Economic Profit vs Accounting Profit: What’s the Difference?

You can use accounting profit to look at your business’s financial performance and see how profitable your business is. Capital is made up of long-term liabilities and the equity account of the business. To calculate opportunity cost, you multiply the interest rate against long-term debt and add that to the required return of equity investors. He generated $1,200,000 of revenue across his stores and turned that into $85,345 of accounting profits after all expenses.

  1. We’re going to calculate it a little differently for this article by looking at what Todd could earn if he sold the business.
  2. Both are intimately concerned with the financial health of a company or business firm.
  3. However, economic profit goes one step ahead and helps us understand whether it is better to run a business or work elsewhere.
  4. Individuals starting their own business might use economic profit as a proxy for their first year of business (since they have given up some prior opportunity).
  5. This is because accounting deals with different costs and expenses that mean different things to various stakeholders.
  6. The Accounting Profit is also known as net income or the bottom line.

You could be earning thousands each year in accounting profit but missing out on even more cash if you sold the business or changed your capital structure. We will calculate economic profit by subtracting economic costs, such as opportunity cost, from net income. Opportunity costs can be used for deeper analysis of business decisions, specifically when alternatives are available. Companies may look at opportunity costs when considering production levels for different types of products that they produce collectively but in varying quantities. Companies use accounting profit to figure out how much profit the business actually made in a specified period.

Accounting profit vs. economic profit: What’s the difference?

Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. It’s the cost to an individual or company of not pursuing a particular business option. For example, let’s say you purchase a computer for $2,000 and rent office space for $1,000 per month.

Accounting profit vs. economic profit

Using the formula above, we can determine that the economic profit of producing these toys is $3,000 ($10,000 – $5,000 – $2,000). The $2,000 is included as an implicit cost that is otherwise not recorded on the financial statements. A business would tend to exist only when the business is to generate economic profit that is more than accounting profit. It indicates the profit earnings capability of the business even in the near future as well as how they have performed in the past.

We’re going to calculate it a little differently for this article by looking at what Todd could earn if he sold the business. As you can see, Project #2 generates a positive economic profit, relative to Project #1. Common sources of revenue include the sale of goods and services, receipt of dividends or interest, and rental income, to name a few. All things being equal, the company could have earned $3 more per unit if they had produced shorts instead of t-shirts. Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.

Economic and accounting profit differences

Economic profits are determined separately without your accounting books or software. This is because you cannot bookkeep implicit difference between accounting profit and economic profit costs since no actual transactions were made. $5,000 is positive economic profit, meaning the decision was a good one.

If it declines one opportunity for another, the potential income from the declined opportunity is factored into economic profit but not accounting profit. Normal Profit is the minimum amount of profit required by the entity for its perpetual succession. When the economic profit equals zero (break even point) as a result of the difference between total revenue and total cost, normal profit arises.

Implicit cost is the opportunity cost, i.e. the option forgone by the firm while investing the money somewhere else or using some other option. When calculating economic profit, we ignore net income and instead consider the actual amount of cash made by the company or free cash flow. Once the free cash flow is determined, we use theoretical principles rather than GAAP to find the opportunity costs of comparable alternatives.

It gives a full picture of what our resources are really costing us. Generally, you may turn toward your accounting profit to see how your company is doing. You also need to consider other types of profit, such as economic profit. But, what’s the difference between accounting profit vs. economic profit? Accounting Profit sticks to the basics – direct expenses, taxes, and interest. It thinks about both clear and hidden costs, including opportunity costs.

You report your accounting profit to the IRS and analyze it to see how your business is doing financially. Accounting profit is what you get with a traditional income statement. You start with revenue and then subtract all cash expenses from the year, plus some non-cash expenses such as depreciation and amortization. The next step is to take the difference between the cash flows of each project and compare them to see which generates more economic profit. Individuals starting their own business might use economic profit as a proxy for their first year of business (since they have given up some prior opportunity).

Adding non-operating revenue (if any) to operating profits leads us to EBIT. Limited resources mean that we have to make decisions based on certain trade-offs which come from not being able to use the said resources for an alternative purpose. Opportunity cost accounts for the limited amount of resources that we can use. In this case, it is the $200,000 salary you receive from your job, which is known as the opportunity cost. Instead, they consider it a sunk cost, i.e., there is no way to recover it, and thus, it is irrelevant to the production decisions.

It gives you a peek into the business’s money health based on clear costs. Economic profit, however, gives decision-makers a deeper view, thinking about potential gains from different resource uses. Economic profit is the difference between Total Revenue and Total Costs.

Economic profit can be calculated using accounting profit, but it can also be calculated based on the opportunity cost of capital. Opportunity cost accounts for the money that could have been made if it was in a different investment. Accounting profit can be the profit that the business earns as per the book of accounts of the business. The accounting profit is the difference between total sales by the business and the costs incurred by the business that could be accounted for explicitly. The explicit costs may comprise the cost of goods sold, operational expenses, and non-cash expenses.