How Do Economic Profit and Accounting Profit Differ?
Profit is one of the most widely watched financial metrics in evaluating the financial health of a company. Accounting profit and economic profit share similarities, but there are distinct differences between the two metrics.
Accounting profit is also known as the net income for a company or the bottom line. It’s the profit after various costs and expenses are subtracted from total revenue or total sales as stipulated by generally accepted accounting principles (GAAP). Those costs include:
- Labor costs, such as wages,
- Inventory needed for production,
- Raw materials,
- Transportation costs,
- Sales and marketing costs,
- Production costs and overhead.
Accounting profit is the amount of money left over after deducting the explicit costs of running the business. Explicit costs are merely the specific amounts that a company pays for those costs in that period, for example, wages. Typically, accounting profit or net income is reported on a quarterly and annual basis and is used to measure the financial performance of a company.
Economic profit is similar to accounting profit in that it deducts explicit costs from revenue. However, economic profit also includes the opportunity costs for taking one action versus another in the period. Economic profit is determined by economic principles, not by accounting principles.
Economic profit also uses implicit costs, which are typically the costs of a company’s resources. Examples of implicit costs include:
- Company-owned buildings,
- Plant and equipment,
- Self-employment resources.
Economic profit is the profit from producing goods and services while factoring in the alternative uses of a company’s resources.
For example, a company may choose Project A versus Project B. The profit from Project A after deducting expenses and costs would be the accounting profit. The economic profit would include the opportunity cost of choosing Project A versus Project B. In other words; economic profit would consider how much more or less profit would have been generated, by using the company’s resources, had management chosen Project B.
Economic profit is more of a theoretical calculation based on alternative actions that could have been taken while accounting profit calculates what actually occurred and the measurable results for the period.
If you enjoy reading above profit, please read How are gross profit and EBITDA different?
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