Accounting Profit vs. Economic Profit: Key Differences and Business Impact
When evaluating a business’s financial success, two important profit metrics come into play: accounting profit and economic profit. While both measure earnings, they serve different purposes. Accounting profit focuses on actual revenue and expenses recorded in financial statements, while economic profit considers opportunity costs—the potential earnings lost when choosing one business decision over another.
Understanding the differences between accounting profit vs. economic profit is crucial for financial planning, investment decisions, and long-term business strategy.
What is Accounting Profit?
Accounting profit is the total revenue a business earns after subtracting all explicit costs—the actual expenses incurred in running a business. These costs include:
- Salaries and wages
- Rent and utilities
- Cost of goods sold (COGS)
- Taxes
- Depreciation
Formula for Accounting Profit
Accounting Profit=Total Revenue−Explicit Costs\text{Accounting Profit} = \text{Total Revenue} – \text{Explicit Costs}
Example Calculation
A manufacturing company generates $1,000,000 in revenue and incurs the following explicit costs:
- Salaries: $200,000
- Rent and utilities: $50,000
- Raw materials: $400,000
- Marketing and advertising: $30,000
- Taxes: $50,000
Accounting Profit=1,000,000−(200,000+50,000+400,000+30,000+50,000)\text{Accounting Profit} = 1,000,000 – (200,000 + 50,000 + 400,000 + 30,000 + 50,000) Accounting Profit=1,000,000−730,000=270,000\text{Accounting Profit} = 1,000,000 – 730,000 = 270,000
Thus, the company’s accounting profit is $270,000.
What is Economic Profit?
Economic profit takes accounting profit a step further by considering implicit costs, also known as opportunity costs. These are the potential earnings a business owner sacrifices by choosing one option over another.
Implicit costs include:
- Lost income from an alternative investment
- Wages the owner could have earned elsewhere
- Rental income foregone by using a building for business instead of leasing it
Formula for Economic Profit
Economic Profit=Accounting Profit−Implicit Costs\text{Economic Profit} = \text{Accounting Profit} – \text{Implicit Costs}
Example Calculation
Using the $270,000 accounting profit from our previous example, assume the business owner could have earned $80,000 per year in a corporate finance job.
Economic Profit=270,000−80,000=190,000\text{Economic Profit} = 270,000 – 80,000 = 190,000
The company’s economic profit is $190,000, meaning it made $190,000 more than the next best alternative.
Key Differences Between Accounting Profit and Economic Profit
| Feature | Accounting Profit | Economic Profit |
|---|---|---|
| Definition | Revenue minus explicit costs | Revenue minus explicit & implicit costs |
| Includes Opportunity Costs? | No | Yes |
| Used For? | Financial reporting, tax calculations | Business strategy, investment decisions |
| Key Focus | Actual earnings and expenses | Alternative income sources and cost of capital |
| Reported in Financial Statements? | Yes | No |
| Affects Business Taxes? | Yes | No |
Why is Economic Profit Important?
While accounting profit shows how much a business earns on paper, economic profit helps business owners and investors make better decisions by evaluating whether resources are being used efficiently.
1. Decision-Making for Business Owners
If a company has high accounting profit but low (or negative) economic profit, it may indicate that resources could be better allocated elsewhere.
2. Competitive Advantage
Businesses with consistently high economic profits likely have strong competitive advantages, such as:
- Brand reputation
- Efficient cost management
- Exclusive access to resources
3. Investment Strategy
Investors use economic profit to determine if a business is generating true value beyond just covering expenses.
Can a Business Have High Accounting Profit but Low Economic Profit?
Yes! This happens when a business is profitable on paper but sacrifices high opportunity costs.
Example:
Imagine a successful bakery making $200,000 in accounting profit. The owner, however, could be earning $150,000 as a restaurant consultant.
Economic Profit=200,000−150,000=50,000\text{Economic Profit} = 200,000 – 150,000 = 50,000
Even though the bakery is making $200,000 in accounting profit, its economic profit is only $50,000. If the owner could make more money elsewhere, they might reconsider their business strategy.
How to Improve Both Accounting and Economic Profit
1. Reduce Explicit Costs to Boost Accounting Profit
- Cut unnecessary expenses
- Negotiate better supplier contracts
- Increase operational efficiency
2. Maximize Revenue Streams
- Expand product lines
- Offer premium services
- Optimize pricing strategies
3. Evaluate Opportunity Costs to Improve Economic Profit
- Invest in higher-return opportunities
- Lease underutilized assets
- Focus on high-growth, high-margin businesses
Final Thoughts
Both accounting profit and economic profit are valuable financial metrics, but they serve different purposes.
- Accounting profit is essential for financial reporting, tax compliance, and evaluating short-term performance.
- Economic profit provides deeper insight into long-term business strategy, resource allocation, and investment decisions.
By understanding and optimizing both, businesses can maximize profitability, improve efficiency, and sustain long-term success.
