Learn all about accounting versus economic profit in just a few minutes! Professor Jadrian Wooten of Penn State University details accounting profits and economic profits as differing methods of measuring profit.
Accounting Profit versus Economic Profit
Accounting profit accounts for only explicit costs, while economic profit accounts for total economic cost.
Economists use different names for different measures of profit. The amount left over from total revenue (TR) once explicit cost is subtracted is known as accounting profit.
Accounting Profit=TR−Total Explicit Cost
Accounting profit is the measure used to compare the financial performance of companies. It is also used to prepare financial statements and to determine income taxes. Accounting profit is an important number for investors or others who may be interested in a company, but doesn't shed light on the complete financial position of the company. There are many other things a company may spend money on or invest in that are not considered as part of accounting profit.
In contrast, the amount left over from total revenue (TR) once explicit and implicit costs are subtracted is known as economic profit.
Economic Profit=TR−(Explicit Cost+Implicit Cost)
Economic Profit=Accounting Profit−Implicit Cost
Total economic cost is often written simply as total cost, or TC. Most instances of "profit" referred to in an economics course refer to economic profit rather than accounting profit. It also implies that the goal of companies is to maximize economic profit. Economic profit is the measure used to determine a company's overall worth. Economic profit is usually smaller than accounting profit because it includes expenses that are not necessarily directly connected to making a product or providing a service. These implicit costs reduce a company's profit.
For example, a small phone repair company has a total revenue of $1,000, explicit costs of $400 for screen protectors, and implicit costs of $300, money that could have been earned from a savings account if the owner had placed his money in the bank. The accounting profit is then equal to $1,000 minus $400, or $600. However, the economic profit is equal to
$1,000−($400+$300)
. So the economic profit is $300—only half as much as the accounting profit. But, it is necessary for the business to teach employees how to do their job properly so the business is able to grow.
Accounting profit is equal to or higher than economic profit because economic profit is calculated by subtracting implicit as well as explicit costs.
Economic profit can never be greater than accounting profit. In most cases, it is significantly less than accounting profit. Economic profit is typically information shared privately within a company. Thus, it does not affect the decisions of potential investors. If a business makes the right choices, it may have lower economic profit for a period of time, but then move on to having an economic profit much closer to its accounting profit.
