At the time of business endeavour, every entrepreneur and business entity wonders whether the business activity generates appropriate profit or could have done better with another way of business. It helps them evaluate different opportunities and allocate their resource in the right direction.
Economic Profit is a financial analysis of business activities to determine whether one business endeavour’s profit exceeds other business endeavour opportunities. Economic profit is calculated by subtracting explicit and opportunity costs from the revenue. Let’s learn how economic profit works and what the advantages and disadvantages associated with these financial metrics.
- Economic profit is the difference between total revenue and opportunity cost, including explicit and implicit costs.
- If economic profit is positive, the firm is earning more than just covering its costs and making a profit.
- If economic profit is negative, the firm is not earning enough to cover its opportunity cost, and it is better off shutting down its operations.
How does it work?
Every business got opportunities to invest their activity in different business activity streams. For this reason, it is important to know which business activity is more profitable for them. It is one of the prime reasons behind economic profit calculation. For example, Tom opened a business with $100,000 and earned a revenue of $160,000.
So his operating profit is $160,000 – $100,000 = $60,000. If Tom had worked in a different company, he would have earned $35,000 annually. So we can say that opening his own business benefits him, and in this venture, his economic profit is $60,000 – $35,000 = $25,000.
It is not mandatory to disclose economic profit to others. For this reason, no corporation publishes any details of its economic profit to regulators, financial institutions, or investors. It is an internal assessment that almost every business does to know its best opportunities. However, many financial analysts use these metrics to measure the potential of any business. Based on economic profit numbers, they can suggest a company change its business strategy and try different avenues of opportunities. One biggest drawback of economic profit analysis are that it does not consider different risk factors associated with different business ventures.
Advantages of Economic Profit
Economic Profit analysis allows the business to explore multiple revenue stream opportunities and see how much revenue can be earned with an alternative business venture. It helps an entrepreneur see whether his business venture makes economic productivity. Another benefit of Economic profit analysis is its confidential nature. A company must not disclose this report to regulators, financial institutions, or investors. The economic profit analysis report remains confidential among the top few executives and protects the company from public scrutiny.
Disadvantages of Economic Profit
The primary disadvantage of economic profit analysis is that the process does not include all business factors. Every business venture has several risk factors, and the economic profit analysis does not evaluate these risk factors well.
As a result, different analysts calculate economic profit margins differently, which can differ from one report to another. Another problem of the economic profit analysis report is its nature. Due to confidentiality, no company discloses this report to the public. For this reason, most investors can never know the outcome of this report and don’t see multiple business opportunities for the company.
Last Updated : 11 June, 2023
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.