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What Is Economic Profit?

Economic profit is a financial metric that calculates the difference between a company's total revenue and the total costs, including both explicit and implicit costs. Unlike accounting profit, which considers only direct, out-of-pocket expenses, economic profit provides a more comprehensive view of a firm's true profitability by factoring in the opportunity cost of all resources used. This measure is central to performance measurement within corporate finance, aiming to assess whether a business is generating value above the minimum required return for its invested capital. Understanding economic profit helps stakeholders determine if a company is truly creating value creation for its owners, rather than just covering its explicit expenses.

History and Origin

The concept of economic profit has roots in classical economics, distinct from how accountants view profitability. Early economists, such as Alfred Marshall, laid the groundwork by emphasizing the importance of considering the "normal" return on capital, which represents the minimum return necessary to keep resources employed in a particular venture. This idea recognizes that capital, like any other resource, has an opportunity cost – the return it could earn in its next best alternative use.

²⁰The more formalized application and popularization of economic profit in modern corporate finance, particularly as a performance metric for businesses, can be largely attributed to the development of Economic Value Added (EVA). While the underlying principles were discussed earlier, the consulting firm Stern Stewart & Co. developed and copyrighted the term Economic Value Added (EVA) in the early 1980s. S¹⁸, ¹⁹tern Stewart & Co. championed EVA as a tool to measure true economic performance and align management incentives with shareholder value maximization. T¹⁶, ¹⁷his approach aimed to overcome the limitations of traditional accounting measures by explicitly deducting a charge for the use of capital, reflecting its opportunity cost.

¹⁴, ¹⁵## Key Takeaways

• Economic profit accounts for both explicit (out-of-pocket) and implicit (opportunity) costs.
• A positive economic profit indicates that a business is generating more than the minimum required return on its capital, effectively creating value.
• It offers a more complete picture of a firm's financial health and efficiency than accounting profit alone.
• Economic profit is a crucial metric for evaluating capital allocation decisions and strategic investments.
• It is often associated with value-based management frameworks, such as Economic Value Added (EVA).

Formula and Calculation

The calculation of economic profit extends beyond the simple subtraction of explicit costs from revenue. It requires identifying and quantifying implicit costs, especially the cost of capital. A common formulation, particularly in the context of Economic Value Added (EVA), involves adjusting Net Operating Profit After Tax (NOPAT) by a capital charge.

The basic formula for economic profit is:

Alternatively, relating it to accounting profit:

A widely used method, particularly for publicly traded companies or large internal divisions, calculates economic profit as:

Where:

• NOPAT (Net Operating Profit After Tax) represents the profit a company generates from its core operations after deducting taxes but before considering any financing costs.
• Invested Capital is the total capital deployed in the business, which can be approximated as the sum of interest-bearing debt and equity, or total assets minus non-interest-bearing current liabilities.
• WACC (Weighted Average Cost of Capital) is the average rate of return a company expects to pay to all its capital providers (debt and equity) for using their funds. It serves as the implicit cost or required rate of return on the invested capital.

Interpreting Economic Profit

Interpreting economic profit involves assessing whether a business is truly adding value above and beyond what its capital could earn elsewhere. A positive economic profit signifies that the firm is earning more than its opportunity cost of capital, indicating that the business is creating wealth for its owners. This suggests efficient utilization of resources and successful strategic decisions.

¹³Conversely, a zero economic profit implies that the company is earning just enough to cover all its costs, both explicit and implicit. While this is often referred to as a "normal profit" in economics and would typically mean the business is sustainable, it indicates no additional wealth creation beyond the required return. A negative economic profit means the business is not even covering its total costs, including the opportunity cost of its capital, and is effectively destroying value. Investors and managers use this metric to evaluate the efficacy of capital budgeting decisions and to ensure that resources are allocated to projects yielding returns greater than their minimum acceptable rate.

Hypothetical Example

Consider "GreenTech Innovations Inc.," a startup focused on developing sustainable energy solutions. The company's founders invested $1,000,000 of their own savings into the business. If they had invested this capital in a diversified market index fund, they could have reasonably expected an annual return of 8%. This 8% represents the implicit cost of their capital.

In its first year, GreenTech Innovations Inc. generated $500,000 in revenue. Its explicit costs, including salaries, rent, and materials, totaled $400,000.

1. Calculate Accounting Profit:
   Accounting Profit = Total Revenue - Explicit Costs
   Accounting Profit = $500,000 - $400,000 = $100,000

2. Calculate Implicit Cost:
   Implicit Cost = Invested Capital × Opportunity Cost of Capital
   Implicit Cost = $1,000,000 × 0.08 = $80,000

3. Calculate Economic Profit:
   Economic Profit = Accounting Profit - Implicit Costs
   Economic Profit = $100,000 - $80,000 = $20,000

In this hypothetical example, GreenTech Innovations Inc. generated an economic profit of $20,000. This positive economic profit indicates that the company not only covered all its explicit expenses but also generated a return that exceeded what the founders could have earned by investing their capital passively in the market. This suggests the business is successfully creating value beyond the mere accounting profitability.

Practical Applications

Economic profit serves as a powerful analytical tool across various financial domains, moving beyond the superficiality of financial statements to gauge true performance.

• Corporate Performance Evaluation: Companies utilize economic profit to assess the real economic performance of business units, projects, or the entire firm. It encourages managers to make decisions that truly add value by considering the full cost of capital, rather than merely maximizing accounting earnings. Many corporations, including some large multinational entities, have adopted frameworks like EVA to align executive compensation and strategic planning with value creation.
• ¹² Investment Analysis: Investors employ economic profit to evaluate whether a company is generating returns above its cost of capital, signifying sustainable competitive advantage and potential for long-term return on investment (ROI). It helps distinguish between companies that are merely profitable in an accounting sense and those that are truly creating wealth.
• Resource Allocation: Within an organization, economic profit guides the allocation of scarce capital to projects and divisions that are most likely to yield returns exceeding their capital charge. This ensures that resources are deployed efficiently across the enterprise.
• Strategic Decision-Making: For major strategic choices, such as mergers, acquisitions, or significant capital expenditures, economic profit provides a framework to evaluate if the proposed action will genuinely enhance overall firm value after accounting for all costs, including the implicit cost of capital. The Federal Reserve Bank of Boston, for instance, has published research on how banks use economic profit for performance measurement and capital allocation, underscoring its relevance in complex financial institutions.

##¹¹ Limitations and Criticisms

While economic profit offers a more insightful view of value creation than traditional accounting measures, it is not without limitations or criticisms. One primary challenge lies in the accurate calculation of implicit costs, particularly the opportunity cost of capital. Determining the precise Weighted Average Cost of Capital (WACC) can be complex, as it involves estimating the cost of equity, which often relies on assumptions about market risk premiums and betas. Inaccuracies in these inputs can significantly distort the economic profit calculation.

Fu⁹, ¹⁰rthermore, critics argue that despite its theoretical soundness, the practical implementation of economic profit measures like EVA can be challenging for companies lacking sophisticated financial information systems. Small or privately held businesses may find it difficult and costly to gather the detailed data required for a robust economic profit analysis. Som⁸e academics and practitioners also point out that focusing solely on maximizing current economic profit might incentivize short-term decisions, potentially overlooking long-term strategic investments that may initially reduce economic profit but yield substantial future value. For instance, research from the Federal Reserve Bank of San Francisco indicates that supernormal economic profits in the banking industry can be surprisingly long-lived, suggesting that the competitive forces assumed to drive economic profit to zero may not always operate swiftly in real-world scenarios. The⁷refore, while economic profit is a valuable metric, it should be used in conjunction with other performance indicators and a holistic understanding of the business environment.

Economic Profit vs. Accounting Profit

The fundamental distinction between economic profit and accounting profit lies in the treatment of costs, specifically the inclusion of implicit costs.

While accounting profit provides a snapshot of a company's performance based on historical transactions and explicit outlays, economic profit delves deeper. It asks whether the company is earning enough to compensate all capital providers for the risk they undertake and the opportunities they forego by investing in this particular venture. This distinction is crucial for strategic planning and evaluating the true economic viability of a business or project.

FAQs

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

The main difference is that economic profit considers both explicit costs (actual cash outflows) and implicit costs (opportunity costs, like the return on capital that could have been earned elsewhere), while accounting profit only considers explicit costs. This makes economic profit a more comprehensive measure of true value creation.

##⁵, ⁶# Why is economic profit important for businesses?
Economic profit is important because it helps businesses understand if they are truly creating value beyond just covering their operating expenses. By including opportunity costs, it guides managers in making better capital allocation decisions and ensuring that investments yield returns higher than the minimum required by investors. It encourages efficient use of all resources.

##³, ⁴# Can a company have an accounting profit but an economic loss?
Yes, a company can have an accounting profit but an economic loss. This occurs when the accounting profit is positive, but it is not large enough to cover the implicit costs, particularly the opportunity cost of the capital invested. In such a scenario, while the business appears profitable on its books, it is not generating sufficient returns to justify the use of its capital when compared to alternative investments.

Is Economic Value Added (EVA) the same as economic profit?

Economic Value Added (EVA) is a specific type of economic profit. EVA is a trademarked financial performance metric developed by Stern Stewart & Co. that calculates economic profit using a specific formula (NOPAT - (Invested Capital × WACC)). While all EVA is economic profit, not all economic profit calculations strictly adhere to the EVA methodology.

###² How does economic profit relate to a company's stock price?
Economic profit is theoretically linked to a company's market capitalization and shareholder value. When a company consistently generates positive economic profit, it signifies that it is creating value for its shareholders above the cost of their capital. This sustained value creation is often reflected in a higher stock price and increased market value for the firm, as investors recognize the company's superior ability to generate returns.¹