Advanced profit

What Is Economic Profit?

Economic profit is a crucial metric in financial performance measurement that extends beyond traditional accounting figures by incorporating both explicit and implicit costs, including opportunity cost. While accounting profit only considers direct, out-of-pocket expenses like wages and rent, economic profit provides a more comprehensive view of a firm's true profitability by also factoring in the value of foregone alternatives. It assesses whether a business is generating a return that exceeds what could have been earned by employing its capital and other resources in their next best alternative use. A positive economic profit indicates that the business is not only covering its explicit costs but also earning more than it would have by pursuing another investment opportunity¹⁰, ¹¹.

History and Origin

The concept of economic profit, with its emphasis on opportunity cost, has roots in classical economics, distinguishing it from the simpler accounting perspective. While various economists contributed to the underlying principles, the modern application and popularization of a related metric, Economic Value Added (EVA), significantly brought these ideas into corporate finance. EVA, akin to economic profit, gained prominence in the 1990s, championed by firms like Stern Stewart & Co. Its introduction aimed to provide a more holistic measure of value creation for shareholders by explicitly accounting for the cost of capital. Although its popularity fluctuated, the core concept of evaluating profit against the true cost of all resources, including alternative uses, remains a fundamental principle in advanced financial analysis⁹. Academic institutions have also extensively explored and taught these concepts, emphasizing their importance in understanding a company's true performance⁸.

Key Takeaways

• Economic profit considers both explicit costs (actual outlays) and implicit costs (opportunity costs) to assess true profitability.
• A positive economic profit indicates that a business is generating returns greater than its best alternative investment.
• It is a theoretical concept used for decision-making and resource allocation, rather than for financial reporting.
• Economic profit helps businesses determine the efficiency of their resource allocation and sustainable value creation.
• Unlike accounting profit, it is not found directly on a company's financial statements.

Formula and Calculation

Economic profit is calculated by subtracting both explicit and implicit costs from total revenue. Implicit costs represent the opportunity cost of resources, such as the income an entrepreneur could have earned elsewhere or the return on capital that could have been achieved in an alternative investment.

The formula for economic profit is expressed as:

Where:

• Total Revenue: The total income generated from sales of goods or services.
• Explicit Costs: Direct, out-of-pocket expenses, such as wages, rent, utilities, and raw materials. These are typically reported on an income statement.
• Implicit Costs: The opportunity costs of using resources already owned by the firm or an individual, rather than selling or renting them to others. This includes the normal profit, which is the minimum profit required to keep a business operating.

This calculation provides a more comprehensive view of financial performance by factoring in the true economic sacrifice of pursuing a particular venture⁷.

Interpreting the Economic Profit

Interpreting economic profit involves assessing whether a business is truly adding value above and beyond what its resources could earn elsewhere. A positive economic profit suggests that the chosen business activity is superior to the next best alternative use of resources. This indicates that the firm is efficiently utilizing its capital and talent to generate returns that surpass the implicit costs associated with its operations⁶. Conversely, a negative economic profit implies that the resources could have yielded a higher return in an alternative endeavor, even if the business is showing an accounting profit. A zero economic profit, known as normal profit, means the business is earning just enough to cover all its costs, including the opportunity cost of capital and labor, and is therefore performing as well as its next best alternative⁵. Understanding this metric is vital for strategic decision-making, as it pushes managers to consider the broader economic context of their operations and optimize resource allocation.

Hypothetical Example

Consider "GreenGrow Farms," a small organic vegetable farm. In a given year, GreenGrow Farms generates $150,000 in revenue from selling produce.

Their explicit costs are:

• Seeds, fertilizer, and supplies: $20,000
• Labor (hired help): $40,000
• Rent for land and equipment: $30,000
• Total Explicit Costs = $20,000 + $40,000 + $30,000 = $90,000

The owner, Sarah, works full-time on the farm. Before starting GreenGrow, she was a software engineer earning a salary of $70,000 per year. This foregone salary is an implicit cost. Additionally, Sarah invested $100,000 of her own savings into the farm. If she had invested this money in a diversified stock portfolio, she could have reasonably expected a 5% return, or $5,000, which is another implicit cost.

Implicit Costs:

• Foregone salary: $70,000
• Foregone investment return: $5,000
• Total Implicit Costs = $70,000 + $5,000 = $75,000

Now, let's calculate the economic profit:

Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)
Economic Profit = $150,000 - ($90,000 + $75,000)
Economic Profit = $150,000 - $165,000
Economic Profit = -$15,000

In this hypothetical example, despite generating $60,000 in accounting profit ($150,000 revenue - $90,000 explicit costs), GreenGrow Farms has an economic profit of -$15,000. This indicates that Sarah's resources (her labor and capital) could have earned $15,000 more in their next best alternative use, suggesting that from an economic standpoint, the farm is not generating sufficient returns to justify its existence over other opportunities. This analysis can inform Sarah's future strategic planning for GreenGrow Farms.

Practical Applications

Economic profit is a vital tool in various real-world financial contexts, particularly in strategic decision-making and capital allocation. Businesses frequently use this concept to evaluate the true profitability of projects, divisions, or even entire companies by assessing whether they are generating returns above their cost of capital. For instance, when considering a new investment, a company will look beyond just the expected accounting profit to ensure that the project's return surpasses the return achievable from alternative uses of its funds.

Consulting firms, such as McKinsey & Company, frequently emphasize the importance of value creation, which is deeply linked to the concept of economic profit, in their advice to corporate clients. They advocate for strategies that ensure businesses not only grow but also generate returns above their cost of capital in a sustainable manner³, ⁴. This approach helps companies enhance long-term shareholder value. Furthermore, the concept is applied in market analysis to understand industry dynamics. Industries with consistently high economic profits tend to attract new entrants, while those with zero or negative economic profits may see firms exit or consolidate, driving the long-term equilibrium of market structures. Even regulatory bodies and economists at institutions like the Federal Reserve System analyze corporate profits, though they typically focus on aggregate accounting profits, the underlying economic principles inform their understanding of market efficiency and resource allocation².

Limitations and Criticisms

While economic profit offers a more robust measure of profitability by including implicit costs, it does come with certain limitations and criticisms. A primary challenge lies in the subjective nature of calculating implicit costs. Estimating the true opportunity cost of an entrepreneur's time or the return on an owner's invested capital can be difficult and prone to bias, as it relies on assumptions about foregone alternatives. This subjectivity can make comparisons between different businesses or industries challenging.

Another criticism, particularly leveled at its derivative, Economic Value Added (EVA), is that it can sometimes discourage long-term investments. Projects with long payback periods might show a negative economic profit in their initial years due to high upfront capital charges, potentially leading managers focused solely on short-term economic profit to reject otherwise valuable strategic initiatives¹. Critics also point out that, unlike accounting profit, economic profit is not a standardized metric found on publicly reported financial statements, making external analysis and benchmarking more complex. Despite these drawbacks, economic profit remains a valuable internal tool for management decision-making, especially in evaluating capital allocation and guiding long-term strategy, provided its subjective elements are carefully considered.

Economic Profit vs. Accounting Profit

The distinction between economic profit and accounting profit is fundamental in finance and economics. Accounting profit is the more commonly understood measure, representing a company's total revenue minus its explicit costs. Explicit costs are tangible, out-of-pocket expenses, such as salaries, rent, and raw materials, that are easily quantifiable and appear on an income statement. This is the profit figure that companies report for tax purposes and to shareholders.

In contrast, economic profit goes a step further by subtracting both explicit and implicit costs from total revenue. Implicit costs are non-tangible costs, primarily representing the opportunity cost of using resources in one way rather than their next best alternative. For example, if a business owner invests their own money into the business, the foregone interest or investment return they could have earned elsewhere is an implicit cost. The main confusion arises because accounting profit can be positive, while economic profit for the same venture might be zero or negative. A positive accounting profit only indicates that revenues exceed direct expenses, but a positive economic profit signifies that the business is truly outperforming alternative uses of its resources, thereby creating real economic value.

FAQs

Q1: Is economic profit used for tax purposes?

No, economic profit is generally not used for tax purposes or for external financial reporting. Businesses report their accounting profit to tax authorities and shareholders on their financial statements. Economic profit is primarily an internal tool for decision-making and evaluating the true profitability of a venture.

Q2: Can a business have an accounting profit but zero economic profit?

Yes, this is a common scenario. A business can have a positive accounting profit (revenue minus explicit costs) but zero economic profit. This means that while the business is covering its direct costs, the returns generated are just enough to compensate the owners for their time and capital at the same rate they could have earned in their next best alternative use. This is also known as earning a normal profit.

Q3: Why is opportunity cost so important in economic profit?

Opportunity cost is critical to economic profit because it accounts for the value of the best alternative foregone when a particular decision is made. By including it, economic profit provides a more accurate picture of a business's true profitability and whether it is efficiently using its resources to generate returns above what could be achieved elsewhere. It encourages a broader perspective on resource allocation.