Accounting vs Economic Profit: Difference and Comparison

When you hear a word called “profit”, the image that comes to mind is monetary benefits. But according to economists, profit is way more than monetary benefits.

It is not just cost/expenses reduced from the revenues; there are multiple terms for the profits. Some of the types of profits are accounting profits and economic profits.

While most people think these terms are the same and relate them to the profits of organizations, they are missing the point that these two terms are entirely different.

Key Takeaways

1. Accounting profit is the difference between revenue and expenses calculated based on financial accounting principles.
2. Economic profit is the difference between total revenue and total cost, including opportunity cost, and is used to measure the long-term viability of a business.
3. Accounting profit focuses on the financial performance of a business, while economic gain considers both financial and opportunity costs.

Accounting vs Economic Profit

The difference between accounting and economic Profit is that accounting profit refers to monetary revenue minus monetary costs, which includes any type of cost in the organization in the form of rents, salaries, material costs etc. Economic profit refers to the monetary revenue minus total cost. Total cost includes opportunity cost and implicit cost, consisting of salaries, rents, etc.

Accounting profit consists of only implicit costs, whereas economic profit consists of explicit and implicit costs.

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Comparison Table

Parameter of Comparison	Accounting Profit	Economic Profit
Definition	Accounting profit refers to the economic profits earned by the company at the end of the financial year.	Economic profits are the profit earned by the company after reducing both the explicit and implicit costs from the revenue earned by the organization.
Importance	Accounting profits of the company signify the profitability of the company.	Economic profit signifies how efficiently the company allocates its resources for earning revenue.
Relevance	Accounting profit is relevant for understanding the financial performance of the firm.	Economic profits may not provide the correct picture of the firm’s financial performance as it also includes some other aspects, like opportunity costs.
Numerical calculation	Accounting profits = Revenue – Explicit costs	Economic profits = Revenue – (Explicit + Implicit costs)

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What is Accounting Profit?

Accounting profit is the net income earned by the company after reducing both the explicit cost and other expenses from the net revenue earned by the company by selling the core product or service of the company.

Accounting profit is calculated in compliance with the GAAP accounting standards.

Explicit costs are the costs that can be measured easily. It includes rent, labour charges, administrative costs, bills, etc. Accounting profits are also referred to as book profits.

Accounting profit = Total revenue – Explicit costs

Let’s understand accounting profit with a simple example.

There is a firm named ABC which is in the business of selling t-shirts. Suppose the annual turnover of the firm is Rs 1000000. Some of the firm’s expenses are the raw material cost of Rs 700000 and salaries of Rs 50000.

Then the accounting profit of ABC is 1000000 – (700000+50000)

Accounting profit = Rs 250000

Some of the advantages of accounting profit are

1. It helps take some of the critical business decisions like investments etc.
2. Investors are interested in investing in those businesses which have high accounting profits.

It also shows the financial performance of the company in a financial year.

 

What is Economic Profit?

Economic profits are defined as the net profits earned by the firm after reducing both explicit and implicit costs, like opportunity costs, from the total revenue earned by the company.

Numerically, economic profits can be calculated using the below-mentioned formula.

Economic profit =Total revenue – (Explicit cost + Implicit cost)

Let’s try to understand economic profits with the help of an example.

Let’s say a manufacturing firm named ABC has been facing losses for the last few years.

The manager of this company suggested to its top management that they could survive in the market by reducing the cost of manufacturing or adding new products to its product line.

The top management of the firm decided to reduce the cost of manufacturing. Then, in this case, the revenue which the firm could not earn as they have not launched new products is known as opportunity costs.

This opportunity cost is the cost that has to be reduced from the total earned revenue to calculate the firm’s economic profits.

Some of the advantages of economic profit are

1. It helps measure the firm’s efficiency by including how efficiently the resource is allocated.
2. Economic profits and accounting profits also help measure companies’ success factors.

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Main Differences Between Accounting and Economic Profit

Although both are methods of measuring the net income of the organizations operating in any industry, there exist many differences between accounting and economic profits regarding the type of cost and importance.

1. The firm’s economic profit is less than the accounting profit as the opportunity cost is not deducted from total revenue to calculate accounting profits.
2. The actual profits of the firm are determined by the accounting profit, whereas economic profit is termed an abnormal profit.
3. Opportunity costs are considered while calculating economic costs, whereas other costs, like non-cash costs, are considered in accounting profit.

References

1. https://scholarworks.sjsu.edu/cgi/viewcontent.cgi?article=1037&context=econ_pub
2. https://www.bostonfed.org/-/media/Documents/neer/neer498c.pdf