Accounting profit vs economic profit:
The term profit in general, is the difference between the total revenues and total expenses. However, economists use the term “profit” differently from the way accountants use it. This is just because of the various differences between the two terms and we have entitled it as accounting profit vs economic profit.
It is the profit that we see at the bottom of the income statement. Accounting profit is the bottom line for many businesses and we can calculate it simply by using this formula.
Accounting profit = Revenue – Cost of Goods Sold – Operating expenses
Accounting profit = Total revenue – explicit cost
Accounting profit is the firm’s total revenue less accounting costs or (explicit costs). Here, it is quite important to understand the concept of explicit cost and implicit cost to better understand the core differences between accounting profit and economic profit.
Explicit costs are monetary payments or (cash expenditures) made for purchasing materials, fuel, transportation services, labor services, etc.
Implicit costs are the opportunity costs of using its self-owned, self-employed resources. These costs are not measurable and we may not find them in books of accounts as well. Examples include Salary forgone for entrepreneurial talent that owners might otherwise receive outside the firm for performing similar services.
For calculation of accounting profit, Only explicit costs are taken into account. These include the cost of goods sold, marketing and advertising expenses, administration expenses, salaries and wages, commissions, rent, depreciation and amortization, interest, and taxes.
When the total revenue of a business entity exceeds all its economic costs (explicit or implicit), any residual goes to the entrepreneur. That residual is called an economic, or pure profit.
Economic profit is quite different from accounting profit. As we discussed earlier, accountants consider the only explicit cost while economists consider both explicit and implicit cost while determining economic profit. So, economic profit is what we get after subtracting economic costs (explicit and implicit costs) from the total revenue of a business entity.
For economists, the economic costs of the business entity are the opportunity costs of the resources used, whether those resources are supplied by others or by the business itself.
Economic profit = Total revenue – Economic costs
Economic profit = Total revenue – (Explicit costs + Implicit costs)
Economic profit = Accounting profit – Opportunity costs
Let’s understand this with a simple example. A business entity has an accounting profit 0f $50000. This profit is obtained after the payments made to individuals and other businesses for the materials, labor, and capital they have supplied. However, this profit ignores the implicit cost ( forgone income on own financial capital, building, and labor provided by the owners). Hence, economic profit is achieved after subtracting implicit costs from accounting profit.