What Is Economic Profit vs. Accounting Profit?

Profitability is a central focus for any business, but its calculation and interpretation can vary significantly. Understanding these different viewpoints provides a more complete picture of a business’s financial standing and operational efficiency.

Accounting Profit Explained

Accounting profit is the most widely recognized measure of a company’s financial performance, frequently reported on financial statements. It is calculated by subtracting explicit costs from total revenue. Explicit costs are direct, out-of-pocket expenses that involve a clear monetary transaction.

These costs include wages, salaries, rent, utility bills, and raw materials. Accounting profit provides a snapshot of a business’s profitability over a specific period, reflecting the net income after covering these expenses. This calculation adheres to generally accepted accounting principles (GAAP), making it consistent for financial reporting and tax purposes.

Economic Profit Defined

Economic profit offers a broader assessment of profitability by considering both explicit and implicit costs. It represents total revenue minus the sum of all costs, including those not directly paid out. The formula for economic profit is Total Revenue minus the sum of Explicit Costs and Implicit Costs. A distinguishing feature of economic profit is its inclusion of opportunity cost, which is the value of the next best alternative not pursued. This comprehensive approach helps determine if a business is generating returns that exceed the minimum required to compensate for all resources used.

Explicit and Implicit Costs

Understanding the distinction between explicit and implicit costs is fundamental to grasping economic profit. Explicit costs are tangible expenditures involving direct monetary payments by a business. These costs appear on financial records and include operational expenses like salaries, utilities, marketing, interest on loans, and raw materials. These expenses are easily quantifiable and directly affect accounting profit.

Implicit costs, however, are more subtle and do not involve an actual cash outlay. They represent the opportunity cost of using resources the business already owns or that are contributed by its owners. For instance, if a business owner uses their personal building for operations instead of renting it out, the foregone rental income is an implicit cost. Similarly, the salary an owner could have earned working elsewhere, or the interest income foregone by using personal capital in the business instead of investing it, are also implicit costs. These costs reflect the value of the next best alternative use of the business’s resources.

Key Differences Between Accounting and Economic Profit

The primary distinction between accounting profit and economic profit lies in the treatment of implicit costs. Accounting profit only subtracts explicit, out-of-pocket expenses from revenue, providing net income for financial reporting and tax compliance. Economic profit incorporates both explicit and implicit costs, offering a more complete assessment of a business’s profitability and resource allocation efficiency. Accounting profit is typically higher than economic profit for the same business, as it does not account for foregone opportunities.

Accounting profit serves external stakeholders, such as investors and the Internal Revenue Service (IRS), providing a standardized view of financial performance on income statements. In contrast, economic profit is primarily an internal tool for strategic decision-making and evaluating resource use. It helps owners and managers determine if current ventures generate returns superior to alternative uses of capital and time.

For example, a business earns $200,000 in revenue. Explicit costs, such as rent, wages, and materials, total $100,000. Accounting profit is $100,000 ($200,000 – $100,000).

If the owner could have earned $60,000 elsewhere, and invested capital could have yielded $10,000 in interest, implicit costs total $70,000. Economic profit would be $30,000 ($200,000 – $100,000 – $70,000). This shows a business can have positive accounting profit but lower, or even negative, economic profit, indicating resources might be better utilized elsewhere.