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What does economic profit mean?
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In this article, we will break down the notion of Economic Profit so you know all there is to know about it!
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What Is Economic Profit
Economic profit is a phrase use to refer to the difference between your revenues and your costs, including your opportunity costs.
In other words, your economic profit is how much you generated in sales by selling your products and services (revenues) less how much it cost you to make your products or render your services (explicit costs) along with the cost associated with other opportunities that you could have pursued (opportunity costs).
A positive economic profit is when your revenues exceed your explicit costs and opportunity costs (which means that the project appears to be profitable both from an accounting perspective and an economic perspective).
A negative economic profit is when your total costs (express costs along with opportunity costs) exceed your revenues.
With a negative economic profit, you may still see a positive accounting project when the explicit costs are less than your revenues but the combination of the explicit costs and opportunity costs exceed your revenues.
When we talk about opportunity costs, we are referring to the cost associated with missing out on one project versus another (an implicit cost).
For example, if you choose to invest your money in Project A to earn a certain reward, your opportunity cost is how much you potentially lose out by not investing in Project B or Project C (this is an implicit cost to you).
When dealing with opportunity costs, you are asking yourself “what if” questions.
What if I had taken Project B instead of Project A, how much would I have earned?
To invest in the best project, you should take the one that provides you the most possible revenues and where you don’t lose out on other great investment alternatives.
Economic profits or economic losses are generally considered along with the accounting profits.
A company’s accounting profits represent the number shown on its income statement.
On an income statement, a company will typically report its revenues from all sources (cash inflows) and its expenses to generate its revenues (explicit expenses).
On the other hand, economic profit does not appear on a company’s financial statement.
Economic profits consider the opportunity cost of investing in one thing as opposed to another.
As a result, companies evaluate their business decisions by considering their opportunity costs to ensure that they chose to invest in the best business project among the different alternatives they had available to them.
Definition Economic Profit
According to the Corporate Finance Institute, economic profit is defined as follows:
Economic profit (or loss) refers to the difference between the total revenues, less costs, and the opportunity cost associated with the revenue generated. Opportunity cost is the cost of an opportunity foregone, i.e., given up in order to pursue another one.
As you can see from this definition, “economic” profit is:
- The difference between
- Total revenues and
- Total costs and
- Your opportunity costs
Economic Profit Formula
What is the economic profit formula?
How to find economic profit?
To calculate economic profit, you can use the following economic profit equation:
Economic Profit = Revenues – Explicit Costs – Opportunity Costs
We can also present the formula as follows:
Economic Profit = Revenues – Explicit Costs – Implicit Costs
When you look at this equation, you can see that you have the accounting profit embedded in it.
If your formula did not include “opportunity costs”, you will be calculating accounting profits by taking your revenues minus your costs.
When you add the opportunity cost component, you then compute “economic profit”.
By calculating economic profit, you are taking into account how much profit you could have generated by taking on another project or choosing another investment option.
How To Calculate Economic Profit
How do you calculate economic profit?
Economic Profit Equation
The equation for economic profit is:
EP = Rev – EC – OC
- EP = Economic Profit
- Rev = Revenues
- EC = Explicit Costs
- OC = Opportunity Costs
With the formula for economic profit, you have two figures that can be computed objectively with concrete figures (Rev and EC) whereas you have one figure that is more arbitrary and subjective (OC).
A company that invests in a particular project, such as launching a new product, entering into new markets, or investing in a commercial project, can calculate its accounting profits by calculating its revenues and deducting its expenses (such as cost of goods sold or other expenses).
To take the assessment further and evaluate the profitability of the project at hand versus the other projects that the company could have invested in, you can introduce a more arbitrary figure into the equation (opportunity cost) to calculate the potential profits you’ve foregone by investing in the current project.
Economic Profit Example
Let’s look at an example of economic profit to better illustrate the point.
Imagine that you are the president of a business and you have $100,000 to invest in two investment options.
The first investment option is to launch a new product by investing $100,000 and potentially earning $150,000 in your first year of launch.
The second investment option is to continue doing business as usual and investing your $100,000 in the stock market and you earn can earn a 10% return (equal to $10,000).
For the first option, your accounting profit is $150,000 – $100,000 = $50,000 (revenues less expenses).
However, since you decided to invest in the launch of a new product, you foregone the opportunity to invest your money in the stock market to earn $10,000.
Your economic profit is equal to $150,000 – $100,000 – $10,000 = $40,000.
As you can see, you have a positive economic profit.
However, if you would have selected the stock market investment over the launch of your product, you would have a negative economic profit of $140,000 ($10,000 – $100,000 – $50,000 = -$140,000).
Based on this calculation, you are better off launching a new product.
Benefits And Drawbacks of Economic Profit
What are the advantages and disadvantages of calculating economic profit?
One of the main advantages in economic profit calculation is it allows companies to evaluate, compare, and rank different business opportunities.
If you have the option to reduce costs or launch a new product, which option is best?
By calculating your economic profit, you may be able to make a better decision.
Another benefit in assessing the profit economically speaking is that you can validate that the business investment option you undertook was effectively better than the ones you decided to forego.
Finally, you are able to better decide how to allocate your available resources into projects with different risk and reward potential.
The assessment of profit in an economic sense is not necessarily an accurate measure of profitability.
In fact, since you must incorporate the opportunity cost in your equation, you are introducing a subjective and arbitrary figure in the evaluation of your profit (economic).
As such, two different companies faced with the exact same business options and having the same financial position may calculate different economic profit figures.
Economic Profit vs Accounting Profit
What is the difference between accounting profit and economic profit?
Although both economic and accounting profits measure the profitability of a certain project or business, they have key differences.
The accounting profit is intended to calculate a company’s net income representing its revenues less its expenses.
The expenses are actual costs and expenses incurred (or that must be incurred) by the company such as costs of goods sold, purchase of raw material, salaries, wages, administration costs, rent, and so on.
In essence, when you calculate accounting profit, you are looking to calculate how much money is left over once you deduct all your expenses from your revenues.
On the other hand, economic profit equals the accounting profit less the company’s opportunity cost.
Opportunity cost is the implicit cost associated with the selection of one investment option over another.
Every company may evaluate its opportunity costs differently and so the process is not governed by a specific accounting principle.
A company’s total economic profit or the result of its calculations will be a “theoretical” number based on a company’s accounting profits in choosing one project and what it has potentially lost in not investing in other alternative projects.
Here is a list of key differences between economic versus accounting profit:
- Accounting profit is reflected on a company’s income statement whereas economic profit is not
- Economic profit is a theoretical number companies use to evaluate different business investment alternatives
- Accounting profits account for the actual revenues and expenses
- Economic profits considers the implicit costs to a business whereas accounting profits only considers measurable and explicit expenses
Economic Profits Takeaway
So, what does Economic Profit mean?
What is the formula for economic profit?
In this article, we’ve looked at the definition of economic profit representing the difference between the money made by a business from its outputs and the total of its input costs and implicit costs.
When a company’s economic profit is positive, it means that the current business decision is better than the other one considered in the calculation.
When the economic profit is negative, it means that the company’s current business investment is not as interesting as the other one.
When you have a zero economic profit, it means that you are in a state of normal profit meaning that both investment options are viable when considering their implicit and explicit costs.
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Economic Profit Meaning
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