Skip to main content
diversification.com
← Back to E Definitions

Economic return

What Is Economic Return?

Economic return is a financial metric that calculates the profit generated by a business or investment after accounting for both explicit costs and implicit costs, including the opportunity cost of the capital employed. Unlike traditional financial performance measures such as accounting profit, economic return provides a more comprehensive view of profitability by considering all costs, whether they involve direct cash outlays or represent the foregone earnings from alternative uses of resources. It is a key concept within managerial economics, guiding decision-making and highlighting the true economic viability of an enterprise or project. Economic return helps businesses and individuals assess whether their chosen course of action is truly generating value above and beyond what could have been earned by pursuing the next best alternative.

History and Origin

The concept of economic return, with its emphasis on opportunity cost, has roots in classical and neoclassical economic thought. Early economists wrestled with defining profit beyond mere accounting surpluses, recognizing that the "true" cost of production included not just monetary outlays but also the value of resources used that could have been employed elsewhere. Frank Knight, a prominent economist, significantly contributed to the understanding of profit in his 1921 work, "Risk, Uncertainty, and Profit." He posited that profit, in an economic sense, arises primarily from the entrepreneur's ability to bear uninsurable risk and uncertainty, differentiating it from returns to capital or labor.4 This intellectual lineage paved the way for distinguishing between accounting profit, which focuses on historical, explicit costs, and economic return, which incorporates the more nuanced and forward-looking consideration of foregone opportunities and the cost of capital.

Key Takeaways

  • Economic return considers both explicit (out-of-pocket) and implicit (opportunity) costs to provide a holistic view of profitability.
  • A positive economic return indicates that an investment or business is generating more value than its total costs, including the value of the next best alternative.
  • It serves as a critical tool for strategic decision-making, helping to allocate capital and resources efficiently.
  • Economic return is fundamental to understanding whether a firm is earning more than a normal profit and can sustain itself in the long run within competitive markets.

Formula and Calculation

The formula for economic return accounts for both explicit and implicit costs.

Economic Return = Total Revenue - Explicit Costs - Implicit Costs

Alternatively, it can be expressed as:

Economic Return = Accounting Profit - Implicit Costs

Where:

  • Total Revenue represents the total income generated from sales of goods or services.
  • Explicit Costs are direct, out-of-pocket expenses incurred in running a business, such as wages, rent, raw materials, and utility payments.
  • Implicit Costs are the opportunity costs of resources owned by the firm and used in production, for which no direct payment is made. This includes the foregone income from the owner's time or the return on capital if it were invested elsewhere.
  • Accounting Profit is the total revenue minus total explicit costs.

For example, if a business generates $500,000 in revenue, incurs $300,000 in explicit costs, and the owner could have earned $100,000 managing another company (an implicit cost), the economic return would be:

Economic Return = $500,000 - $300,000 - $100,000 = $100,000

Interpreting the Economic Return

Interpreting economic return is crucial for evaluating the true effectiveness of resource allocation and investment strategies. A positive economic return indicates that a business or project is not only covering all its explicit expenses but is also generating a return that exceeds what could have been earned from the best alternative use of its resources. In essence, the firm is creating true economic value. Conversely, a zero economic return, often referred to as normal profit, suggests that the business is covering all its costs, both explicit and implicit, but is not outperforming the next best alternative use of its resources. A negative economic return signifies that the resources employed could generate greater value elsewhere, implying that the current venture is economically inefficient or unsustainable in the short run. Understanding economic return helps stakeholders make informed choices about where to direct their resources for maximum overall benefit.

Hypothetical Example

Consider a software developer who decides to start their own mobile application company.

  • Scenario: The developer previously earned a salary of $120,000 per year at a tech firm (this is an implicit cost—the opportunity cost of their labor). They invest $50,000 of their savings into the new company, which could have earned a 5% annual return ($2,500) in a low-risk bond (another implicit cost—the opportunity cost of their capital).
  • First Year Results:
    • Total Revenue: $250,000
    • Explicit Costs (rent, salaries for employees, marketing, software licenses): $100,000
  • Calculation:
    1. Calculate Accounting Profit: $250,000 (Revenue) - $100,000 (Explicit Costs) = $150,000
    2. Identify Implicit Costs: $120,000 (foregone salary) + $2,500 (foregone bond interest) = $122,500
    3. Calculate Economic Return: $150,000 (Accounting Profit) - $122,500 (Implicit Costs) = $27,500

In this hypothetical example, the software developer's company generated a positive economic return of $27,500. This indicates that their entrepreneurial venture is not only profitable in accounting terms but is also a more financially beneficial choice than their next best alternatives, considering the value of their time and capital. This positive economic return provides a strong incentive for the developer to continue and potentially expand their business.

Practical Applications

Economic return is a vital tool across various financial and business contexts, influencing strategic profit maximization and financial performance analysis. Businesses use it to evaluate the true profitability of new projects, product lines, or mergers and acquisitions. By considering all costs, including the implicit ones, firms can make better capital budgeting decisions. Investors, too, leverage the concept when assessing companies, understanding that a business earning a positive economic return is likely to be sustainable and attractive in the long run, even if its accounting profits appear modest. Furthermore, the concept underpins economic policy discussions, especially regarding the efficient allocation of national resources and the impact of regulations on business viability. For instance, empirical research on the return to capital in different countries utilizes this broader perspective to understand why capital might or might not flow to certain regions, even if traditional investment returns appear similar.

##3 Limitations and Criticisms

While economic return offers a more comprehensive measure of profitability than accounting profit, it is not without limitations. The primary challenge lies in accurately quantifying implicit costs. Assigning a precise monetary value to foregone opportunities, such as the salary an entrepreneur could have earned elsewhere or the alternative return on owned assets, can be subjective and difficult. This inherent subjectivity can lead to variations in economic return calculations, making direct comparisons between different analyses potentially challenging. Furthermore, the concept relies on the accurate identification of the "next best alternative," which itself can be a complex exercise. As a result, while the theoretical framework of economic return is robust, its practical application requires careful judgment and a deep understanding of all relevant costs and opportunities. Understanding the distinction between accounting and economic profit, particularly regarding the role of implicit costs, is crucial for a complete financial picture.

##2 Economic Return vs. Accounting Profit

The distinction between economic return and accounting profit is fundamental in financial analysis. Accounting profit is a straightforward calculation: it is the total revenue minus all explicit costs. Explicit costs are direct, out-of-pocket expenses such as wages, rent, utilities, and raw materials. This measure is crucial for financial reporting, tax purposes, and understanding a business's short-term financial health.

In contrast, economic return takes into account both explicit and implicit costs. Implicit costs are the opportunity costs of resources already owned by the firm, for which no direct monetary payment is made. For example, the foregone income an entrepreneur could have earned working for someone else, or the interest that could have been earned on capital invested in the business, are implicit costs. The inclusion of these opportunity costs means that economic return provides a more holistic view of profitability, reflecting whether a business is truly creating economic value beyond what could be achieved in its next best alternative. While a business can have a positive accounting profit, it may have a zero or negative economic return if its implicit costs are high, meaning its resources could be more profitably employed elsewhere. This concept is closely tied to opportunity cost, which is the value of the next best alternative that was not taken when a decision was made.

##1 FAQs

What is the main difference between economic return and accounting profit?

The main difference is that economic return includes both explicit and implicit costs, while accounting profit only considers explicit costs. Implicit costs are the opportunity costs of using resources already owned, like the salary an owner could earn elsewhere.

Why is economic return important for businesses?

Economic return is important because it provides a more accurate picture of a business's true profitability and efficiency. It helps businesses make better resource allocation decisions by showing if their current operations are generating more value than alternative uses of their resources.

Can a business have a positive accounting profit but a negative economic return?

Yes, absolutely. A business can have a positive accounting profit if its revenues exceed its explicit costs. However, if the implicit costs (like the owner's foregone salary or the return on invested capital from an alternative investment) are higher than the accounting profit, the economic return will be negative. This indicates that the resources could be used more profitably elsewhere.

Is economic return used in financial statements?

No, economic return is typically a theoretical concept used for internal decision-making and analysis, not for official financial statements. Financial statements are based on accounting principles, which focus on explicit, verifiable transactions.