Economics and business operations

What Is Economic Profit?

Economic profit represents the difference between a business's total revenue and the sum of its explicit and implicit costs. It is a critical concept within the field of Managerial economics, providing a more comprehensive view of profitability than traditional accounting measures. While accounting profit primarily considers easily quantifiable out-of-pocket expenses, economic profit delves deeper by factoring in the value of forgone opportunities, known as Opportunity cost. This holistic approach helps ascertain whether a business is truly creating value beyond merely covering its expenses. A positive economic profit indicates that a business is generating returns greater than the best alternative use of its resources, suggesting efficient resource allocation and a sustainable business model. Conversely, a negative economic profit implies that resources could be better utilized elsewhere.

History and Origin

The concept of profit, in various forms, has been a central subject in economic thought for centuries. Classical economists, such as Adam Smith and David Ricardo, focused on profit as a return to capital or a residual after wages and rent. However, the more nuanced understanding of "economic profit," specifically differentiating it from accounting profit by including implicit costs, largely emerged with the development of neoclassical economics. A pivotal figure in this evolution was Alfred Marshall, a British economist whose work, Principles of Economics (1890), integrated ideas of supply and demand, marginal utility, and costs of production into a cohesive framework.⁷ Marshall implicitly laid the groundwork for understanding the full cost of doing business, including the concept of "normal profit," which is essentially the implicit cost of capital and entrepreneurship. Economic profit, therefore, can be viewed as any profit earned above this normal profit. The inclusion of opportunity costs in calculating profit reflects a more complete understanding of resource allocation and decision-making within a competitive economic landscape.

Key Takeaways

• Economic profit measures a business's true profitability by subtracting both explicit and implicit costs from total Revenue.
• Implicit costs include the Opportunity cost of using resources for one venture instead of their next best alternative.
• A positive economic profit indicates that the business is generating returns higher than what could be achieved by employing the same resources elsewhere.
• Economic profit is a key tool for strategic Decision making and resource allocation, highlighting true value creation.
• Unlike Accounting profit, economic profit is not typically found on standard financial statements but is crucial for internal analysis.

Formula and Calculation

The calculation of economic profit involves subtracting both explicit and implicit costs from total revenue.

The formula for economic profit is:

Alternatively, since Accounting profit is defined as total revenue minus Explicit costs, the formula can also be expressed as:

Where:

• Total Revenue is the total income generated from sales of goods or services.
• Explicit Costs are the direct, out-of-pocket expenses for a business, such as wages, rent, raw materials, and utility payments.
• Implicit Costs are the opportunity costs of resources owned and used by the firm, for which no monetary payment is made. These include the forgone income from alternative uses of the owner's time and capital.

Interpreting the Economic Profit

Interpreting economic profit provides a crucial perspective on a business's true financial viability and strategic effectiveness. A positive economic profit means the business is not only covering all its direct expenses but also generating more value than its resources could in their next best alternative use. This suggests that the enterprise is efficient and sustainable in the long run, attracting or retaining resources because it offers a superior return. For instance, if a company generates an economic profit, it implies that its investors are earning more than their Cost of capital, making it an attractive venture.

Conversely, a zero economic profit (also known as Normal profit) indicates that the business is covering all its explicit and implicit costs. While it might still show a positive accounting profit, it means the firm is earning just enough to retain its resources, as they could earn the same return elsewhere. A negative economic profit, even with a positive accounting profit, signals that the resources employed by the business could generate a higher return in an alternative investment or activity. This situation often prompts businesses to reconsider their strategies, reallocate resources, or even exit a particular market. Understanding economic profit is therefore vital for informed strategic resource allocation and evaluating genuine value creation.

Hypothetical Example

Consider a hypothetical scenario of "GreenThumb Landscaping," a small business owned and operated by Sarah.

Scenario:
Sarah operates her landscaping business as a sole proprietor. In the past year, GreenThumb Landscaping generated $150,000 in total Revenue.

Explicit Costs:

• Wages for employees: $60,000
• Supplies and equipment maintenance: $20,000
• Rent for office and storage: $10,000
• Utilities and other operational expenses: $5,000
  Total Explicit Costs = $60,000 + $20,000 + $10,000 + $5,000 = $95,000

Implicit Costs (Opportunity Costs):

• Sarah's forgone salary: Before starting GreenThumb, Sarah worked as a landscape designer for a larger firm, earning $45,000 per year. This is the income she forgoes by running her own business.
• Forgone interest on invested capital: Sarah invested $30,000 of her personal savings into the business. If she had invested this money in a relatively safe alternative, such as a bond fund, she could have earned a 5% return.
  • Forgone interest = $30,000 * 0.05 = $1,500

Calculation:

1. Calculate Accounting Profit:

   • Accounting Profit = Total Revenue - Explicit Costs
   • Accounting Profit = $150,000 - $95,000 = $55,000

2. Calculate Economic Profit:

   • Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)
   • Economic Profit = $150,000 - ($95,000 + $45,000 + $1,500)
   • Economic Profit = $150,000 - $141,500 = $8,500

Interpretation:
While GreenThumb Landscaping shows a healthy Accounting profit of $55,000, its economic profit is $8,500. This positive economic profit indicates that Sarah's business is genuinely creating value. Even after considering the income she could have earned elsewhere and the return on her invested capital, she is still making a surplus. This suggests that continuing to operate GreenThumb Landscaping is a sound economic choice for Sarah, as her resources are being utilized more effectively than their next best alternative.

Practical Applications

Economic profit is a valuable analytical tool used across various facets of business and economics, extending beyond basic accounting.

• Investment and Capital Allocation: Businesses use economic profit to evaluate the attractiveness of potential projects and to guide Capital allocation. Projects with positive expected economic profit are favored, as they indicate that the venture is likely to generate returns exceeding the cost of all resources, including the opportunity cost of capital. This helps businesses decide where to deploy their limited resources most effectively to maximize value.⁶
• Strategic Decision-Making: For corporate executives, understanding economic profit informs critical strategic choices, such as market entry or exit, product line expansion, or outsourcing decisions. It helps in assessing whether existing business units or proposed strategies are truly creating wealth or if capital could be more profitably employed elsewhere.⁵
• Competitive Analysis and Market Structures: In industries with intense competition, economic theory suggests that competition tends to drive economic profits towards zero in the long run, as firms enter and exit based on profit opportunities. Analyzing economic profit helps gauge the competitiveness of a market and the sustainability of a firm's position within it. Firms that consistently achieve positive economic profit often possess a strong Competitive advantage or operate within favorable Market structures.
• Performance Measurement: Some companies and investors use economic profit, often in the form of Economic Value Added (EVA), as a performance metric to assess how effectively management is utilizing capital. It encourages managers to make decisions that not only increase revenue but also optimize resource use and minimize both explicit and implicit costs.

Limitations and Criticisms

While economic profit offers a more thorough assessment of a business's true financial performance than accounting profit, it also has certain limitations and faces criticisms.

One primary challenge lies in the difficulty of accurately estimating implicit costs, particularly opportunity costs.⁴ Quantifying the "next best alternative" can be highly subjective and complex, as it often involves hypothetical scenarios and requires significant judgment. For instance, determining the exact foregone salary or the precise return on alternative capital investments can be challenging and may introduce bias into the calculation.³ This inherent subjectivity means that economic profit figures can vary significantly depending on the assumptions made, making comparisons across different analyses potentially difficult.

Another criticism is that economic profit, despite its depth, does not always account for all important financial aspects or risk-adjusted returns that may influence a company's long-term success.² While it considers the cost of capital, it may not fully capture the nuances of Risk assessment or the non-financial benefits and drawbacks of a business activity.

Furthermore, a common misunderstanding about economic profit, especially in competitive markets, is that it implies businesses should always operate on the brink of bankruptcy if economic profit trends towards zero.¹ However, economic theory posits that in perfectly competitive markets, firms tend to earn zero economic profit in the long run, which simply means they are earning a "normal profit"—just enough to cover all explicit and implicit costs, including a fair return on capital and entrepreneurial effort. This "zero economic profit" state does not mean the business is unprofitable in an accounting sense, but rather that it is not generating returns above what its resources could earn elsewhere.

Economic Profit vs. Accounting Profit

The distinction between economic profit and Accounting profit is fundamental in economics and business operations. While both measure profitability, they do so from different perspectives and for different purposes.

The key difference lies in the inclusion of implicit costs in economic profit. Accounting profit provides a picture of a company's financial results based on readily quantifiable transactions. However, it does not consider the alternative uses of a company's resources. Economic profit addresses this by factoring in what a firm's capital and entrepreneurial effort could have earned in their next best alternative. Therefore, a business can report a substantial accounting profit but still have zero or negative economic profit if its implicit costs are high. This distinction is crucial for managers and investors seeking to understand the true underlying profitability and sustainability of an enterprise.

FAQs

What does "zero economic profit" mean?

Zero economic profit, also known as Normal profit, means that a business is earning just enough to cover all its explicit costs and its implicit costs. This implies that the business is making a return equivalent to what its resources (capital, labor, etc.) could earn in their next best alternative use. It does not mean the business is losing money or is unprofitable in an accounting sense; rather, it signifies that the firm is breaking even from an economic perspective, covering the Opportunity cost of its resources.

Why is economic profit important for businesses?

Economic profit is crucial for businesses because it provides a more accurate measure of true value creation and resource efficiency. By including implicit costs, it helps managers make better strategic Decision making regarding investments, capital allocation, and market participation. It allows businesses to assess whether they are truly outperforming their next best alternatives and ensures long-term sustainability.

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

Yes, absolutely. This is a common scenario. A business can report a positive Accounting profit (total revenue minus explicit costs) if its revenues exceed its readily recorded expenses. However, if the implicit costs (e.g., the owner's forgone salary, or the interest that could have been earned on invested capital elsewhere) are higher than the accounting profit, the economic profit will be negative. This indicates that while the business is making money, its resources could be generating a higher return in an alternative venture.

How does economic profit relate to competition?

In perfectly competitive markets, economic theory suggests that in the long run, firms tend to earn zero economic profit. This is because the absence of barriers to entry and exit allows new firms to enter if they observe positive economic profits, driving down prices and increasing supply until only Normal profit is earned. Conversely, if firms face negative economic profits, they will exit the market, reducing supply and allowing remaining firms to return to normal profit. This dynamic ensures that resources are allocated efficiently across industries.