What Is Economic Profit?

What Is Economic Profit?

Let me explain economic profit directly: it's the difference between the revenue you get from sales and the explicit costs of producing your goods and services, plus any opportunity costs involved.

You need to understand that opportunity costs are a form of implicit cost, which management determines and can change based on different scenarios and viewpoints.

Key Takeaways

Economic profit is what remains after you subtract both explicit costs and opportunity costs from your revenue. Think of opportunity costs as the profits your business misses by picking one venture over another. I use economic profit for internal analysis; it's not something you have to disclose publicly. Accounting profit is simple—it's just revenue minus explicit costs. Even though it's theoretical, economic profit helps you evaluate and choose between potential business opportunities.

Understanding Economic Profit

You often analyze economic profit alongside accounting profit. Accounting profit is what shows up on your income statement as net income, measuring actual inflows versus outflows, and it's required for financial transparency.

Economic profit, however, isn't on your financial statements and doesn't need to be shared with regulators, investors, or institutions. You can use it for 'what if' scenarios when deciding on production levels or business alternatives—it acts as a stand-in for profits you might have foregone.

To calculate it, the formula is straightforward: economic profit equals revenues minus explicit costs minus opportunity costs. If you skip opportunity costs, you're left with accounting profit. Explicit costs appear on your income statement, like cost of goods sold, which you can break down per unit for more detail.

If you're starting a business, economic profit can proxy your first year's results, considering what you gave up from a prior job. For larger operations, managers might compare it against gross, operating, or net profit at various stages.

Economic Profit vs. Accounting Profit

Accounting profit is net income after subtracting all costs from revenue in a period, while economic profit goes further by also deducting opportunity costs. The first is a real number on financial statements; the second helps you assess decision effectiveness or plan strategies.

Advantages and Disadvantages of Economic Profit

On the advantages side, economic profit aids your decision-making by showing how subtracting explicit and opportunity costs affects net income, letting you rank ventures before committing. You can review it afterward to learn from choices and see resource efficiency.

Disadvantages include its theoretical nature, as opportunity costs are assumptions—you don't know the exact revenue from untaken paths. Short-term calculations might mislead you, since initial losses can precede long-term gains, so consider longer periods for accuracy.

Special Considerations: Opportunity Costs

Opportunity costs deepen your business decision analysis, especially with alternatives. They're arbitrary implicit costs varying by management's estimates and market conditions, often equaling the accounting profit from an alternative choice. You might apply them when comparing production levels for different products.

Examples of Economic Profit

Suppose you start a business with $100,000 in startup costs and earn $120,000 in revenue the first year—that's a $20,000 accounting profit. But if staying at your old job would have paid $45,000, your economic profit is $120,000 minus $100,000 minus $45,000, equaling negative $25,000.

This is just for year one; if costs drop to $10,000 later, the outlook improves. Zero economic profit means 'normal profit.' For per-unit analysis, economic profit is revenue per unit minus COGS per unit minus unit opportunity cost. Say t-shirts yield $10 revenue with $5 costs for $5 gross profit, but shorts could have $10 revenue with $2 costs for $8 opportunity—resulting in negative $3 economic profit per unit, suggesting shorts were better.

What Are Economic Profits?

Economic profits are theoretical results from subtracting all expenses and lost opportunity costs from revenue over a period.

Why Is Economic Profit Important?

It's important because it helps you spot flaws in strategies, missed opportunities, and resource use efficiency.

What Is an Opportunity Cost?

It's the cost of not pursuing a business option, referring to foregone money rather than spent funds.

The Bottom Line

Economic profit is your revenue minus explicit and opportunity costs, used internally. Accounting profit is revenue minus direct, indirect, and capital costs, reported publicly. Economic profit gives insights into opportunities and decisions, while accounting profit measures profitability for investors.