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Economic Profit (Or Loss) : Definition, Formula, and Example: Explicit Costs Opportunity Costs Implicit Cost

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15 views4 pages

Economic Profit (Or Loss) : Definition, Formula, and Example: Explicit Costs Opportunity Costs Implicit Cost

New presepective of EVA

Uploaded by

Nauman Akram
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Economic Profit (or Loss): Definition, Formula, and Example

What Is Economic Profit?


An economic profit is the difference between the revenue received from sales
and the explicit costs of producing its goods and services, as well as
any opportunity costs.
Opportunity costs are a type of implicit cost determined by management and
will vary based on different scenarios and perspectives.
Understanding Economic Profit
Economic profit is often analyzed in conjunction with accounting profit.
Accounting profit is the profit that a company shows on its income statement.
It is also known as "net income."
Accounting profit measures actual money inflows versus money outflows and
is part of the required financial reporting and transparency of a company.
Economic profit, on the other hand, is not recorded on a company’s financial
statements, nor is it required to be disclosed to regulators, investors, or
financial institutions.
Economic profit can be used in a "what if" analysis. Companies and
individuals may choose to consider economic profit when they are faced with
choices involving production levels or other business alternatives. Economic
profit can provide a proxy for foregone profit considerations
How to Calculate Economic Profit
The calculation for economic profit can vary by entity and scenario. In
general, it can be captured as follows:
Economic profit = revenues - explicit costs - opportunity costs
If you excluded the opportunity costs from this equation, you'd get simply the
accounting profit. However, when you subtract the opportunity costs as well,
the economic profit results. It can serve as a comparison to other options that
could have been undertaken by a company, for better or worse.
Companies state their explicit costs on the income statement. The accounting
profit on the bottom line of the income statement is the net income after
subtracting for direct, indirect, and capital costs.
The cost of goods sold is the most basic explicit cost used in analyzing per-
unit costs. Thus, in the equation above, a company could also break down its
opportunity costs by units to arrive at a per-unit 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). With large entities, business managers can potentially look more
intricately at gross, operating, and net profit versus economic profit at
different phases of the business operations
Economic Profit vs. Accounting Profit
Accounting profit, or net income, is determined by subtracting all costs from
revenue for a particular accounting period. Economic profit is determined by
going a step further and subtracting opportunity costs, as well. The former
represents an actual figure that's included on financial statements. The latter
can be used by company management to determine how effective its
business decisions were. It can also be used before actions are taken to
decide on the best business strategy to put to work.
Here's a quick reference chart that summarizes the differences between
economic profit and accounting profit.
Economic Profit Accounting Profit

A theoretical financial figure based on Actual profit (net income) is determined


assumptions

Isn't part of financial statements or reported Calculated according to GAAP and reported
to IRS

Used for internal analysis Used by investors to analyze a potential


investment

Illuminates for management the wisdom of Provides insight into how well management is
various business options running company

Can reveal how efficiently a company uses its Is used to calculate investors' earnings per
resources share

Advantages and Disadvantages of Economic Profit


Advantages
1. Economic profit figures can be helpful for business decision-making. By
studying the effect on net income of subtracting not just explicit costs
but the estimated costs of giving up potential business opportunities,
companies can size up the wisdom of business ventures from high to
low before launching one or more.
2. Economic profit can also be reviewed after the fact. Lessons can be
learned about the choices that were made.
3. Economic profit can show management how efficiently the company
has been using its resources.
Disadvantages
1. The economic profit figure is theoretical because opportunity
costs are based on assumptions. Since the opportunity wasn't
taken, a company doesn't know the exact amount of revenue that
might have been made
2. Thelculation of economic profit over the short-term can lead to
inappropriate conclusions about the business option chosen.
That's because short-term losses can be inevitable before
expected long-term profitability. It's smarter to analyze economic
profits over long-term time periods.

Special Considerations
Opportunity Costs
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.
Opportunity costs are somewhat arbitrary and are a type of implicit cost. They
can vary depending on management’s estimations and market
circumstances. Generally, opportunity cost will be the accounting profit that
could have been achieved by making an alternative choice.
Examples of Economic Profit
An individual starts a business and incurs startup costs of $100,000. During
the first year of operation, the business earns revenue of $120,000. This
results in an accounting profit of $20,000. However, if the individual had
stayed at her previous job, she would have made $45,000. In this example,
the individual’s economic profit is equal to:
$120,000 - $100,000 - $45,000 = ($25,000)
This calculation only considers the first year of business. If after the first year,
costs decrease to $10,000 then the economic profit outlook would improve for
future years. If economic profit comes out to zero, the company is said to be
in a state of "normal profit."
In using economic profit in comparison to gross profit, a company may look at
different types of scenarios. In this case, gross profit is the focus, and a
company would subtract the opportunity cost per unit:
Economic profit = revenue per unit - COGS per unit - unit opportunity cost
If a company generates $10 per unit from selling t-shirts with a $5 cost per
unit, then its gross profit per unit for t-shirts is $5. However, if it could have
produced shorts with revenue of $10 and costs of $2 then there would be an
opportunity cost of $8 as well:
$10 - $5 - $8 = ($3)
All things being equal, the company could have earned $3 more per unit if
they had produced shorts instead of t-shirts. Thus, the -$3 per unit is
considered an economic loss.

Companies can use this type of analysis to decide on production levels. More
complex scenario analysis of profits may also factor in indirect costs or other
types of implicit costs, depending on the expenditures involved in doing
business as well as different phases of a business cycle.
What Are Economic Profits?
Economic profits are the theoretical profits that result when company
management subtracts all expenses plus the costs of lost opportunities from
revenue earned in a particular period of time.
Why Is Economic Profit Important?
It can be important because it can help a company's management
understand potential flaws in its choices for business strategies or ventures,
missed financial opportunities, and how efficiently it uses company resources.
What Is an Opportunity Cost?
It's the cost to an individual or company of not pursuing a particular business
option. The cost isn't related to something they spend. It refers to money they
forego.
The Bottom Line
Economic profit represents a company's revenue less its explicit costs as well
as its opportunity costs. It's used for internal analysis. Accounting profit (net
income) is a company's revenue less its direct, indirect, and capital costs. It's
reported on financial statements and to the IRS.
Economic profit is important for the insight that it can give the management of
a company about potential or past business opportunities. Accounting profit is
an important measure of profitability and management capability for
investors.

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