Accounting Profit vs. Economic Profit
In economics, accounting profit and economic profit are two different ways of measuring the profit earned by a business. Accounting profit considers the explicit costs paid by a firm, whereas economic profit considers both explicit costs and implicit costs, including the opportunity cost of resources owned by the business owner.
1. Meaning and definitions
Accounting Profit
Accounting profit is the difference between a firm’s total revenue and its explicit costs.
\[
\text{Accounting Profit}=\text{TR}-\text{Explicit Costs}
\]
Explicit costs are actual monetary payments, such as wages, rent, electricity bills, raw materials, and interest paid on borrowed funds.
Economic Profit
Economic profit is the difference between total revenue and the sum of explicit and implicit costs.
\[
\text{Economic Profit}=\text{TR}-\text{Total Economic Costs}
\]
Implicit costs represent the value of the next-best alternative forgone, such as the salary an owner could have earned elsewhere or rent they could have received by leasing their own building.
2. Main differences between accounting profit and economic profit
Basis Accounting Profit Economic Profit
Meaning Revenue minus explicit costs Revenue minus explicit and implicit costs
Costs included Actual monetary expenses Actual expenses plus opportunity costs
Implicit costs Excluded Included
Main purpose Financial reporting and measuring business earnings Economic decision-making and resource allocation
Usually calculated by Accountants Economists and business analysts
Value Generally higher than or equal to economic profit Generally lower than or equal to accounting profit
Normal profit Not deducted as a separate implicit cost Included as part of opportunity cost
Business decision Shows recorded profitability Shows whether resources earn more than their next-best alternative
3. Numerical example: A clothing business
Suppose a business earns annual revenue of ₹10,00,000. Its owner incurs the following costs.
Annual business figures
Total revenue
₹10,00,000
Explicit costs
Employee salaries
₹2,00,000
Shop rent
₹1,20,000
Raw materials and inventory
₹2,00,000
Electricity and other expenses
₹80,000
Total explicit costs
₹6,00,000
Implicit costs
Salary forgone by owner
₹1,50,000
Rent forgone on owner’s building
₹1,00,000
Total implicit costs
₹2,50,000
Step 1: Calculate accounting profit
\[
\begin{aligned}
\text{Accounting Profit}&=\text{TR}-\text{Explicit Costs}\\
&=₹10,00,000-₹6,00,000\\
&=\boxed{₹4,00,000}
\end{aligned}
\]
The business reports an accounting profit of ₹4,00,000.
Step 2: Calculate economic profit
Total economic costs are:
\[
₹6,00,000+₹2,50,000=₹8,50,000
\]
Therefore,
\[
\begin{aligned}
\text{Economic Profit}&=\text{TR}-\text{Total Economic Costs}\\
&=₹10,00,000-₹8,50,000\\
&=\boxed{₹1,50,000}
\end{aligned}
\]
The economic profit is ₹1,50,000.
What does this result tell us?
– Accounting profit = ₹4,00,000.
– Economic profit = ₹1,50,000.
– Difference = ₹2,50,000, representing the implicit costs.
The business earns more than the owner could have earned from the next-best alternatives. Therefore, it generates a positive economic profit.
4. Relationship between accounting profit and economic profit
Accounting Profit
₹4,00,000
Implicit Costs
₹2,50,000
Economic Profit
₹1,50,000
The relationship can be expressed as:
\[
\boxed{\text{Economic Profit}=\text{Accounting Profit}-\text{Implicit Costs}}
\]
This assumes the same revenue and accounting-cost basis and that all relevant implicit costs are included.
5. Three possible situations
Economic situation Meaning
Positive economic profit Revenue exceeds all explicit and implicit costs.
Zero economic profit Revenue covers all explicit and implicit costs. The firm earns normal profit.
Negative economic profit Revenue fails to cover all explicit and implicit costs. The firm may be better off using its resources elsewhere.
Important: Zero economic profit does not necessarily mean the business earns zero accounting profit. It means the business earns enough to cover its opportunity costs, including the owner’s normal return.
6. Test your understanding
A business earns ₹5,00,000 in revenue and incurs ₹3,00,000 in explicit costs and ₹1,00,000 in implicit costs. What is its economic profit?
₹2,00,000
₹1,00,000
₹4,00,000
₹3,00,000
Conclusion
Accounting profit tells us how much a business earns after paying its recorded expenses. Economic profit goes one step further by considering the opportunity cost of the resources used in the business. For this reason, economists often use economic profit to evaluate whether a firm is making the best possible use of its resources.
