Economic Profit Definition Interpretation Limitations

Economic Profit Definition

Whenever a firm rattle on profit, it is usually an accounting profit. Accounting profit is the difference between total revenue and the direct costs the company is incurring. But, in economics, accounting for profit does not make sense because it does not ensure whether the business is making real profits. So, that is the reason economists turn to economic profit.

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Economic Profit Example

Mr. A has left his job to start a restaurant business. He was a lawyer and was earning $100,000 per year. However, he felt more inclined towards food and fun, so he started his business. In the first year, he made an accounting profit of $50,000. But if noticed closely, we would see that to make an accounting profit of $50,000, Mr. A has to forgo his job as a lawyer and the salary (which is the opportunity cost), i.e., $100,000.

So, even if he has made an accounting profit in his restaurant business, he has made an economic profit of ($50,000 – $100,000) = – $50,000.As a rational decision-maker, if Mr. A keeps on earning an accounting profit of $50,000, returning to the job as a lawyer may seem to be the right decision.If it is not negative or equal, he may choose a restaurant business over his career as a lawyer.

Formula

Economic Profit = Accounting Profit – Opportunity Cost Foregone

Now, you may wonder what accounting profit is?

Accounting Profit = Total Revenue – Explicit Costs

When we say our firm has made “profit,” we indicate that our firm has made “accounting profit.”

Here’s what is relevant.

Total Revenue = Sale Price / Unit * Number of Products Sold

And explicit costs include –

Explicit Costs = Wages + Rent + Equipment Rent + Electricity + Telephone Expenses + Advertising Expenses.

Every business has to incur some of the expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more they need to pay out of their pocket to keep running and produce the products they would be selling. These expenses are called explicit costsExplicit CostsExplicit costs are the culmination of all direct and indirect expenses recorded in a company’s ledger. read more.

So, let us now look at the formula of economic profit Formula Of Economic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.read more calculation.

Economic Profit = Total Revenue – Explicit Costs – Opportunity Costs Foregone

How to Interpret?

Why is it important? Because it is based on a concept called trade-off.

Let us take a simple example to understand the concept of “trade-off.” Instead of playing a game on your mobile, you decided to read this article. At the same time, it could have been invested in different things. But you chose to invest your time in this article to understand it.

Let us take another example. Suppose, after completing your graduation, you decided to go for an MBA instead of doing a full-time job. Now, you have invested around $60,000 in an MBA. And also, if you had joined a job after graduation, you could have earned a decent $40,000 per annum.

So, what would be the cost of an MBA? Do you think it is $60,000?

No.

It would be the amount you have foregone (being employed) by choosing to do an MBA plus the cost of an MBA. So here is what your MBA costs: – $60,000 + ($40,000*2) = $140,000.

Now, if you get a job after MBA and it is not more than $140,000, you have incurred a loss by doing the trade-off of choosing an MBA over full-time employment.

Now, think about business. If a company only thinks about the profit they are making and not the trade-off the firm has made because of choosing to invest in one project (and not in another), then it would not be an appropriate calculation. For example, company MNP has invested $100,000 in project G. They think they would make around $30,000 as a return on investment. However, as company MNP has invested in project G, they have foregone the opportunity to fund other projects that might have yielded better returns for company MNP.

If you do not consider the “trade-off,” you are doing the wrong calculation.

Economic Profit Examples

Example # 1

Ramen left his job as a doctor and started a restaurant business. He earned $200,000 per annum, which he left because he did not find medicine interesting anymore. In the first year, he made $550,000 in revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more.

Since he is new in this business, he had to rent a place and all the equipment. So, he rented a small area to start his small food business. He also rented out all the equipment like stoves, utensils, chairs, tables, etc.

He made a scribbled note which looks as follows: –

Wages paid to employees – $100,000Food items – $200,000Rented place – $50,000Rented Equipment – $50,000

Using the information above, you need to find out the accounting profit of Ramen in the first year of his restaurant business. Also, calculated economic profit (or loss) due to his decision to start this business.

From the information mentioned above, first, let us find out the accounting profit: –

Here is the formula for accounting profit: –

Accounting Profit = Total Revenue – Explicit Costs

So, we know the total revenue here, i.e., $550,000.

We need to compute the explicit costs: –

Now, let’s calculate the accounting profit –

To calculate economic profit (or loss), we need to check his salary as a doctor. If he had not started his business this year, we assume he could have earned $200,000 as a doctor. That means $200,000 is his opportunity cost for creating this business.

Here’s the formula –

Putting the value of accounting profitAccounting ProfitAccounting profit is the net income available after deducting all explicit costs and expenses from total revenue, and it is calculated in accordance with generally accepted accounting principles (GAAP). Operating expenses, labour, transportation, and sales expenses are common examples of these costs.read more and opportunity cost, we would get –

Economic Loss = $150,000 – $200,000 = – $50,000.

So, it is clear that if Ramen wants to continue this business, he needs to earn more profit to make sense of preceding the job as a doctor. If he cannot earn at least $200,000 in accounting profit, he should return to his career.

Example # 2

Let us look at the Income StatementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more of ABC Co. for 2016: –

ABC Co. was started by three gentlemen, A, B, and C, who have left their lucrative jobs, earning $140,000, $110,000, and $95,000, respectively, each year, to start ABC Co. Therefore, we need to calculate the economic profit (or loss) ABC Co. has made and find it individually for A, B, and C.

In this example, we will not take net incomeNet IncomeNet income for individuals and businesses refers to the amount of money left after subtracting direct and indirect expenses, taxes, and other deductions from their gross income. The income statement typically mentions it as the last line item, reflecting the profits made by an entity.read more as “accounting profit” because accounting profit is usually profit before taxes. So, here, the accounting profit is profit before tax of ABC Co., i.e., $450,000 in 2016 and $400,000 in 2015.

Let us assume that the accounting profit for each year will be divided among the owners in equal proportion. We also think that A, B, and C did not have any other source of income, and as they had invested in the business, their opportunity cost is similar to the salary they have foregone.

Total opportunity cost foregone = ($140,000 + $110,000 + $95,000) = $345,000 per year.

So, here is the calculation (or loss): –

From the above calculation, it is clear that ABC Co. earned $50,000 more economic profit in 2016 than what it made in 2015. But what is about individual profit?

Let us have a look: –

As the accounting profit is shared equally, in 2015, each of them would earn = ($400,000 / 3) = $133,333.

A, B and C in 2015 is as per below: –

For A, in 2015 = ($133,333 – $140,000) = – $6,667.For B, in 2015 = ($133,333 – $110,000) = $23,333.For C, in 2015 = ($133,334 – $95,000) = $38,334.

As the accounting profit is shared equally, in 2016, each of them would earn = ($450,000 / 3) = $150,000.

A, B and C in 2016 is as per below: –

For A, in 2016 = ($150,000 – $140,000) = $10,000.For B, in 2016 = ($150,000 – $110,000) = $40,000.For C, in 2016 = ($150,000 – $95,000) = $55,000.

Limitations of Economic Profit

Even if it is used to consider the opportunity cost, it has some weaknesses that we cannot ignore: –

It is only applicable for a year. Therefore, if we calculate the last year’s profit, it does not always necessarily give any due advantage.Any value obtained by the employees or the company is not considered in the calculation.Many economists mention that it is all you need to have, depending on one metric that is not free from risk. However, the investor should look at many other ratios and this profit.

Conclusion

There are two things you need to consider. First, accounting profit is not always exhaustive. It would be best if you thought through the opportunity cost too. Second, before investing in any new project or company, you primarily need to look at the market and find out whether you are making the best investment or not.

Economic Profit Definition Interpretation Limitations