Accounting, Economic vs Normal Profit: Difference and Comparison

Accounting profit is the difference between total revenue and explicit costs, including operating expenses. In contrast, economic profit considers explicit and implicit costs, including the opportunity cost of resources used. It indicates whether an enterprise is earning more or less than what could be obtained in the best alternative use of those resources.

Normal profit, in economic terms, is the minimum profit required to keep a business in operation, covering all costs, including implicit costs, and providing a return equal to what could be earned in the next best alternative investment, resulting in zero economic profit

Key Takeaways

1. Accounting profit is the difference between total revenue and explicit costs.
2. Economic profit is the difference between total revenue and total opportunity cost, including explicit and implicit costs.
3. Normal profit is the minimum profit required to keep a business running and is equal to the opportunity cost of the resources used in the industry.

Accounting vs Economic vs Normal Profit

Accounting profit is the company’s net income, economic profit is the surplus, and normal profit is minimal profit. The first reflects the efficacy of the company, economic profit shows progress of the company in allocating resources, and Normal Profit aids ascertain prospects of the company.

Comparison Table

Feature	Accounting Profit	Economic Profit	Normal Profit
Definition	Net income reported on financial statements	Profit after accounting for both explicit and implicit costs	Minimum profit needed for a business to survive and avoid closure
Purpose	Measure financial performance for investors and creditors	Measure economic efficiency and resource allocation	Determine minimum acceptable profitability for business owners
Cost Considerations	Explicit costs only (e.g., production costs, operating expenses)	Explicit and implicit costs (e.g., opportunity cost of capital)	Explicit and implicit costs, normal rate of return on capital
Accuracy	Easily calculated from financial statements	May be more difficult to calculate due to estimations of implicit costs	Subjective and depends on industry standards, business goals, and individual expectations
Relevance for Decision-Making	Limited to evaluating past performance	Provides a more comprehensive picture of profitability and resource allocation efficiency	Useful for determining minimum acceptable performance and setting strategic goals
Focus	Short-term financial performance	Long-term economic sustainability and efficiency	Business viability and competitive advantage

What is Accounting Profit?

Accounting profit, also known as financial profit or bookkeeping profit, is the net income of a business after subtracting all its explicit costs from its total revenue. It is calculated using the following formula:

Accounting Profit = Total Revenue – Explicit Costs

Explicit costs are the direct and measurable costs a business incurs during its operations, such as:

• Cost of goods sold (COGS)
• Operating expenses (e.g., rent, utilities, salaries)
• Depreciation of assets
• Interest expense
• Taxes

Accounting profit is a readily available measure of a business’s financial performance and is used by investors and creditors to assess its financial health, solvency, and profitability. It is also used to calculate various financial ratios, such as the profit margin and return on equity.

However, accounting profit has certain limitations:

• It only considers explicit costs and ignores implicit costs, such as the opportunity cost of capital.
• It is a historical measure and does not provide information about future profitability.
• It can be manipulated through accounting practices, making it difficult to compare across different companies.

What is Economic Profit?

Economic profit, also known as pure profit, is a broader measure of profitability that goes beyond accounting profit by considering all explicit and implicit costs. It essentially represents the true economic return a business generates from its operations.

Calculation:

Economic profit can be calculated using the following formula:

Economic Profit = Total Revenue – Explicit Costs – Implicit Costs

Implicit costs are the indirect and non-monetary costs that are not explicitly recorded in the financial statements, but still represent a real cost to the business. Examples of implicit costs include:

• Opportunity cost of capital: The potential return on investment that could have been earned if the capital was invested elsewhere.
• Imputed rent: The cost of using owner-occupied assets, such as buildings or equipment.
• Entrepreneurial cost: The compensation the owner(s) could have earned if they worked for another company.

Economic profit provides several advantages over accounting profit:

• More comprehensive: It considers all costs, including those not explicitly recorded in the financial statements.
• Forward-looking: It helps assess a business’s long-term economic sustainability and resource allocation efficiency.
• Improved decision-making: It provides a more accurate picture of profitability, leading to better-informed decisions about investments, resource allocation, and business strategy.

However, calculating economic profit can be more challenging than accounting profit:

• Estimating implicit costs: Accurately estimating implicit costs, such as the opportunity cost of capital, can be subjective and require additional analysis.
• Limited information availability: Some implicit costs are difficult to quantify and may not be readily available.
• Not directly reported: Economic profit is not directly reported in financial statements and may require adjustments to accounting data.

What is Normal Profit?

Normal profit, also known as zero economic profit, is a business’s minimum profit to survive and avoid closure. It represents the compensation for the resources used and the risks involved in running the business.

Calculation:

Normal profit can be calculated using the following formula:

Normal Profit = Economic Profit + (Normal Rate of Return x Capital Invested)

Where:

• Economic Profit: The profit after accounting for both explicit and implicit costs.
• Normal Rate of Return: The expected return on capital in a similar industry or investment opportunity.
• Capital Invested: The total capital invested in the business, including equity and debt.

Normal profit serves several key functions:

• Survival: It ensures the business can generate enough profit to cover its costs and remain operational.
• Competitive advantage: It allows the business to attract and retain resources, such as capital and labor, by offering a return comparable to other investment options.
• Benchmarking: It provides a basis for comparing the performance of different businesses within the same industry.
• Business viability: It helps determine if a business uses its resources efficiently and generates sufficient profit to justify its continued operation.

Normal profit is subjective and can vary based on several factors:

• Industry standards: The normal rate of return can vary significantly across different industries.
• Business goals: Businesses with aggressive growth plans may accept a lower normal profit than those seeking stability and income generation.
• Individual expectations: The owners’ expectations for return on investment can influence their perception of normal profit.

Understanding normal profit is crucial for business owners and managers. It allows them to:

• Set realistic goals and expectations: By understanding the minimum acceptable profit level, businesses can set realistic goals and expectations for their performance.
• Make informed investment decisions: By comparing the expected return on an investment to the normal profit, businesses can decide whether to invest in new projects or expansions.
• Negotiate with stakeholders: By understanding the normal profit level, businesses can negotiate with stakeholders, such as investors and lenders, from a position of strength.

Main Differences Between Accounting, Economic and Normal Profit

1. Definition:
   • Accounting Profit: Accounting profit is calculated by subtracting explicit or out-of-pocket costs from total revenue. It focuses on the financial performance of a business and does not consider opportunity costs or implicit costs.
   • Economic Profit: Economic profit considers explicit costs (such as operating expenses and salaries) and implicit costs, including the opportunity cost of resources used in the business. It represents an enterprise’s true economic gain or loss by considering the forgone alternatives.
   • Normal Profit: Normal profit, also known as zero economic profit, occurs when a business earns enough to cover both explicit and implicit costs, including the opportunity cost of the owner’s resources. It signifies that the business is earning a competitive return, but no excess profit.
2. Calculation:
   • Accounting Profit: Accounting profit is calculated by deducting only explicit costs (easily measurable and documented) from total revenue.
   • Economic Profit: Economic profit is calculated by subtracting explicit and implicit costs (opportunity costs) from total revenue. Implicit costs include the return that could be earned in the next best alternative use of resources.
   • Normal Profit: Normal profit is a theoretical concept that occurs when economic profit equals zero. It represents the level of profit needed to keep a business in operation, covering all costs, including opportunity costs.
3. Purpose:
   • Accounting Profit: Accounting profit is primarily used for financial reporting and tax purposes. It measures a business’s financial success according to standard accounting principles.
   • Economic Profit: Economic profit is used to assess a business’s overall performance from an economic perspective. It helps evaluate whether a business generates a surplus or resources could be better utilized elsewhere.
   • Normal Profit: Normal profit is a theoretical concept used to analyze whether a business earns a competitive return. It helps determine whether an entrepreneur adequately compensates for their investment and effort.
4. Implication:
   • Accounting Profit: A positive accounting profit indicates that a business generates more revenue than explicit costs, but it does not consider the opportunity costs of resources.
   • Economic Profit: A positive economic profit suggests that a business earns a surplus after considering all costs, including the opportunity costs of resources. A negative economic profit implies that the business is not covering all costs, including the opportunity costs.
   • Normal Profit: Normal profit indicates that a business is earning a competitive return, covering all costs, including opportunity costs. It signifies a situation where the business is doing well as the next best alternative.

References

1. https://www.emerald.com/insight/content/doi/10.1108/JFEP-09-2013-0045/full/html
2. https://www.semanticscholar.org/paper/Estimating-Monopoly-Power-with-Economic-Profits-Williams-Kreitzman/504613ba3ba4beb99c4812ac86e11d1d385dba80