vehicle. Similarly, if an owner works in their business without drawing a formal salary, the forgone salary they could have earned working elsewhere is an implicit cost.
Other examples of implicit costs include forgone interest income on capital invested in the business, or lost rental income if a business uses its own building instead of leasing it. These costs are not recorded in traditional financial statements but are important for understanding the economic viability of a business. Including implicit costs in the calculation of economic profit allows business owners to make more informed decisions about resource allocation and evaluate their business venture’s profitability.