Economic Profit vs. Accounting Profit: Uses & Differences

Economic profit and accounting profit sound like two peas in a pod. But don’t be fooled by their seemingly interchangeable names. These concepts are as different as a penny-pinching accountant and a risk-taking entrepreneur.

Understanding the nuances of Economic Profit vs. Accounting Profit is crucial for anyone navigating the realms of finance and business strategy.

Accounting profit loves to play by the rules. It takes into account explicit costs, like wages, materials, and other expenses. It’s the profit that puts a smile on your face when you see it on your income statement.

Economic profit, on the other hand, is the revolutionary of the profit party. It goes beyond the explicit costs and includes the opportunity cost of resources.

It considers the value of what you could have done with those resources if you had used them differently. Economic profit isn’t afraid to challenge the status quo and push the boundaries of what’s possible.

So, why does comparing economic profit vs. accounting profit matter?

It helps you see the bigger picture. You get insights into the performance of your business beyond what the numbers on your balance sheet say. Thus, you can make informed decisions and understand the real value you’re creating.

Table of Contents:

1. Economic Profit vs. Accounting Profit: An Overview
2. What is Economic Profit?
3. How to Calculate Economic Profit?
4. Economic Profit Formula
5. What is Accounting Profit?
6. How to Calculate Accounting Profit?
7. Formula For Accounting Profit
8. Accounting Profit vs. Economic Profit Example
9. Economic Profit vs. Accounting Profit: Key Differences
10. How to Compare Economic Profit vs. Accounting Profit?
11. How to Examine Economic Profit vs. Accounting Profit?
12. How to use Economic Profit and Accounting Profit for Business Decisions?
13. Economic Profit vs. Accounting Profit FAQs
14. Wrap Up

Now, let’s dig deeper into Economic Profit vs. Accounting Profit.

Economic Profit vs. Accounting Profit: An Overview

Accounting Profit is the difference between total revenue and explicit costs (e.g., wages, rent) recorded in financial statements. Economic Profit considers both explicit and implicit costs (e.g., opportunity costs) and measures the true profitability of a business.

Economic profit is typically lower than accounting profit because it accounts for the cost of foregone alternatives.

What is Economic Profit?

Definition: Economic profit is a financial metric that factors explicit and implicit costs, including opportunity costs. Unlike accounting profit, it considers the total cost of resources used, emphasizing the true profitability of an endeavor.

Economic profit accounts for the value of alternative uses of resources, providing a more comprehensive measure that considers both monetary gains and forgone opportunities. By analyzing marginal revenue vs marginal cost, it offers a deeper insight into overall financial performance

How to Calculate Economic Profit?

1. Determine Total Revenue: Calculate the total revenue earned from the business.
2. Calculate Explicit Costs: Sum up all direct expenses (e.g., wages, rent, materials) involved in running the business.
3. Estimate Implicit Costs: Determine the opportunity costs of allocating resources to the current business instead of the next best alternative, such as lost salary or potential investment returns.
4. Calculate Economic Profit: Subtract both explicit and implicit costs from total revenue.

Economic Profit Formula

The formula for economic profit is expressed as follows:

Economic Profit = Total Revenue – Explicit Costs – Implicit Costs

1. This formula essentially measures the excess return generated by a business. This is after considering all costs, including the opportunity cost of using capital.
2. If the result is positive, it indicates that the business is generating returns above its cost of capital. To calculate return on investment capital, one must consider both the returns and the costs involved. Conversely, a negative economic profit suggests that the business is not covering its cost of capital. Thus, the investment may not be considered economically viable.

What is Accounting Profit?

Definition: Accounting profit is a financial metric representing the profit a company reports on its income statement in Excel. It is calculated by subtracting total expenses, including explicit costs like operating expenses and interest, from total revenue.

Accounting profit provides a standardized view of profitability based on accepted accounting principles. It offers a straightforward measure of a company’s financial performance without considering implicit or opportunity costs.

How to Calculate Accounting Profit?

1. Determine Total Revenue: Add together all revenue generated from sales or services.
2. Calculate Explicit Costs: Add up all direct expenses incurred in generating the revenue, such as wages, rent, utilities, and materials.
3. Calculate Accounting Profit: Subtract the total explicit costs from the total revenue.

Formula For Accounting Profit

The formula for accounting profit is:

Accounting Profit = Total Revenue – Total Explicit Costs

Where:

1. Total Revenue is the total income earned from sales or services.
2. Total Explicit Costs are the direct, out-of-pocket expenses incurred in the production of goods or services, such as wages, rent, and materials.

Accounting Profit vs. Economic Profit Example

Imagine a freelance graphic designer who is evaluating the profitability of their business.

Total Revenue: $80,000

Explicit Costs:

• Software subscriptions: $5,000
• Equipment and supplies: $7,000
• Rent for office space: $12,000
• Utilities and internet: $2,500
• Other expenses: $3,500

Implicit Costs:

• Forgone Salary (if the designer had taken a full-time job): $40,000
• Forgone Investment Income (if the designer had invested their savings): $8,000

Calculations:

1. Accounting Profit: Accounting Profit = Total Revenue – Total Explicit Costs = $80,000 – ($5,000 + $7,000 + $12,000 + $2,500 + $3,500) = $80,000 – $30,000 = $50,000

2. Economic Profit: Economic Profit = Total Revenue – Total Explicit Costs – Total Implicit Costs = Accounting Profit – Total Implicit Costs = $50,000 – ($40,000 + $8,000) = $50,000 – $48,000 = $2,000

Economic Profit vs. Accounting Profit: Key Differences

Let’s separate the economic profit vs. accounting profit, shall we?

• Inclusion of Implicit Costs

Economic profit includes explicit costs (monetary expenses) and implicit costs (non-monetary expenses, such as opportunity costs).

It considers the value of resources used in a venture, whether paid in cash or not. Conversely, accounting profit only includes explicit costs, focusing on monetary transactions recorded in financial statements.

• Treatment of Opportunity Costs

Economic profit calculations consider the opportunity costs. These costs represent the value of the next best alternative foregone when a particular resource is used.

Thus, it reflects the actual cost of resources employed. On the other hand, opportunity costs are not factored into accounting profit. The focus is primarily on direct monetary expenses incurred by the business.

• Scope of Measurement

Economic profit provides a broader measure of profitability by considering both explicit and implicit costs. It offers a holistic view of the actual financial impact of an investment or business activity. Contrarily, accounting profit offers a narrower perspective, limited to the financial transactions recorded in accounting books. It provides a standardized view based on accepted accounting principles.

• Financial Performance Assessment

Economic profit assesses a business’s actual economic value by accounting for all costs involved. This leads to a more accurate evaluation of profitability. Conversely, accounting profit reflects the financial performance of a business according to conventional accounting standards. It may not capture the true economic picture due to excluding implicit costs.

• Positive or Negative Values

Economic profit can be positive, negative, or zero. A positive economic profit indicates that the business generates returns above and beyond the cost of all resources used. In contrast, a negative economic profit suggests the venture may not be economically viable.

Typically, accounting profit results in positive values as it focuses on explicit costs. It may not reflect the true economic success of an endeavor, especially when opportunity costs are high.

How to Compare Economic Profit vs. Accounting Profit?

Follow these steps to compare economic profit vs. accounting profit better.

• Understand the Definitions

Economic profit recognizes explicit and implicit costs, including opportunity costs, providing a comprehensive measure of profitability. In comparison, accounting profit focuses on explicit costs recorded in financial statements, omitting implicit costs and opportunity costs.

• Evaluate Components

Economic profit comprises Net Operating Profit After Tax (NOPAT) minus the total cost of capital, including opportunity costs. On the other hand, accounting profit involves subtracting explicit costs from total revenue, providing a standard accounting measure.

• Scope of Measurement

Economic profit offers a broader assessment, considering all costs associated with a business activity. Thus, it provides a more accurate reflection of economic success. Accounting profit offers a more limited view, adhering to accounting principles, and may not capture all economic factors.

• Use in Decision-Making

The economic profit is valuable for strategic decision-making, as it considers the true economic impact of an investment. Conversely, accounting profit is commonly used for financial reporting and tax purposes. However, it may not fully inform strategic decisions due to its limited scope.

• Long-Term Sustainability

Economic profit offers insights into the long-term sustainability of an endeavor by considering all costs, including opportunity costs. Accounting profit may not provide a complete picture of long-term sustainability, as it focuses on immediate financial outcomes.

• Positive or Negative Values

Economic profit can be positive, negative, or zero, reflecting the actual economic success of an endeavor. Accounting profit typically results in positive values. This potentially masks economic realities, especially when significant opportunity costs are involved.

• Strategic Implications

Economic profit informs strategic planning by providing a holistic view of profitability. This encourages decisions that consider the full economic impact. In contrast, accounting profit may lead to suboptimal decisions if not supplemented with additional economic analysis. It focuses primarily on accounting conventions.

How to Examine Economic Profit vs. Accounting Profit?

Visualizations take center stage in data analysis, turning complex datasets into visual symphonies that resonate with insights. However, Excel, the traditional maestro of spreadsheets, sometimes falls short in the grand orchestration of data visualization.

Fear not, for there is a hero in town ChartExpo. ChartExpo adds a visual dimension to analysis, allowing for a more nuanced exploration of accounting profit, and economic profit.

Let’s learn how to install ChartExpo in Excel.

1. Open your Excel application.
2. Open the worksheet and click the “Insert” menu.
3. You’ll see the “My Apps” option.
4. In the office Add-ins window, click “Store” and search for ChartExpo on my Apps Store.
5. Click the “Add” button to install ChartExpo in your Excel.

ChartExpo charts are available both in Google Sheets and Microsoft Excel. Please use the following CTA’s to install the tool of your choice and create beautiful visualizations in a few clicks in your favorite tool.

The sample data below presents quarterly financial metrics, distinguishing between accounting profit and economic profit. It also includes explicit and implicit costs, providing insights into the company’s financial performance and cost structure.

Quarters	Accounting Profit	Economic Profit	Explicit Cost	Implicit Cost
Q1	60,000	30,000	25,000	18,000
Q2	70,000	25,000	32,000	15,000
Q3	80,000	28,000	33,000	16,000
Q4	90,000	32,000	35,000	20,000

Let’s create a visualization of this data with ChartExpo to help us glean insights.

• To get started with ChartExpo, install ChartExpo in Excel.
• Now Click on My Apps from the INSERT menu.

• Choose ChartExpo from My Apps, then click Insert.

• Once it loads, scroll through the charts list to locate and choose the “Multi-Axis Line Chart”.

• Click the “Create Chart From Selection” button after selecting the data from the sheet, as shown.

• ChartExpo will generate the visualization below for you.

• Click on Settings and change the “Data Representation” of Accounting Profit into Bar as follows.

• If you want to add anything to the chart, click the Edit Chart button:
• Click the pencil icon next to the Chart Header to change the title.
• It will open the properties dialog. Under the Text section, you can add a heading in Line 1 and enable Show.
• Give the appropriate title of your chart and click the Apply button.

• Let’s add the Prefix (e.g., $ sign) with the “Implicit Costs” values.
• Click the highlighted pencil icon. Expand the “Label” properties to add the Prefix value (e.g., $ sign).

• Let’s add the $ sign with the “Economic Profit” values.
• Click the highlighted pencil icon. Expand the “Label” properties to add the Prefix value ($ sign).

• Let’s add the $ sign with the “Accounting Profit” values.
• Click the highlighted pencil icon. Expand the “Label” properties to add the Prefix value ($ sign).

• Change the Legend shape of “Accounting Profit” into a column and click the “Apply” button.

• Change the Legend shape of “Explicit Cost” to Line and Circle and click the “Apply” button.

• Change the Legend shape of “Economic Profit” to Line and Circle and click the “Apply” button.

• Click the “Save Changes” button to persist the changes made to the chart.

• Your final chart will look like the one below.

Insights

The data unveils the financial performance of the company across four quarters. Although accounting profits demonstrate a steady rise, economic profits exhibit fluctuations attributed to changing explicit and implicit costs.

Notably, elevated explicit costs in Q4 led to a boost in economic profit. This observation contributes valuable insights into deciphering the intricate relationship between financial metrics and different cost components.

How to use Economic Profit and Accounting Profit for Business Decisions?

Evaluate Financial Health:

• Accounting Profit: Assess operational performance and profitability.
• Economic Profit: Determine if the business is exceeding the return of alternative investments.

Investment Decisions:

• Accounting Profit: Guide budgeting and financial planning.
• Economic Profit: Evaluate if investing in a project provides a higher return than other opportunities.

Resource Allocation:

• Accounting Profit: Measure short-term profitability for operational decisions.
• Economic Profit: Optimize resource use by comparing returns against opportunity costs.

Economic Profit vs. Accounting Profit FAQs

Is accounting profit always greater than economic profit?

No, accounting profit is not always greater than economic profit. Economic profit considers both explicit and implicit costs, including opportunity costs, providing a broader measure. Accounting profit focuses solely on explicit costs recorded in financial statements, potentially resulting in different outcomes.

Why is a firm’s economic profit always less than its accounting profit?

A firm’s economic profit is less than its accounting profit because economic profit includes implicit and opportunity costs. Accounting profit, considering only explicit costs, tends to be a more conservative measure of profitability.

How do you compare economic profit vs. accounting profit?

To compare economic profit vs. accounting profit, use ChartExpo. ChartExpo visualizes the nuanced relationship between these metrics, uncovering insights beyond numbers. The intuitive interface makes analysis seamless, offering a dynamic perspective on financial performance.

Wrap Up

The comparison between Economic Profit vs. Accounting Profit delves into the intricate facets of financial performance measurement.

Accounting profit, rooted in conventional financial reporting, provides a clear snapshot based on explicit costs and revenues. However, economic profit introduces a richer dimension by considering implicit costs, notably the value of forgone opportunities. This distinction becomes pivotal in decision-making, influencing resource allocation and strategic planning.

Understanding the interplay of these metrics is paramount, as it ensures a comprehensive evaluation of profitability. Accounting profit serves as a fundamental benchmark for financial reporting, laying the groundwork for compliance with accounting practices. Economic profit extends the narrative by revealing the true profitability of an endeavor, incorporating the broader economic landscape.

With ChartExpo, the comparison journey evolves into an expedition of financial discovery. Each chart tells a story that transcends mere balance sheets. Embrace the transformative power of ChartExpo today and watch your data come to life with insights.