Accounting & Economic Profit
Compare your actual book earnings against your total opportunity costs to see the true value of your business decisions.
Rent, wages, materials, utilities, etc.
Forgone salary, lost interest, owner’s time value.
Accounting vs. Economic Profit: Understanding the True Bottom Line
When a business owner looks at their financial statements at the end of the year, they usually focus on one number: profit. However, in the world of finance and economics, “profit” can mean two very different things. While Accounting Profit tells you how much cash is left in your bank account, Economic Profit tells you whether your business is truly the best use of your time and resources.
To make strategic decisions—like whether to expand a company, quit a job to start a venture, or invest in new equipment—you must understand the distinction between explicit and implicit costs. This guide breaks down these concepts to help you calculate the real value of your business activities.
What is Accounting Profit?
Accounting profit is the figure most people are familiar with. It is calculated according to Generally Accepted Accounting Principles (GAAP) and represents the net income of a company after deducting all “explicit” costs from total revenue.
- Revenue: The total money brought in from sales.
- Explicit Costs: Out-of-pocket expenses that involve a direct payment of money. Examples include rent, employee wages, raw materials, marketing costs, and utility bills.
The formula is simple: Accounting Profit = Total Revenue - Explicit Costs
What is Economic Profit?
Economic profit goes a step further. It takes accounting profit and subtracts Implicit Costs. Implicit costs are “opportunity costs”—the value of what you gave up to pursue your current path. These do not appear on a balance sheet but are vital for economic decision-making.
Common implicit costs include:
- Forgone Salary: If you quit a $100,000/year job to start a business, that $100,000 is an implicit cost.
- Forgone Interest: If you invested $50,000 of your savings into the business instead of keeping it in a high-yield account, the lost interest is an implicit cost.
- Owner’s Time: The value of the time the owner spends managing the business without taking a formal market salary.
The formula is: Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)
Key Differences Between the Two
The primary difference lies in the scope of the costs considered. Accounting profit is used for tax purposes, financial reporting, and assessing historical performance. Economic profit is used by managers and investors to determine if a firm should enter or exit a market.
| Feature | Accounting Profit | Economic Profit |
|---|---|---|
| Calculation | Total Revenue – Explicit Costs | Total Revenue – (Explicit + Implicit Costs) |
| Focus | Historical Cash Flow & Taxes | Resource Allocation & Decision Making |
| Implicit Costs | Ignored | Included |
| Visibility | Appears on Financial Statements | Not recorded in general ledgers |
Why is Economic Profit Important?
Economic profit helps answer the question: “Is this business worth it?”
If a business has a positive accounting profit but a negative economic profit, it means the owners would actually be better off (financially) doing something else. For example, if your business makes $50,000 in accounting profit, but you could earn $70,000 working for a competitor, your economic profit is -$20,000. Economically, you are “losing” money by running the business, even though your bank account is growing.
Frequently Asked Questions
Can accounting profit be higher than economic profit?
Yes, accounting profit is almost always higher than economic profit because it does not subtract implicit costs. Economic profit only equals accounting profit if there are zero implicit costs, which is rare in the real world.
What is “Normal Profit”?
Normal profit occurs when economic profit is exactly zero. This means the business is generating just enough revenue to cover both explicit and implicit costs. It indicates that the business is performing as well as the next best alternative.
How do investors use economic profit?
Investors use metrics like Economic Value Added (EVA) to see if a company is generating returns above its cost of capital. A positive EVA suggests the company is creating wealth for its shareholders.
Practical Example
Imagine Sarah runs a bakery. Her annual revenue is $200,000. Her explicit costs (flour, rent, employee pay) are $120,000. Her accounting profit is $80,000. However, Sarah left a $90,000-a-year manager job to bake. Her implicit cost is $90,000. Sarah’s economic profit is $200,000 – $120,000 – $90,000 = -$10,000. Despite making $80,000 in cash, Sarah is technically $10,000 worse off than if she had stayed at her old job.