What is Economic Profit?
An economic profit or loss is the difference between the revenue received from the sale of an output and the costs of all inputs used, as well as any opportunity costs. In calculating economic profit, opportunity costs and explicit costs are deducted from revenues earned.
Opportunity costs are a type of implicit cost determined by management and will vary based on different scenarios and perspectives.
Economic profit is the result of subtracting both explicit and opportunity costs from revenue.
Opportunity costs are the profits that a business misses out on when choosing between alternatives.
Economic profit is used for internal analysis and is not required for transparent disclosure.
How to calculate economic profit
Economic profit (or loss) can be calculated as revenue minus explicit costs minus opportunity cost. Explicit costs are all costs typically accounted for, such as labor expenses, materials costs, marketing, depreciation, and taxes. As previously noted, opportunity or implicit cost is the theoretical cost for a company of not pursuing a business option.
Let’s say a steel manufacturing company owns raw steel it could sell for $1 million, or it could use the same raw steel to manufacture steel products, which it can then sell to consumers for $3 million. The company decides to manufacture steel products and earns $3 million, but it incurs expenses of $2.5 million.
The company’s accounting profit is $500,000, and its economic profit is the accounting profit minus the $1 million in sales it could have earned by simply selling unfinished steel. Rather than accruing an economic profit, the company, at least in the short term, incurs an economic loss of $500,000.
Economic profit is best calculated over long time horizons because short-term economic losses often become long-term economic profits. The same steel manufacturing company could conceivably lower its production costs in subsequent years, which would turn the initial economic loss to a long-term economic profit.
If manufacturing steel products is expected to produce an economic profit for the company in the long term, than it would be acceptable to incur the short-term economic loss by forgoing the income from selling raw steel.
Why is economic profit important?
Economic profit is crucial because it helps assess a company’s profitability and financial performance. It shows whether a particular business can cover its expenses and bring revenue to stakeholders. According to this measure, brands are successful only when they bring wealth to the parties involved. By estimating the measure, entrepreneurs determine their primary sources of big financial profits and the costs incurred by their company.
Although the process is considered time-consuming, it helps estimate a possible profit a certain brand can obtain. It’s done by reviewing any alternative options that stakeholders decided not to undertake for some reason. When companies want to compare the revenues they could obtain from different options, they use economic profit.
Now that you know why economic profit is essential, let’s make the difference between economic and accounting profit clear.
Example of Economic Profit
An individual quits his job to start a business. In his job, he is making $50,000 per year. To set up the business, the initial startup cost is $ 30,000. We will assume that these are all immediate expenses that do not include acquired assets. In the first year, the firm earned $40,000. If the individual had maintained his job he would have made $10,000 more than his earnings. In the example accounting profit is $10,000 ($40K – 30K).
In real terms, he incurred an economic loss of $40,000 ($10,000 + $30,000). This is a simple example, but it goes to illustrate the point that assets employed in one project cannot be employed in another. As such, you must calculate any forgone profits associated with selecting one project over another. This concept will be explored further in our material on the cost of capital.
Advantages of Economic Profit
1. Helps rank all opportunities
Economic profit is an excellent way to compare various opportunities for a business and to select the best and the most profitable option. It helps rank each and every opportunity in order to make an informed decision.
2. Measures success
Economic profit, along with accounting profit, is an excellent way to measure a company’s success. If all potential opportunities were carefully assessed and an informed decision was made, economic profit is an excellent way of showing how the company is doing better than it would’ve had it gone forward with any other option.
3. Measures efficiency
While accounting profit measures the profitability of a business, economic profit is an excellent way to measure the business’ efficiency, specifically its efficiency in resource allocation.
Disadvantages of Economic Profit
- Does not account for several important financial aspects
While economic profit is an excellent way to measure a company’s success, it is not an accurate and complete measure of a company’s profitability. It does not include all important financial aspects and transactions that may occur during a given time frame.
2. Difficult to estimate
The opportunity cost of a business activity not pursued is difficult to estimate accurately. Therefore, it is difficult to accurately estimate economic profit.