Accounting profit and economic profit are two different concepts used to measure a company’s financial performance. While they both assess profitability, they consider different factors and provide distinct insights into the company’s overall financial health.
In some cases, businesses make decisions that are profitable from an accounting perspective but can be destroying value from an economic perspective. The following explains the difference between the two:
Accounting profit is the most common measure of profit and is calculated by subtracting explicit, out-of-pocket costs (also known as accounting costs) from total revenue. The formula for accounting profit is as follows:
Total Revenue – Explicit Costs = Accounting Profit
Explicit costs include direct expenses such as raw materials, labour wages, rent, utilities, and other operating costs. These costs are easily quantifiable and reported in the company’s financial statements. Accounting profit focuses solely on the explicit costs incurred in conducting business operations.
Economic profit takes a broader perspective and factors in both explicit costs (as in accounting profit) and implicit costs. Implicit costs are opportunity costs that represent the value of resources used in the best alternative opportunity forgone. Economic profit is calculated using the following formula:
Total Revenue – (Explicit Costs + Implicit Costs) = Economic Profit
Implicit costs include the opportunity cost of using the company’s resources, such as the foregone interest on invested capital, the salary that the owner could have earned in another job, or the rental income that could have been earned from assets not used in the business.
Unlike accounting profit, economic profit provides a more realistic measure of the company’s true profitability. If economic profit is positive, it indicates that the company is generating more returns than the standard alternatives available elsewhere.
Conversely, if economic profit is negative, it suggests that the company’s resources could be better utilised elsewhere, and it might not be truly profitable considering all opportunity costs.
Implications for Business Owners
The main difference between accounting profit and economic profit lies in the consideration of additional implicit costs that take into account the return from alternative uses of key resources and assets.
For business owners it is important to understand both profit figures. For a number of businesses it may be as simple as deducting a fair salary for the owner and a fair return for capital employed.
In OMP+ (our accelerator program exclusive for OMP Alumni) we provide participants with an Insights Report to help them measure both profits figures and the relationship between the two.