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.
Key Takeaways
- 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.
Resources
- https://www.bostonfed.org/-/media/Documents/neer/neer498c.pdf
- https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1745-6622.2003.tb00461.x
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.
The economic profit analysis encourages a more comprehensive view of business opportunities.
Yes, it certainly opens up different perspectives for businesses.
It’s important to consider a wide range of factors in business decisions.
The drawbacks of the economic profit analysis certainly highlight the need for a more comprehensive assessment.
Yes, it’s important to consider all angles in business evaluation.
Absolutely, the limitations should be acknowledged and addressed.
I find the confidentiality of economic profit analysis intriguing as well.
The economic profit analysis makes sense, but I think it’s a bit limiting on full business evaluation.
Yes, it’s important to consider all factors when assessing business opportunities.
I agree, there are definitely more aspects to consider.
The informative nature of the economic profit analysis is certainly valuable for businesses.
Yes, it provides a clear framework for business evaluation.
It’s essential to consider all factors, and this analysis provides a good foundation.
I appreciate the explanation of economic profit, it was very informative.
The advantages and disadvantages are clearly laid out, which makes it easy to understand.
Yes, this will be very helpful for business owners.
The lack of considering all risk factors in economic profit analysis seems like a significant drawback.
I agree, it’s essential to have a comprehensive view of risks in business.
It’s interesting to learn about economic profit and its implications.
I find the confidential nature of economic profit analysis very intriguing.
Yes, it’s interesting that it’s not disclosed to the public.
I think the economic profit analysis can be quite subjective and vary greatly depending on perspectives.
Absolutely, it’s not always a definitive measure.
Different viewpoints on economic profit can definitely cause discrepancies.