What Is Economic Profit?
Economic profit represents the residual wealth generated by a business after accounting for both explicit and implicit costs incurred in its operations. Unlike traditional measures of profitability, economic profit takes a holistic view by incorporating the opportunity cost of resources—what a firm gives up by using its assets in their current application rather than their next best alternative. This concept is central to managerial economics and helps in optimal decision making regarding resource allocation and strategic choices. A positive economic profit indicates that a business is generating returns greater than what could have been earned by employing the same capital and labor in their most lucrative alternative use.
History and Origin
The concept of economic profit is deeply rooted in classical and neoclassical economics, evolving from the fundamental understanding of costs beyond mere monetary outlays. Early economists, particularly those focusing on resource allocation, recognized that the true cost of production must include the value of what is foregone. Alfred Marshall, a prominent economist, significantly contributed to the understanding of profit in the context of normal returns to factors of production. David R. Henderson, a research fellow at the Hoover Institution, elaborates on profit and loss, emphasizing that economists, unlike accountants, incorporate all costs, both explicit and implicit, when analyzing a firm's profitability. T4his comprehensive view ensures that firms consider the true cost of their inputs, including the return that could have been achieved on those resources elsewhere.
Key Takeaways
- Economic profit accounts for both explicit (out-of-pocket) and implicit (opportunity) costs.
- A positive economic profit signals that a business is outperforming its next best alternative use of resources.
- It serves as a critical metric for strategic evaluation and resource allocation within a company.
- Economic profit is often used internally for business strategy and investment decisions, rather than for financial reporting.
- When economic profit is zero, it implies a "normal profit," meaning resources are earning precisely what they could in their best alternative use.
Formula and Calculation
The calculation of economic profit integrates both the direct, recorded costs and the indirect, unrecorded costs associated with choosing a particular course of action.
Economic Profit is calculated as:
Where:
- Total Revenue represents all income generated from sales, services, or other business activities.
- Explicit Costs are direct, out-of-pocket expenses for a business, such as wages, rent, raw materials, and utilities. These are typically recorded on a company's financial statements.
- Implicit Costs represent the opportunity cost of using owned resources in one way instead of their next best alternative. For example, the implicit cost of a business owner's time could be the salary they could earn working for another company, or the implicit cost of invested capital could be the return that capital could generate in an alternative investment. These costs are not typically recorded in standard accounting records.
By subtracting both explicit and implicit costs from total revenue, the formula provides a comprehensive measure of a firm's true profitability and efficiency in resource utilization.
Interpreting Economic Profit
Interpreting economic profit goes beyond simply looking at a positive or negative number; it offers insight into the effectiveness of a firm's resource allocation and its true competitive standing. A positive economic profit indicates that the firm's current venture is generating returns above and beyond what its resources could earn in their next best alternative employment. This suggests the firm has a strong competitive advantage or is operating in a particularly lucrative market segment.
Conversely, a negative economic profit, also known as an economic loss, implies that the resources employed by the firm could generate a higher return elsewhere. Even if a business reports an accounting profit, a negative economic profit suggests that the current allocation of resources is inefficient from an economic perspective. A zero economic profit, often referred to as "normal profit," means the firm is covering all its explicit and implicit costs, earning just enough to keep its resources in their current use, but not outperforming alternative opportunities. This state of normal profit indicates efficient resource allocation and is often the long-run equilibrium in perfectly competitive markets. This metric is a powerful tool for internal analysis and strategic planning.
Hypothetical Example
Consider "GreenGrow," a landscaping company owned and operated by Alex. Last year, GreenGrow generated $300,000 in revenue. Alex's explicit costs for labor, equipment, fuel, and supplies amounted to $180,000.
Based on these figures, GreenGrow's accounting profit is:
Now, let's consider Alex's implicit costs. If Alex were not running GreenGrow, he could earn a salary of $70,000 annually as a senior landscape designer for a larger firm. Additionally, he used his own truck, valued at $50,000, which he could have rented out for $10,000 a year if he wasn't using it for GreenGrow. Therefore, Alex's total implicit costs are $70,000 (foregone salary) + $10,000 (foregone rental income) = $80,000.
GreenGrow's economic profit is:
In this scenario, GreenGrow has an economic profit of $40,000. This indicates that Alex is not only covering all his direct expenses but is also earning $40,000 more than he could have by pursuing his next best alternative opportunities. This positive economic profit suggests that continuing to operate GreenGrow is the economically sound decision making for Alex.
Practical Applications
Economic profit is a crucial metric for evaluating true business performance and strategic viability across various financial contexts.
- Investment Analysis: For investors, understanding economic profit provides deeper insights into a company's fundamental strength than net present value alone. A company consistently generating positive economic profit often possesses a sustainable competitive advantage, sometimes referred to as an "economic moat." T3his moat protects its profitability from competitors, enabling long-term outperformance. Morningstar, for instance, extensively uses the concept of economic moats in its equity research, identifying companies likely to sustain competitive advantages and generate economic profit over long periods.
*2 Corporate Strategy and Capital Budgeting: Within a firm, economic profit is invaluable for capital budgeting decisions and evaluating different projects. It helps management assess whether a proposed investment will truly add value by considering all associated costs, including the opportunity cost of the capital employed. It guides firms in allocating resources to their most productive uses, ensuring that each business unit or project contributes more than its cost of capital. In fact, some argue that focusing solely on maximizing earnings per share can be misleading, advocating for an emphasis on economic profit to align management incentives with true wealth creation.
*1 Antitrust and Regulation: In the realm of public policy, regulators and antitrust authorities may consider economic profit when assessing market power and potential monopolistic behavior. Persistent high economic profits in an industry can indicate barriers to entry or lack of competition, prompting regulatory scrutiny regarding market structure.
Limitations and Criticisms
While economic profit offers a more comprehensive view of performance than accounting profit, it is not without its limitations and criticisms. A primary challenge lies in the subjective nature of calculating implicit costs. Unlike explicit costs, which are recorded transactions, implicit costs like opportunity cost require estimation and assumptions about the best alternative uses of resources. This subjectivity can make economic profit difficult to measure precisely and compare consistently across different entities or time periods.
For instance, determining the exact alternative return a business owner could earn, or the market rate for their self-owned capital, involves inherent assumptions and can vary depending on individual circumstances and market conditions. As discussed by the Federal Reserve Bank of San Francisco, the practical difficulty in quantifying these non-monetary costs means economic profit is often a theoretical tool rather than a universally applied financial reporting standard.
Furthermore, the focus on economic profit requires considering various types of risk and the dynamic nature of markets. A project with positive economic profit today might face increased competition or changing market conditions that erode its advantage tomorrow. Critics also point out that, while conceptually sound, the practical application of economic profit can be complex, especially for large, diversified corporations with numerous assets and business lines that could theoretically be deployed elsewhere. It is primarily used as an internal decision making tool and not for external financial reporting.
Economic Profit vs. Accounting Profit
The distinction between economic profit and accounting profit is fundamental to understanding a firm's true financial health and economic efficiency. While both measure a business's financial success, they do so from different perspectives.
| Feature | Economic Profit | Accounting Profit |
|---|---|---|
| Costs Included | Explicit costs + Implicit (Opportunity) costs | Only Explicit (Out-of-pocket) costs |
| Purpose | Internal decision-making, resource allocation, strategic evaluation | External financial reporting, tax purposes, legal compliance |
| Focus | Economic efficiency, true profitability, value creation | Historical financial performance, verifiable transactions |
| Calculation Basis | Incorporates foregone alternatives | Based on actual recorded transactions |
| Result | Generally lower than accounting profit, can be zero (normal profit) even if accounting profit is positive | Typically higher than economic profit |
Accounting profit, often referred to as net income or the "bottom line," is derived from a company's income statement and represents the surplus of revenue over explicit costs. This is the figure that businesses report to shareholders and for tax purposes. Economic profit, on the other hand, provides a more comprehensive picture by also subtracting the implicit costs, which are the values of opportunities foregone. A business might show a healthy accounting profit but still have zero or negative economic profit if its resources could generate a greater return in an alternative venture.
FAQs
Is it possible to have a positive accounting profit but zero economic profit?
Yes, this is not only possible but represents a state of "normal profit." A business can earn enough revenue to cover all its explicit costs (resulting in an accounting profit) and also cover all its implicit costs. In this scenario, the business is earning just enough to justify keeping its resources in their current use, as they are generating a return equivalent to their best alternative.
Why do economists focus on economic profit more than accounting profit?
Economists are primarily concerned with the optimal allocation of scarce resources. Economic profit, by including opportunity cost, provides a clearer picture of whether resources are being used in their most efficient and value-maximizing way. It helps analyze market behavior, market structure, and the incentives for firms to enter or exit an industry, which are central to marginal analysis.
Can economic profit be negative?
Yes, economic profit can be negative. A negative economic profit, or an economic loss, means that the total revenue generated is less than the sum of explicit costs and implicit costs. This suggests that the resources employed by the business could earn a higher return if they were utilized in an alternative venture, even if the business is still reporting an accounting profit. It indicates an inefficient allocation of resources from an economic perspective.
Is economic profit reported on financial statements?
No, economic profit is generally not reported on a company's standard financial statements, such as the income statement or balance sheet. It is primarily an internal metric used by management for decision making, strategic planning, and performance evaluation. Financial statements adhere to accounting principles, which primarily record explicit, historical costs.