At the time of business endeavor every entrepreneur and business entity wonders, whether the business activity is generating appropriate profit or it 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 know whether the profit earned by one business endeavor exceeds other business endeavor opportunities. Economic profit is calculated by subtracting explicit cost and opportunity cost from the revenue. Let’s learn how economic profit works and what are the advantages and disadvantages associated with these financial metrics.
How does it work?
Every business got opportunities to invest their activity in different streams of business activity. 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 opens a business with $100,000 and earns revenue of $160,000.
So his operating profit is $160,000 – $100,000 = $60,000. If Tom worked in a different company then he would have earned $35,000 per year. So we can say that opening his own business is beneficial to 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 publish any details of their economic profit to regulators, financial institutions, or investors. It is an internal assessment that almost every business does to know their 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 is 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 or not. Another benefit of Economic profit analysis is its confidential nature. A company is not obligated to disclose this report to any 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 factors of the business. Every business venture is associated with several risk factors and the economic profit analysis does not evaluate these risk factors well.
As a result, different analysts calculate economic profit margin in different ways and it 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.