What Is Economic Profit?
Economic profit is a crucial financial metric that measures the true profitability of a business or investment by considering both explicit and implicit costs. Unlike standard accounting profit, which only accounts for direct, out-of-pocket expenses, economic profit integrates the concept of opportunity cost, representing the value of the next-best alternative forgone when a particular choice is made. This makes economic profit a fundamental concept within profitability analysis, offering a more comprehensive view of a venture's financial performance. It helps individuals and organizations make informed decision-making by revealing whether resources are being utilized in their most efficient way.
History and Origin
The foundational concept of profit, encompassing what we now understand as economic profit, has deep roots in economic thought. Early economists wrestled with how to define surplus beyond mere production costs. The distinction between accounting profit and economic profit gained clearer definition with the development of neoclassical economics, which formalized the role of opportunity cost. This theoretical framework allowed for a more rigorous assessment of a firm's true economic performance, moving beyond just monetary flows. Modern understanding builds on these historical perspectives, aiming to integrate various aspects of profit, including those related to production surplus and risk-adjusted returns, as discussed in academic discourse on the history and meaning of profits.8
Key Takeaways
- Economic profit measures a business's true profitability by subtracting both explicit and implicit costs from total revenue.
- It incorporates the critical concept of opportunity cost, which represents the value of the best alternative forgone.
- A positive economic profit indicates that a business is generating returns greater than it could from its next-best alternative use of resources.
- In theory, firms in a state of perfect competition tend toward zero economic profit in the long run.
- Understanding economic profit aids in strategic resource allocation and evaluating investment decisions.
Formula and Calculation
The calculation of economic profit involves subtracting both explicit and implicit costs from total revenue.
The formula for economic profit is:
Where:
- Total Revenue represents all income generated from sales, services, or other operations.
- Explicit Costs are the direct, out-of-pocket expenses incurred in running a business, such as wages, rent, raw materials, utilities, and other operating expenses. These are the costs that typically appear on a company's financial statements.
- Implicit Costs represent the opportunity cost of using the firm's own resources (such as capital or owner's time) in its current business rather than in their next-best alternative use. For example, if a business owner uses their own building, the implicit cost would be the rent they could have earned by leasing it to someone else.
Alternatively, economic profit can be expressed as:
Here, accounting profit is simply total revenue minus explicit costs.
Interpreting the Economic Profit
Interpreting economic profit provides deeper insights into a firm's performance beyond what standard financial metrics offer. A positive economic profit signifies that the business is not only covering all its direct expenses but also generating returns that exceed the potential earnings from its next-best alternative use of capital and other resources. This suggests efficient resource allocation and a truly profitable venture.
Conversely, a negative economic profit (an economic loss) indicates that the firm's resources could be better utilized elsewhere, even if it is reporting a positive accounting profit. A zero economic profit, often referred to as normal profit, means the business is earning just enough to cover all its costs, including the opportunity cost of capital, implying no incentive for firms to enter or exit the market in the long run, particularly in a perfectly competitive market structure.7
Hypothetical Example
Consider "Green Thumb Landscaping," a small business owned and operated by Sarah. In a year, Green Thumb Landscaping generates $150,000 in total revenue.
Her explicit costs for the year are:
- Wages for employees: $60,000
- Equipment rental: $10,000
- Supplies: $20,000
- Utilities and office expenses: $5,000
- Total Explicit Costs = $60,000 + $10,000 + $20,000 + $5,000 = $95,000
Sarah's accounting profit would be:
$150,000 (Revenue) - $95,000 (Explicit Costs) = $55,000
Now, let's consider her implicit costs:
- Owner's Salary Opportunity Cost: Sarah could have worked as a landscape manager for a larger company, earning a salary of $70,000 per year.
- Capital Opportunity Cost: Sarah invested $50,000 of her savings into starting Green Thumb Landscaping. If she had invested this money in a diversified portfolio, she could have reasonably expected a 6% return, or $3,000 per year ($50,000 * 0.06).
- Total Implicit Costs = $70,000 + $3,000 = $73,000
To calculate Green Thumb Landscaping's economic profit:
Economic Profit = Accounting Profit - Implicit Costs
Economic Profit = $55,000 - $73,000 = -$18,000
Despite a positive accounting profit of $55,000, Green Thumb Landscaping has an economic profit of -$18,000. This indicates that Sarah's resources (her time and capital) could have earned $18,000 more if she had chosen the next-best alternatives (working as a landscape manager and investing her capital). This negative economic profit suggests that while the business is covering its direct costs, it's not generating sufficient returns to compensate Sarah for the opportunity cost of her entrepreneurial efforts and invested capital.
Practical Applications
Economic profit serves as a powerful analytical tool for businesses and investors seeking to make optimal decision-making and evaluate the true effectiveness of their endeavors. For businesses, it guides strategic resource allocation by highlighting whether a particular project or operation is truly adding value beyond simply covering expenses. Management can use it to compare potential investments, ensuring capital is directed towards ventures that promise the highest returns relative to their cost of capital.
In corporate finance, economic profit is closely related to concepts like Net Present Value (NPV) and Economic Value Added (EVA). Firms often aim to maximize economic profit, which directly correlates with increasing shareholder wealth. For instance, measures like Market Value Added (MVA) are often considered the present value of all future economic profits, providing a direct link between strategic decisions based on economic profit and investor value creation.6 By focusing on economic profit, companies strive for superior profitability that accounts for the full economic cost of their operations.
Limitations and Criticisms
While economic profit provides a more robust measure of true profitability compared to accounting profit, it has several limitations. One primary challenge lies in the subjective nature of estimating implicit costs, particularly the opportunity cost of various resources. Unlike explicit costs which are readily available from financial statements, implicit costs are often theoretical and difficult to quantify precisely. This can lead to variations in calculations and make direct comparisons across different businesses or industries challenging.4, 5
Another criticism is that economic profit is typically calculated for a specific, often short, period, making it less reflective of long-term business sustainability or strategic investments that may not yield immediate economic returns.3 Furthermore, despite its theoretical importance, economic profit is not typically used in official external financial reporting, which limits its utility for external stakeholders like investors and creditors. The reliance on estimated opportunity cost and its absence from traditional accounting frameworks means it often remains an internal analytical tool rather than a universally adopted reporting metric.2
Economic Profit vs. Accounting Profit
The fundamental difference between economic profit and accounting profit lies in the costs they consider. Accounting profit is a straightforward calculation that subtracts only explicit, tangible expenses—such as wages, rent, and material costs—from total revenue. This is the profit figure that appears on a company's income statement and is used for tax purposes and external reporting.
Economic profit, by contrast, takes a broader view. It deducts both explicit costs and implicit costs from total revenue. The crucial addition of implicit costs, which represent the opportunity cost of resources used, provides a more accurate picture of a firm's actual economic performance and its efficiency in resource allocation. As a result, economic profit is almost always less than or equal to accounting profit. While a business can have a positive accounting profit and still have zero or negative economic profit, a positive economic profit indicates that the business is truly outperforming its next-best alternative.
FAQs
What is the primary purpose of calculating economic profit?
The primary purpose of calculating economic profit is to assess the true profitability of a business or investment by factoring in both explicit and implicit costs, especially the opportunity cost of capital and other resources. It helps evaluate whether resources are being used in their most efficient and value-maximizing way.
Can a business have a positive accounting profit but a negative economic profit?
Yes, a business can absolutely have a positive accounting profit but a negative economic profit. This occurs when the accounting profit is not large enough to cover the implicit costs (the opportunity cost of the resources used). In such a scenario, the business is making money, but not as much as it could by pursuing its next best alternative.
Why is opportunity cost so important for economic profit?
Opportunity cost is fundamental to economic profit because it accounts for the value of the best alternative forgone when a particular business decision or investment is made. It ensures that the calculation reflects the full economic cost of using resources, providing a more accurate measure of true profitability and aiding in optimal decision-making. As the St. Louis Fed explains, opportunity cost is "the value of the next-best alternative when a decision is made; it's what is given up."
##1# Is economic profit used in financial statements?
No, economic profit is generally not used in official external financial statements. Financial statements adhere to accounting principles, which primarily focus on explicit, quantifiable transactions. Economic profit, due to its inclusion of subjective implicit costs, is typically an internal analytical tool used for strategic decision-making and performance evaluation.