There are two ways of measuring profit. The first way is to measure it based on what we actually receive, and the other is to trade off what we actually received with what we could have received. The term 'accounting' profit is quite frequently used by bookkeepers, for it is the actual revenue calculation. On the other hand, economic profit is more of an theoretical estimate. The paragraphs below highlight some differences between economic and accounting profit with examples.
- In financial terms, it is not the excess of total accounting income over the total accounting expense. To the cost of an investment, it also adds the opportunity lost cost of another investment option.
- Thus, an economic profit means that you have not just made a profit on your investment, but have made more profit than you would have made otherwise.
- This entity is also called 'economic value added (EVA)' and deducts opportunity costs from the revenue.
- It also considers various other entities, like inflation and interest rates.
- Opportunity cost is the value that indicates how much you have lost by choosing one alternative from a given number of choices. If a firm loses a lot of opportunity cost, its economic profit could be very less, and this is disadvantageous for the firm.
- An accounting profit is the excess of business income over the business expenses.
- The business earns money after selling their goods or services. If the money they earn is more than the money they spend for making/providing the goods/services, it is said that the business has made an accounting profit.
- Accounting expenses don't only include the tangible money that was spent by the business, but also includes any provision for losses or depreciation that the business makes over an accounting period.
- So, once all these costs are reduced from the total income earned by a business enterprise, if the remaining amount is positive, it is an accounting profit. If the remaining amount is negative, it is known as an accounting loss, which means that the business has spent beyond its earning capacity in the accounting period.
- Thus, we can say that an accounting profit is the excess of accounting income over accounting expenses.
◼ Economic Profit = Total Income - Total Expenses - Opportunity Lost Cost
◼ Accounting Profit = Total Income - Total Expenses
◼ It considers the in-house as well as purchased resources. These include transportation, training, equipment, self-employment resources, and many other company-owned assets.
◼ It includes only explicit resources - this includes raw materials, company rent, material transport, employee salaries, benefits, and capital interest.
◼ Explicit costs are regular business expenses, while implicit costs are the opportunity costs forgone by the business. Economic profit considers both these costs.
◼ Accounting profit considers only explicit costs.
◼ It is calculated over the entire project timeline - it holds the entire period view.
◼ It is calculated only over a certain period of time.
◼ It is used in mergers and acquisitions. It is used to decide the market position, calculate the total production value of the company, and the profitability.
◼ It is used to measure the financial performance of the company, taxable company income, loans, budget, and interest considerations.
The comparison has prompted experts to state that economic profit is lesser than accounting profit in the long run, when they are compared on an investment. This may possibly be due to the additional consideration of opportunity lost cost. Of course, this need not be true if the other investment ends up in a loss.
◼ You know that you have only so many resources and so many things you can do with that much money. Suppose you have two investment options. You invest the money in option A and totally forgo option B. The opportunity cost lost is the return you would get in case you had invested in option B. Suppose both investment options cost USD 100,000. Simultaneously, you track the progress of option B, although you haven't invested a cent in it. At the end your investment, option A earns USD 150,000, while option B earns USD 120,000. Thus, you made a larger profit by investing in option A. This is economic profit - USD 150,000 - USD 100,000 - USD 20,000 = USD 30,000.
◼ Consider the same example as given alongside. Using the same values, you will realize that by investing in option A, you have made yourself a tidy profit of USD 150,000 - USD 100,000 = USD 50,000. Had you invested in option B, you would have made an accounting profit of USD 120,000 - USD 100,000 = USD 20,000. So basically, you have earned some money, but you have forgone the option of investing in B. The USD 20,000, which you didn't get, is the opportunity cost lost or simply the opportunity cost of not investing in option B.