In this article, we will cover the differences between accounting profit and economic profit. Before jumping to the differences, let’s understand the overview as well as the key definitions.
The aim of profit-making businesses is to generate profit. This profit is generated when the business makes sales to its customers. Once revenues are generated from the sales, all the expenses related to the sales and related to the business as a whole are deducted from the revenues to calculate the profit of the business. The ability to generate profits is very important for businesses due to several reasons.
Profits generated by a business are a key indicator of the performance of a business for a specific period. The goal of owners of a business is always to maximize their wealth. Investors that look into investing into businesses look for businesses with the highest profits. This is because businesses with the highest profits can provide the investors with the highest returns. Other stakeholders of the business, such as its employees, customers, suppliers, etc. also want the business to be profitable to secure their stakes in the business.
As the profits of a business are used as a decision-making tool, there are two different types of profits that can be used for it. These are the accounting profits and economic profits of a business. These types of profits must be differentiated between as both of these profits are calculated differently and give different information about the business.
Definitions of Accounting Profit Vs Economic Profit
In the below section, we will cover the key definition of Accounting Profit vs Economic Profit.
The accounting profits of a business refer to the profits of the business in it books. These are the profits that a business generates through its daily operations and reports in its financial statements, mainly the Statement of Profit or Loss, also known as the Income Statement. Accounting profits are reported to the stakeholders of the business, such as its owners, or potential investors, and these stakeholders make decisions regarding their relationship with the business based on the accounting profits.
The accounting profit of a business is the profit that is calculated by deducting all of the expenses of the business from the revenues that have been generated by the business. These expenses consist of only explicit costs of the business. Explicit costs refer to costs that exist in the business’ accounting systems and can directly affect the profitability of the business. We commonly call explicit costs as accounting costs. The formula for the accounting profit of a business can, therefore, be written as:
Explicit costs or accounting costs of a business include production or service costs such as raw material purchase costs, salaries costs, utilities cost, depreciation related to production or service process. These costs also include other costs, for example, administrative costs or marketing costs. These costs are all taken from the accounting system of the business and affect the profitability of the business directly.
Economic profits of a business are very similar to the accounting profits of the business because these profits are calculated by deducting the explicit costs of the business from its revenues. However, alongside the explicit costs of the business, when calculating the economic profits of a business, its implicit costs are also deducted from its revenues. The economic profit is dictated by economic principles rather than accounting principles. In accordance with this definition, the formula to calculate the economic profit of a business can be written as:
Implicit costs are costs that are borne by the business but do not exist in the accounting system of the business. These costs are related to the usage of the resources of the business. Implicit costs mainly refer to opportunity costs borne by the business by dedicating its resources towards a certain project rather than using it for another project or some other activity altogether. These are also known as notional costs or implied costs.
The implicit costs of a business do not represent real expenses of the business. These are expenses that are used for the calculation of economic profits in accordance with economic principles. The implicit costs of a business are calculated by calculating the cost of alternative usage for the resources of a business. For example, a business uses its building in its operations to generate profits of $10,000 per annum. However, if the business rents the same building, it would receive $5,000 rent per annum. The $5,000 rent is forgone by the business, to earn $10,000 profit instead, is its opportunity cost or implicit cost.
A company ABC Co. generated a revenue of $10 million in the previous accounting period. It’s total costs in its books, also known as explicit costs, for the period amounted to $8 million. To calculate the accounting profit of ABC Co., we use the above formula as follow:
Accounting Profit = $10 million – $8 million
Accounting Profit = $2 million
This accounting profit of ABC Co. will be reported in its financial statements, specifically its Statement of Profit Loss, as Net Profits. It can be used by the shareholders and any potential investors of the company to evaluate the profitability of the company. In addition, this accounting profit can also be used by them to compare the company’s performance with other companies for decision-making purposes.
For the same resources that ABC Co. used to generate the $2 million profit, ABC Co. could have received an interest income of $1 million if it had invested the resources in a bank. Since this $1 million is foregone to use the resources in the operations of the business instead, it is an opportunity cost for the business. This opportunity cost is also known as implicit cost and used to calculate the economic profit of the business. The economic profit of the company can be calculated using the above formula:
Economic Profit = $10 million – ($8 million + $1 million)
= $10 million – $9 million
= $1 million
This economic profit of ABC Co. is not required to be reported to the stakeholders in the financial statements of the company. However, a company may choose to voluntarily report its economic profit on its Statement of Profit or Loss alongside its accounting profits. The company shareholders and potential investors can use this economic profit to evaluate the efficiency of the company in using its resources. However, this economic profit, on its own, cannot be used to evaluate the efficiency of the company or make decisions about the company.
This economic profit must be compared with the historical economic profits of the company for the stakeholders of the company to determine whether the efficiency of the company, in using its resources, has improved or declined. Similarly, the economic profit can also be compared with the competitors of the company, other companies in the same industry or the industrial average as a whole to get better information regarding the efficiency of the company. However, when comparing the information, the stakeholders must also consider the effects of explicit costs on the economic profits of the company alongside the implicit costs.
Key Differences of Accounting Profit and Economic Profit
There are many differences between the accounting profit vs economic profit of a business. These differences can be summarized as below.
As mentioned above, the accounting profit of a business is calculated by deducting only explicit costs of a business from its revenues. On the other hand, we commonly calculate the economic profit of a business by deducting both the explicit and implicit costs of a business from its revenues. Furthermore, the accounting profit of a business is calculated using accounting principles while the economic profit of a business is calculated using economic principles. The economic profit of a business will generally be lower than its accounting profit due to the added deduction of implicit costs.
Another difference between the accounting profit and economic profit of a business is that the accounting profit is based on amounts that are taken from the books of the accounts of the business. The valuation of these costs and expenses is readily available by taking the amount it has cost the business or the business has paid for it. Similarly, the value can also be easily determined from the invoice that the business has received for the expenses. However, the economic profits of the business consist of opportunity costs. The value of these costs must be estimated and is not readily available. These may not be as precise as accounting profits due to the estimated opportunity costs.
However, this does not make the economic profit of a business useless. The accounting profit and economic profit of a business are also different due to their usage.
When to use Accounting profit and Economic Profit
The accounting profit is the main indicator of the performance of a business. It can be used by the owners of the business or any potential investors to check the profitability of the business. Furthermore, other stakeholders can also mainly use the accounting profit of the business to make decisions. For example, financial institutions that provide a loan to the business will use the accounting profit of the business to determine whether the business can return the loan.
This means that the accounting profit of a business is mainly used as a decision-making tool by the stakeholders of the business, whether these are internal stakeholders or external stakeholders. The accounting profit of a business is also readily available to the stakeholders. The same is not the case with the economic profit of the business. The economic profit of the business isn’t readily available to the stakeholders, unlike the accounting profit which can be obtained from the financial statements of the business. Furthermore, the stakeholders of the business cannot calculate the economic profit of the business easily either, since the implicit costs of the business are difficult to estimate.
Although the economic profit of a business also takes into account the explicit costs of a business, it isn’t widely used by stakeholders of the business due to the added implicit costs. For some stakeholders, the concept of implicit costs can be difficult to comprehend as these costs aren’t real costs to the business and are costs that were not explicitly borne. However, it can be used to evaluate the efficiency of the business. It is mainly used by the management of the business to make decisions regarding allocating resources to different projects of the business. Nevertheless, it can still be used by the owners or any potential investors as well to determine the efficiency of the business.
Moreover, the accounting profit is also used as a basis to calculate the taxable profit of the business. Some adjustments are made to the accounting profit, according to the tax laws of the country, that the business operates in, to arrive at the taxable profit of the business. This taxable profit is then multiplied with the relevant tax rate of the country to arrive at the tax expense payable of the business. The economic profit cannot be used for the same purpose as tax laws do not consider implicit costs as a tax-deductible expense.
The economic profits of a business can also be used by the owners and potential investors of the business to compare the income that has been earned by the business with the income that could potentially be earned from choosing a different alternative use for the resources of the business.
Finally, the accounting profit of a business is used as a short-term indicator of the business’ financial performance and financial health. Therefore, the accounting profit is mostly used in short-term decision-making and strategy making of the business. However, the economic profit of a business is used in the long-term decision-making and strategy making of a business. The strategies based on the economic profit of a business are also, therefore, at a higher level than the strategies based on accounting profit.
The accounting profit of a business is calculated by subtracting all the explicit expenses of the business from its revenues. On the other hand, economic profits of a business are calculated by subtracting both the explicit and implicit costs of a business from its revenues. The accounting profit is mainly used by stakeholders to evaluate the financial performance and financial health of a business. The economic profit, however, is used to evaluate the efficiency of a business in using its resources. Both these profits are used for different reasons, for instance, decision-making.