What Is Economic Profit?
Economic profit represents the difference between a firm's total revenue and the total opportunity costs of all resources used in production. Unlike traditional accounting profit, which primarily considers explicit, out-of-pocket expenses, economic profit delves deeper by incorporating implicit costs—the value of the next best alternative forgone when a particular decision is made. 27This concept is fundamental within the broader field of managerial economics, providing a more comprehensive view of a business's true financial performance and efficiency in resource allocation. Understanding economic profit helps businesses evaluate whether they are truly maximizing value or merely covering their operational expenses.
History and Origin
The foundational principles underlying economic profit can be traced back to early economic thought, particularly the concept of opportunity cost. While the explicit term "economic profit" as a distinct measure emerged more formally in the 20th century with the development of modern corporate finance, the idea that costs extend beyond mere monetary outlays has roots in classical economics. Alfred Marshall, a prominent British economist often regarded as the father of neoclassical economics, extensively explored concepts such as supply and demand, marginal utility, and costs of production in his seminal 1890 work, Principles of Economics. Marshall's work laid much of the groundwork for understanding how firms make decisions considering the full spectrum of costs, including the implicit returns to factors of production that are owned by the firm itself.
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A significant evolution in the application of economic profit within corporate settings came with the popularization of Economic Value Added (EVA). EVA, a registered trademark of Stern Stewart & Co., a management consulting firm, aimed to provide a performance measure that aligns managerial incentives with shareholder wealth creation by explicitly accounting for the cost of capital,.25 24Bennett Stewart, one of the firm's founders, outlined adjustments to accounting measures to derive more realistic estimates of surplus value, making economic profit concepts highly practical for corporate performance evaluation.
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Key Takeaways
- Economic profit accounts for both explicit (out-of-pocket) and implicit (opportunity) costs, providing a holistic view of profitability.
- It serves as a critical internal metric for businesses to evaluate the true value generated by their activities beyond simply covering operational expenses.
- A positive economic profit indicates that a business is generating returns greater than those available from the next best alternative use of its resources.
- Economic profit guides strategic decision-making, helping firms allocate resources efficiently to maximize value and sustain long-term growth.
- In perfectly competitive markets, firms tend toward zero economic profit in the long run, as new entrants erode any excess returns.
Formula and Calculation
To calculate economic profit, both explicit and implicit costs are subtracted from total revenue.
The formula is expressed as:
Alternatively, since accounting profit is defined as Total Revenue minus Explicit Costs, the formula can also be written as:
Where:
- Total Revenue represents the total income generated from the sale of goods or services over a specific period.
- Explicit Costs are direct, out-of-pocket expenses incurred by a business, such as wages, rent, utilities, raw materials, and interest payments. These are typically reported on a company's financial statements.
- Implicit Costs are the opportunity costs of resources owned and used by the firm. These are not direct monetary payments but represent the income forgone by not using the resources in their next best alternative use. A common example is the salary an entrepreneur could earn working for someone else, or the return on investment that could be earned by investing capital elsewhere.
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The "cost of capital" is a significant implicit cost, reflecting the required rate of return that investors expect for providing funds to the business. If a company fails to generate returns that exceed its cost of capital, it may be eroding shareholder value.
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Interpreting the Economic Profit
Interpreting economic profit provides critical insights into a business's actual performance and strategic viability. A positive economic profit indicates that a firm is generating returns that are not only covering its operational costs but are also superior to what could be earned from the next best alternative use of its capital and resources. This suggests the business has a sustainable competitive advantage or is operating in an imperfectly competitive market.
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Conversely, a negative economic profit, also known as an economic loss, implies that the resources employed by the business could generate a higher return elsewhere. 19Even if a company reports a positive accounting profit, it might still have a negative economic profit if its implicit costs are substantial. This signals that the current allocation of resources is not optimal, and a reassessment of business strategies or even market presence might be necessary. 18A zero economic profit, or "normal profit," means the business is covering all its explicit and implicit costs, earning just enough to keep its resources in their current use without providing an incentive for new resources to enter or existing resources to leave the industry.
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Hypothetical Example
Consider "GreenGrow Organics," a small farm specializing in heirloom vegetables. The owner, Sarah, manages the farm full-time and uses her own land and equipment.
For the last year, GreenGrow Organics reported:
- Total Revenue: $150,000
- Explicit Costs (seeds, fertilizer, hired labor, utilities): $80,000
If Sarah were not farming, she could earn a salary of $60,000 as an agricultural consultant (an implicit cost). Additionally, the land and equipment she uses are valued at $200,000. If she rented them out, she could earn a 5% return, or $10,000 per year (another implicit cost, representing the forgone return on investment).
First, calculate the accounting profit:
Accounting Profit = Total Revenue - Explicit Costs
Accounting Profit = $150,000 - $80,000 = $70,000
Next, calculate the total implicit costs:
Total Implicit Costs = Forgone Salary + Forgone Rental Income
Total Implicit Costs = $60,000 + $10,000 = $70,000
Finally, calculate the economic profit:
Economic Profit = Accounting Profit - Total Implicit Costs
Economic Profit = $70,000 - $70,000 = $0
In this hypothetical example, GreenGrow Organics earns an accounting profit of $70,000. However, after factoring in Sarah's implicit costs, the economic profit is $0. This means Sarah is covering all her costs, both explicit and implicit, but is not earning a profit above what she could have earned in her next best alternative. While financially viable, there isn't an "economic incentive" for new capital or labor to enter this specific farming venture, nor is there a strong pull for Sarah to exit based on purely financial returns compared to her alternatives.
Practical Applications
Economic profit is a vital tool for strategic decision-making across various business and financial contexts. It extends beyond simple accounting measures to offer a more profound understanding of true profitability and value creation.
- Investment Decisions: Businesses use economic profit to evaluate potential investment decisions and new projects. By comparing expected returns against the full cost of capital and other opportunity costs, companies can determine whether an investment genuinely adds value or if resources could be better utilized elsewhere.
162. Performance Evaluation: Economic profit measures how effectively management is utilizing resources to generate returns above and beyond what investors expect. This makes it a powerful metric for assessing internal divisions or entire firms, particularly when designing incentive compensation plans. 15The concept of Economic Value Added (EVA) is a direct application of economic profit for performance measurement, developed by Stern Stewart & Co. to provide a more accurate picture of a company's financial health by adjusting for accounting "anomalies".
143. Capital Budgeting: In capital budgeting, economic profit can complement metrics like Net Present Value (NPV) by providing a period-by-period assessment of value creation. While NPV focuses on the present value of future cash flows, economic profit emphasizes the annual surplus generated after all capital costs are met, linking it more directly to the income statement and balance sheet,.13
124. Competitive Strategy: Analyzing economic profit helps companies understand their competitive standing. A firm consistently generating positive economic profit, while competitors do not, suggests a sustainable competitive advantage. This insight can inform strategies regarding pricing, market entry or exit, and the optimal allocation of resources to maintain or enhance that advantage.
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Limitations and Criticisms
Despite its comprehensive nature, economic profit, and related measures like Economic Value Added (EVA), face several limitations and criticisms.
One primary challenge lies in accurately estimating implicit costs, particularly opportunity costs. 10Unlike explicit costs, which are tangible and easily recorded, implicit costs are hypothetical and often difficult to quantify precisely. For example, determining the exact salary an entrepreneur could earn elsewhere, or the precise return on alternative investments, involves assumptions that can introduce subjectivity and variability into the calculation. 9This makes economic profit less reliable as an external, auditable measure compared to accounting profit.
Critics also argue that while economic profit provides a valuable internal decision-making tool, it may not encompass all important financial aspects or capture the full complexity of a company's financial performance. 8Furthermore, a strong focus on maximizing economic profit could, in some scenarios, lead to short-term decisions that overlook long-term strategic goals or broader societal impacts, although this is more a critique of misapplication than the concept itself.
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Lastly, specific applications like EVA, while robust, require numerous adjustments to traditional accounting figures (e.g., capitalizing research and development costs that GAAP might expense) to provide a more "economic" view. These adjustments can be complex and are not universally agreed upon, potentially leading to different results depending on the methodology applied.
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Economic Profit vs. Accounting Profit
Economic profit and accounting profit are both measures of profitability, but they differ fundamentally in the types of costs they consider. This distinction is crucial for understanding a business's true financial performance.
| Feature | Economic Profit | Accounting Profit |
|---|---|---|
| Costs Considered | Explicit costs + Implicit costs (opportunity costs) | Explicit costs only (direct, out-of-pocket expenses) |
| Purpose | Internal decision-making, strategic planning, resource allocation, value maximization. | External reporting, tax purposes, financial statements. |
| Focus | True economic viability and efficiency, long-term sustainability. | Historical financial performance, short-term profitability. |
| Calculation | Total Revenue - (Explicit Costs + Implicit Costs) | Total Revenue - Explicit Costs |
| Result Interpretation | Positive means resources are earning more than their next best alternative; zero means normal profit; negative means resources could be better used elsewhere. | Positive means revenue exceeds out-of-pocket expenses; negative means expenses exceed revenue. |
| Flexibility | More conceptual and flexible, involving estimations. | Based on standardized accounting rules (e.g., GAAP, IFRS). |
The confusion between the two often arises because accounting profit is what is typically reported in a company's income statement and used for tax purposes. However, economic profit offers a more comprehensive internal perspective by ensuring that a business is not only covering its direct expenses but also generating a return that justifies the use of its own resources, especially when compared to alternative uses.
FAQs
What is the primary difference between economic profit and accounting profit?
The primary difference is that economic profit includes both explicit costs (like wages and rent) and implicit costs (the opportunity cost of using resources), while accounting profit only considers explicit costs. Economic profit gives a truer picture of a business's financial performance by factoring in what could have been earned elsewhere.
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Why is opportunity cost so important in economic profit?
Opportunity cost is crucial because it accounts for the value of the best alternative forgone when a choice is made. By including it, economic profit helps a business determine if its current operations are the most efficient use of its resources, or if those resources could generate a higher return in a different venture.
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Can a business have a positive accounting profit but a negative economic profit?
Yes, this is possible. A business might have positive accounting profit, meaning its revenues exceed its explicit costs. However, if the implicit costs (like the owner's forgone salary or capital's alternative return) are higher than the accounting profit, the economic profit would be negative. This indicates that while the business is making money on paper, its resources could be better allocated elsewhere to generate more value.
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What does "zero economic profit" mean?
Zero economic profit, also known as normal profit, means that a business is covering all its explicit and implicit costs. It is earning just enough to compensate all factors of production, including the owner's time and capital, at their next best alternative use. While it might sound like no profit, it signifies that the business is viable and sustainable in the long run, as it is providing competitive returns for all resources used.
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How does economic profit influence business decisions?
Economic profit influences business decisions by providing a clear signal about whether a venture is truly creating value. If a project yields a positive economic profit, it suggests it's a worthwhile undertaking. Conversely, a negative economic profit encourages managers to reassess strategies, reallocate resources, or even consider exiting a market to pursue more profitable alternatives, ensuring efficient capital allocation and maximizing overall value.1