What is economic profit?
Meaning of Economic Profit: – An economic profit is the difference between the income a business firm receives from its outputs and the costs of its inputs. The contrast here between money collected from the selling of an item and the expenses of all resources used, and also any financial costs, is known as an economic profit or loss. Opportunity costs and clear costs are excluded from income gained when measuring economic benefit.
Opportunity costs are a form of implied cost that is calculated by managers and varies depending on the scenario and viewpoint.
Understanding in-depth
Meaning of Accounting Profit: – Accounting profit and economic profit are often compared. The benefit shown on a company’s financial statements is known as accounting profit. Accounting profit is also known as the net income for a company or the bottom line. It’s the profit after various costs and expenses are subtracted from total revenue or total sales. Accounting profit is a metric that compares real inflows and outflows and is part of a company’s necessary transparency.
Economic profit is similar to accounting profit, in that it deducts explicit costs from revenue. However, economic profit also includes the opportunity costs for taking one action versus another in the period. Economic profit is determined by economic principles, not by accounting principles. Economic profit, on either hand, is not expected to be reported to authorities, stakeholders, or financial firms and is not listed on a statement of financial position. A form of “what if” assessment is economic profit. When seeing all about production levels or other business options, corporations and people can prefer to prioritize economic benefit. Foregone benefit concerns can be considered by economic profit.
General calculation of economic profit: –
“Economic profit = revenues – explicit costs – opportunity costs”
Economic profit can be positive, negative, or zero
Foregone benefit concerns can be proxied by economic profit.
In this calculation, removing the opportunity costs gives only the accounting profit; however, deducting the opportunity costs as well would provide a substitute for comparisons to other possible choices.
Companies transparently show their explicit costs on the income statement. The accounting profit on the bottom line of the income statement is the net income after subtracting for direct, indirect, and capital costs. The cost of goods sold is the most basic explicit cost used in analyzing per-unit costs. Thus, in the equation above, a company could also break down its opportunity costs by units to arrive at a per-unit economic profit.
As a result, a business firms might disintegrate its opportunity costs by units in the formula above to conclude at a per-unit economic benefit. When comparing income that might have been earned if a certain choice had been chosen, economic advantage can be used. Individuals who are starting a company can use economic benefit as a proxy for their first year of operation. For large organizations, company managers may be able to examine gross, operating, and net profit against economic profit at various stages of the sales operations in greater detail.
What is opportunity cost?
Meaning of opportunity cost: – Opportunity cost is the loss or the benefit that could have been enjoyed if the best alternative choice was chosen. Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. For example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can’t spend the money on something else.
When alternatives exist, opportunity costs may be used to do a more thorough review of business decisions. When evaluating production rates for variety of products that they manufacture collectively but in differing amounts, managers should consider opportunity costs.
Opportunity costs are a form of implied cost that is somewhat subjective. They will change based on management’s forecasts and market conditions. In most cases, opportunity cost is the accounting advantage that might have been realized by making a different decision.
Key Differences between Economic Profit and Accounting profit
Economic profit is more of a theoretical calculation based on alternative actions that could have been taken. In contrast, accounting profit calculates what actually occurred and the measurable results for the period. Another way to think of it is, accounting profit is the profit after subtracting explicit costs (such as wages and rents). Economic profit includes explicit costs as well as implicit costs (what the company gives up to pursue a certain path).
Illustrations
- A person starts a company and spends $100,000 on startup costs. The company generates $120,000 in sales in its first year of service. This results in a $20,000 accounting profit. However, If he/she had worked at her previous job, she would have earned $45,000. The person’s economic advantage in this case is equivalent to: –
$120,000 – $100,000 – $45,000 = -$25,000
This estimate only takes into account the first year of operation. If costs fall to 10,000 over the first year, the economic profit forecast for subsequent years improves. The corporation is said to be in a state of “regular profit” if economic profit is zero.
- If a corporation earns $10 per product from exporting ‘t-shirts’ with a $5 cost per unit, the gross amount of profit is $5. Even then, there might have been an opportunity cost of $8 if they’d have generated ‘shorts’ with sales of $10 and expenses of $2: –
$10 – $5 – $8 = -$3
If all other factors were similar, the company could have gained $3 more per unit by producing shorts rather than t-shirts. As a result, the -$3 per unit is deemed a economic loss.
This method of research can be used by businesses to determine output levels. Based on the expenses associated with doing business as well as various phases of an economic cycle, a more dynamic scenario analysis of income may often factor in operating expenses or other forms of implied costs.