As you develop your business accounting processes, you may notice different types of profits in your reports. Each of these metrics serves a different purpose in providing insight into the financial health of your business.
Economic profit and accounting profit are 2 important business measurements for you to understand. Learn the difference between economic and accounting profit below.
How Is Accounting Profit Calculated?
Accounting profit also goes by the term net income. It is the final number you calculate after subtracting various costs from your total sales.
Accounting Profit = Total Revenue – Total Explicit Costs
For example, you will start with your total revenue and then subtract wages, raw materials, marketing costs, and other overhead. These are the explicit costs of running a business.
Typically, you can find the accounting profit (net income) on the company’s income statement or profit and loss (P&L) documents.
What Is Meant by Economic Profit?
Economic profit is more theoretical than accounting profit. This number reviews the costs and potential revenue had the company made one choice over another through the course of the year. It is the accounting profit minus the opportunity cost of doing something else.
Economic Profit = Total Revenue – Total Explicit Costs – Total Implicit Costs
A common example of implicit costs that you won’t see on the income statement is when a small business owner works overtime or works for a period without drawing a set salary. If you’re an owner doing this, you are not directly costing your business any money, but you are incurring implicit costs because the opportunity cost of your labor is equal to what you could be earning at a regular, salaried position.
Implicit costs are often hard to evaluate and measure, but they are extremely real aspects of running a business. Choosing to use your warehouse to store inventory vs. converting it to a storefront is a decision that has an opportunity cost. Deciding whether to hire employees or outsource work creates implicit costs, too. There are many examples of decisions small business owners have to make that carry implicit costs.
This year, businesses are likely considering economic profit amid the COVID-19 pandemic. What if the store had remained closed longer or opened up faster? What if the company invested in curbside delivery?
Economic profit relies on implicit costs, using the company’s resources in different ways to maximize potential growth.
Can Economic Profit Ever Exceed Accounting Profit?
In short, the economic profit should never exceed the accounting profit.
The economic profit comes from subtracting the opportunity cost from the accounting profit. For example, a restaurant earns $60,000 running a food truck over a year but had the potential opportunity cost of $50,000 from launching a catering arm instead. The economic profit is $10,000 to the company because it profited from the food truck opportunity.
Economic profit can be a negative number. If the economic profit is positive, then it is in the best interest of the business to keep making money in the field. If the economic profit is negative, then the business should exit the market and look for other income sources.
For example, a freelance web designer earned $75,000 in a year. However, if most people in their field earn $100,000 annually working for an agency, there is a negative economic profit and the freelancer should consider seeking full-time employment.
There is also no such thing as a negative opportunity cost. There are always profits for potential opportunities. The opportunity costs track the options that businesses did not choose (or couldn’t choose), not penalties that held them back.
Use Both Types of Profit Calculations
There’s no need to pit accounting profit vs. economic profit on your accounting sheet. You can use economic profit to determine whether or not your company is making smart decisions and whether you should consider pivoting.
You can also use this theoretical process to forecast potential revenue if you change your business plan or make a future investment. Economic profit and accounting profit are both helpful metrics to use when evaluating your financial health and how to best take your business forward.