What is the difference between accounting and economic profit?
The main aim of starting a business activity is to earn a profit. It is a financial metric that helps to assess the financial health of an organization.
The key difference between accounting and economic profit is that accounting profit is more of implicit cost only whereas economic profit consists of both implicit and explicit cost.
Comparison Table (Accounting vs Economic Profit)
|Basic Terms||Accounting Profit||Economic Profit|
|Meaning||Refers to the net income earned during an accounting period||Refers to the surplus remaining after deduction of the total cost from the total revenue|
|Importance||Reflect the profitability of the company||Highlight the efficiency of the company in resource allocation|
|Relevance||Practical from a financial perspective||May not be precise picture since certain aspects are estimates|
|Special Items||No special item involved||Special items such as residual value and inflation level changes|
|Usage||Short term situations||Long term purposes and decisions|
|Type of Costs||Implicit cost||Explicit and Implicit costs|
|Formula||Accounting profit = Total Revenue – Explicit Cost||Economic profit = Total Revenue – (Explicit Cost + Implicit Cost)|
|Type of Profit||Real profit||Abnormal profit|
|Principles||Determined by GAAP||Determined by economic principles|
|Role||Used for income tax and financial performance||Used to determine market entry|
|Period Preview||Single entity||Macro market|
What Is Accounting Profit?
It is the difference between total monetary revenue and total monetary costs. It is computed by following the generally accepted accounting principles (GAAP).
Accounting profit is also known as the net income of a company. Some of the popular monetary costs are labour costs, raw materials costs, transportation costs, sales and marketing costs.
The monetary revenue is the amount the company receive after selling the products in the market. Keep in mind that accounting profit is the same as book-keeping since it has both credit and debit sides.
Accounting profit usually considers the revenue and costs of a single period. The information help organization determine their financial health during a fiscal period.
|Accounting Profit||=||Total Revenue||–||Explicit Costs|
Accounting profit question example:
ABC is a company selling sports merchandise. If the annual turnover of the firm is $ 10,000. Some of the expenses of the firm are the transportation cost of $4000 and salaries of $2000. Calculate the accounting profit of the firm.
Accounting profit = total revenue – explicit cost
= $ 10, 000 – (4000 + 2000)
= $ 6000
Advantages of Accounting Profit
- Provide information for making important business investment decisions
- Encourage investors to invest their money in the business
- Help to show the financial performance of the company
What Is Economic Profit?
It is the difference between total revenue and total cost. The total cost comprises of both explicit and implicit costs.
Keep in mind that economic profit includes opportunity cost linked with production. It is normally lower than accounting profit.
Economic profit is determined by economic principles and it entails the whole of the project timeline view.
Advantages of Economic Profits
- Measure the efficiency of a firm
- Measure the success factor of an organization
Therefore, economic profit formula includes:
|Economic Profit||=||Total Revenue||–||Explicit Cost||+||Implicit Costs|
Main Difference between Accounting and Economic Profit
- Accounting profit is the net income earn during the fiscal year whereas economic profit is the surplus remaining after deducting the total cost from total revenue
- Accounting profit is relevant for practical for financial perspective whereas economic profit does not provide a precise picture since it involves certain aspects of the estimate
- Accounting profit reflects the profitability of a firm whereas economic profit highlights the efficiency of the company in resource allocation
- Accounting profit is the difference between total revenue and explicit cost whereas economic profit is the difference between total revenue and total costs.
- Accounting profits are for short term period whereas economic profits are for a long term period.
Read More: Difference between Sales and Revenue
Accounting vs Economic Profit Frequently Asked Questions
What Is Implicit Cost?
The opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor hires.
What Is Explicit Cost?
A direct payment made to others in the course of running a business, such as wages, rent, and materials, as opposed to implicit costs, which are those where no actual payment is made.
Can Economic Profit Ever Exceed Accounting Profit?
The economic profit is calculated when the opportunity cost is subtracted from the accounting profit.
As the economic profit is calculated by subtracting the opportunity cost from the accounting profit, the accounting profit will always be bigger.
The financial growth of a company in a competitive environment is highly determined by accounting and economic profits.
The main difference between accounting and economic profit is that accounting profit gives the real picture of the financial health of a firm whereas economic profit help in assessing the efficiency of a company in terms of resource allocation.
More Sources and References
- Firm and Industry Effects. San Jose State University Faculty Publication
- Fundamental Analysis. Investopedia