Accounting vs Economic Profit
When you hear a word called “profit”, the image that comes to your 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 but there are multiple terms for the profits. Some of the types of profits are accounting profit and economic profits.
While most people think these terms are the same and relate these terms to the profits of organizations, they are missing the point that these two terms are entirely different from each other
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 as well as implicit cost consists of salaries, rents etc.
The key difference between Accounting and Economic Profit lies in the fact that accounting profit consists of only implicit costs whereas economic profit consists of both explicit and implicit costs.
Comparison Table Between Accounting and Economic Profit (in Tabular Form)
|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 as well as implicit cost from the revenue earned by the organization.|
|Importance||Accounting profits of the company signifies the profitability of the company.||Economic profit signifies how efficiently the company is allocating 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 financial performance of the firm as it also includes some other aspects like opportunity costs.|
|Numerical calculation||Accounting profits = Revenue – Explicit costs||Economic profits = Revenue – (Explicit + Implicit costs)|
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, labor 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 into the business of selling t-shirts. If the annual turnover of the firm is Rs 1000000. Some of the expenses of the firm are the raw material cost of Rs 700000 and salaries of Rs 50000.
Then accounting profit of ABC is 1000000 – (700000+50000)
Accounting profit = Rs 250000
Some of the advantages of accounting profit are
- It is useful in taking some of the important business decisions like investments etc.
- 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, there is a manufacturing firm named ABC who are facing losses from the last few years.
The manager of this company suggested its top management that the can survive in the market by ether reducing the cost of manufacturing or by the addition of new products to its product line.
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 in order to calculate the economic profits of the firm.
Some of the advantages of economic profit are
- It helps in measuring the efficiency of the firm as it includes how efficiently the resource is allocated.
- Along with accounting profits, economic profits also help in measuring the success factor of companies.
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 a lot of difference between accounting and economic profits when it comes to the type of cost and importance.
- Economic profit of the firm is usually less than accounting profit as there is opportunity cost which is not deducted from total revenue to calculate accounting profits.
- The actual profits of the firm are determined by the accounting profit whereas economic profit is termed an abnormal profit.
- Opportunity costs are considered while calculating economic cost whereas other costs like non-cash costs are considered in accounting profit.
Frequently Asked Questions (FAQ) About Accounting and Economic Profit
- How do you calculate accounting and economic profit?
The accounting profit is received when the total cost is removed from the total monetary revenue.
The economic profit is received when the sum of the explicit and implicit cost is removed from the total revenue.
- What is the main role of economic profits?
Profit means the surplus amount which an organization gains after subtracting all the losses and the debts.
The profit can be seen as the monitor of the reward for the shareholders and as well as for the owner of the business. With the help of profit, the businesses and the organization can expand easily.
- What is the difference between zero accounting profit and zero economic profit?
Zero accounting profit means that the revenues are able to cover the explicit . Normal profit means that the revenues are just able to cover all the explicit and implicit costs together.
- Is a normal profit economic profit?
Economic profit is the profit which is received after we have accounted for both the explicit and implicit cost. Normal profit is received when the economic profit is zero or when the revenues are equal to the explicit and implicit cost.
- What happens in a perfectly competitive industry when economic profit is less than zero?
If the economic profit is existing, then it will result in attracting more entrances in the market and hence the losses will lead to the exit from the market.
- What is the perfect competition for economic profit?
Perfect competition is a market structure where all the firms are identical in nature and selling identical product and all the firms are price takers. Here the firm sets the marginal revenue equal to the marginal cost.
- Can economic profit ever exceed accounting profit?
The economic profit is calculated when the opportunity cost is subtracted from the accounting profit.
As the economic profit is calculated by subtracting the opportunity cost from the accounting profit, the accounting profit will always be bigger.
Both types of profits i.e. accounting profits and economic profits are very important for the growth of the company in a highly competitive industry.
Profits of the company determine how the company has performed in the past and how it will perform in the future.
Though accounting profit gives the real picture of the income of the company and it helps investors and shareholders regarding the investment decisions.
Economic profits are more internal to the company as it helps the top management in accessing the opportunity costs in taking various decisions. It also helps in allocating resources efficiently
It doesn’t matter in which industry your organization is performing; what matters is net profits earned by the organization.
But all in all both accounting profits and economic profits are great ways of ensuring both shareholders and investors that your company is performing well in the market.
Word Cloud for Difference Between Accounting and Economic Profit
The following is a collection of the most used terms in this article on Accounting and Economic Profit. This should help in recalling related terms as used in this article at a later stage for you.