What Is Economic Profit?
Economic profit is a financial metric that measures the true profitability of a business by accounting for both the explicit and implicit costs of production. Unlike traditional accounting profit, which only considers direct, out-of-pocket expenses, economic profit provides a more comprehensive view by also factoring in the Opportunity Cost of using resources. This concept is fundamental to Managerial Economics and helps firms make optimal strategic decisions by evaluating whether their resources are being utilized in their most valuable alternative use. A positive economic profit indicates that a firm is generating returns that exceed what could have been earned by investing its resources elsewhere.
History and Origin
The concept of profit has been a subject of economic inquiry for centuries, evolving significantly with different schools of thought. Early classical economists viewed profit as a return to capital or a reward for risk-taking. However, the more nuanced understanding of economic profit, which explicitly incorporates implicit costs and opportunity costs, gained prominence with the development of neoclassical economics.
A key figure in this development was Alfred Marshall, whose seminal work, Principles of Economics (1890), laid much of the groundwork for modern microeconomics. While Marshall's primary focus was on supply and demand and market equilibrium, his analysis of costs and returns implicitly contributed to distinguishing between different forms of profit, paving the way for the explicit definition of economic profit as distinct from accounting profit.10, The idea of "normal profit" as the minimum return necessary to keep resources in their current use is closely tied to the concept of zero economic profit in a perfectly competitive long-run equilibrium.
Key Takeaways
- Economic profit considers both explicit and implicit costs, including opportunity costs.
- It provides a more accurate assessment of a firm's true profitability and efficiency in Resource Allocation.
- A positive economic profit signifies that a business is earning more than its alternative investments.
- In a state of Perfect Competition, firms tend toward zero economic profit in the long run.
- Economic profit is a crucial tool for internal decision-making, guiding investment and operational strategies.
Formula and Calculation
Economic profit is calculated by subtracting both explicit and implicit costs from total Revenue. The key differentiator is the inclusion of implicit costs, which are typically unrecorded in standard financial statements.
The formula for economic profit is:
Alternatively, when considering the return on capital, a related concept known as Economic Value Added (EVA) is often used, particularly in corporate finance. EVA is a specific measure of economic profit trademarked by Stern Stewart. Its formula is:
Where:
- (\text{NOPAT}) = Net Operating Profit After Tax (NOPAT)
- (\text{Invested Capital}) = The total capital employed in the business.
- (\text{WACC}) = Weighted Average Cost of Capital (WACC), representing the average rate of return a company expects to pay to all its capital providers.
The capital charge (Invested Capital (\times) WACC) in the EVA formula effectively represents the Cost of Capital, which includes the opportunity cost of the Capital invested.
Interpreting the Economic Profit Indicator
Interpreting economic profit goes beyond simply looking at whether a number is positive or negative; it provides insights into a firm's true value creation. A positive economic profit indicates that the business is not only covering all its Explicit Costs (such as wages, rent, and materials) but also exceeding the returns that could have been earned by employing its capital and other resources in the next best alternative use. This suggests efficient utilization of resources and potential for long-term sustainability.9
Conversely, a zero economic profit means that the firm is earning just enough to cover all its explicit and implicit costs. While this might appear concerning from an accounting perspective, it implies that the business is earning a "normal profit"—sufficient to keep its resources employed in their current activity, as they are generating a return equivalent to their opportunity cost. A negative economic profit, also known as an economic loss, signals that the firm's resources could be better utilized elsewhere, as the current venture is not even covering its total economic costs. S8uch a result might prompt a strategic review or even a reallocation of resources to more profitable ventures.
Hypothetical Example
Consider "GreenGrow Landscaping," a small business owned and operated by Alex. In a year, GreenGrow generates $150,000 in Revenue from its landscaping services.
Its explicit costs (e.g., wages for employees, equipment maintenance, fuel, supplies) total $90,000.
GreenGrow's accounting profit would be:
( $150,000 - $90,000 = $60,000 )
Now, let's consider the implicit costs. Alex invested $100,000 of his personal savings into the business. If he had invested this money in a diversified index fund, he could have earned an average return of 8% per year. This represents an Opportunity Cost of his capital:
( $100,000 \times 0.08 = $8,000 )
Additionally, Alex could have earned a salary of $50,000 managing a similar landscaping firm for someone else, which is the opportunity cost of his entrepreneurial labor.
Total implicit costs = ( $8,000 \text{ (capital opportunity cost)} + $50,000 \text{ (labor opportunity cost)} = $58,000 )
Now, let's calculate GreenGrow's economic profit:
( \text{Economic Profit} = $150,000 \text{ (Revenue)} - ($90,000 \text{ (Explicit Costs)} + $58,000 \text{ (Implicit Costs)}) )
( \text{Economic Profit} = $150,000 - $148,000 )
( \text{Economic Profit} = $2,000 )
In this scenario, GreenGrow Landscaping has an economic profit of $2,000. This positive economic profit indicates that Alex is not only covering all his out-of-pocket expenses but also earning slightly more than what he could have achieved by pursuing his next best alternatives for his time and capital. This suggests that continuing to operate GreenGrow Landscaping is an economically sound decision.
Practical Applications
Economic profit serves as a powerful analytical tool across various domains, offering a more robust measure of true Financial Performance than traditional accounting metrics.
- Investment Decisions: Businesses employ economic profit, often in the form of Economic Value Added (EVA), to evaluate potential investments and projects. By comparing the economic profit generated by different opportunities, firms can make informed Resource Allocation decisions, prioritizing those that truly create value beyond the cost of their capital., 7C6ompanies aim for positive EVA, as it signifies that investments are generating returns exceeding their associated Cost of Capital. This metric is used in capital budgeting processes to assess whether a project will contribute to long-term Shareholder Value.
5* Performance Measurement and Incentives: Many large corporations utilize economic profit internally as a key performance indicator. Linking management compensation and bonuses to economic profit incentivizes executives to align their decisions with value creation, rather than solely focusing on accounting profits that might not reflect the true cost of doing business. This aligns management interests with those of shareholders.
4* Strategic Planning: Economic profit guides strategic planning by highlighting which business units or product lines are genuinely profitable after accounting for the full cost of capital. This helps companies identify areas of value creation or destruction, informing decisions about divestment, expansion, or restructuring. The use of economic profit facilitates a Value-Based Management approach.
- Market Analysis and Regulation: In Microeconomics, economic profit plays a crucial role in understanding market structures. In a theoretical long-run equilibrium under Perfect Competition, firms are expected to earn zero economic profit, as any positive economic profit would attract new entrants, driving down prices until only normal profit remains. Conversely, persistent positive economic profits can indicate market inefficiencies or the presence of market power, such as in a Monopoly or oligopoly. Regulatory bodies and antitrust economists may consider economic profit when assessing market competitiveness. The consulting firm Stern Stewart, which developed EVA, has championed its use for four decades, reflecting its enduring relevance in financial analysis. Stern Value Management
Limitations and Criticisms
While economic profit offers a more complete picture of profitability, its application is not without challenges and criticisms.
One significant limitation is the inherent difficulty in accurately estimating Implicit Costs, particularly the opportunity cost. Unlike Explicit Costs which are recorded in financial statements, implicit costs are often subjective and require assumptions. For example, determining the precise opportunity cost of an entrepreneur's time or the alternative return on invested capital can be challenging and may introduce bias into the calculation.
3Furthermore, calculating economic profit, especially for large and complex organizations, can be intricate due to the extensive adjustments required for Net Operating Profit After Tax (NOPAT) and Capital to align with economic rather than accounting principles. These adjustments might include reclassifying certain expenses or revaluing assets. T2his complexity can deter some companies from adopting it or lead to inconsistencies in measurement.
Another criticism is that economic profit, like many quantitative metrics, may not fully capture qualitative factors such as brand strength, customer loyalty, or innovation potential. A company with a low or even negative economic profit in the short term might have significant growth prospects or be investing heavily in intangible assets that will yield substantial returns in the future, which traditional economic profit calculations may not adequately reflect.
Economic Profit vs. Accounting Profit
The primary distinction between economic profit and accounting profit lies in the treatment of costs.
| Feature | Economic Profit | Accounting Profit |
|---|---|---|
| Costs Considered | Both Explicit Costs and Implicit Costs (Opportunity Costs) | Only Explicit Costs (out-of-pocket expenses) |
| Formula | Revenue - (Explicit Costs + Implicit Costs) | Revenue - Explicit Costs |
| Purpose | Internal decision-making, Resource Allocation, true profitability assessment | External reporting, tax calculation, compliance |
| Result | Typically lower than accounting profit due to implicit costs | Often higher than economic profit as it ignores implicit costs |
| Perspective | Economic efficiency and optimal resource utilization | Historical financial performance and legal/tax obligations |
Accounting profit is the more commonly reported figure, appearing on a company's income statement and reflecting the profitability based on generally accepted accounting principles. It provides a straightforward measure of a business's financial return on paper. Economic profit, on the other hand, delves deeper by considering the forgone benefits of alternative investments. It aims to reveal whether a business is truly creating wealth for its owners beyond what they could have earned elsewhere with similar risk. If a firm shows a positive accounting profit but zero or negative economic profit, it suggests that while it's making money, it's not the most efficient use of its total capital.
1## FAQs
Why is economic profit considered a better measure of profitability than accounting profit?
Economic profit is considered a better measure because it includes all costs, both explicit and Implicit Costs, providing a more accurate assessment of a business's true Financial Performance and efficiency in using its resources. It answers whether the business is truly creating value for its owners beyond their next best alternative.
Can a company have a positive accounting profit but a negative economic profit?
Yes, a company can have a positive accounting profit while simultaneously having a negative economic profit. This occurs if the explicit costs are covered by revenue, but the implicit costs (like the Opportunity Cost of the owner's time or invested capital) are not. In such a scenario, the business is profitable on paper but not generating enough return to justify keeping its resources in that specific venture compared to alternative uses.
Does economic profit apply to all types of businesses?
The concept of economic profit applies to all types of businesses, from sole proprietorships to large corporations. While its calculation might be more complex for larger entities due to diverse operations and capital structures, the underlying principle of comparing returns to both explicit and implicit costs remains relevant for any economic decision-making process involving Capital allocation.