Economic Profit

Posted in Finance, Accounting and Economics Terms, Total Reads: 246

Definition: Economic Profit

Economic Profit is the difference between the revenue generated from the sale of outputs to the opportunity cost of the inputs. Economic profit helps to understand how investments can help in good returns.

Importance of Economic Profit

When a company is deciding on an investment project, it looks at the expected future cash flows of the project and accordingly finds out the Operating Cash Flow. This is the Accounting profit for the company. But the problem is there are too many inputs or variables affecting the process; many which may not be affecting the accounting profit but have impact on the economic profit. In such cases, we need to decide on the opportunity cost and if this is greater than the accounting profit, then the investment is not to be made because there is better investment options using the input. The concept is also useful when comparing different projects. Along with the accounting profit, the economic profit must also be considered for selection because it gives a fair idea of how the inputs (or capital employed) be used for better returns. Profitability is calculated as accounting profit and economic profit. Average profit is calculated basis average revenue and average costs.

Economic Profit

Difference Between Economic Profit and Accounting Profit

In accounting, we calculate different types of profits like Gross Profit, Net Profit and Operating Profit. Another such indicator of profit which takes opportunity cost into account is the Economic Profit. Opportunity cost measures the alternative profit or returns foregone by the use of input in this project. So accounting profit and Economic profit may show completely different pictures.

Economic Profit= Revenue- Opportunity Cost of inputs

Accounting profit measures the actual cash flows and is represented in financial statements of the company. It is for external purpose as the financial statements give an impression of the performance of the company and is the primary handbook for investors. Economic Profit on the other hand is not reflected in any of the company’s financial statements and the purpose is to help internal decision making on investments.

Accounting Profit= Total Revenue- Total Cost (Monetary)

Advantages of Economic Profit

Economic Profit measures the additional revenue that the company will receive if it invests in the alternative project. So it gives a clear cut idea of the gain in the top line of the income statement making projects easily distinguishable.

Disadvantages of Economic Profit

The alternative investment option may not always be feasible even if the opportunity is high. It may be a better investment option but may require additional inputs and capital which may not be available. There are variables which may affect one among the accounting profit and economic profit but no the other. In such cases, the accounting profit may be high but the economic profit be low and vice-versa. Or the project with higher accounting profit may have lower economic profit. In any such case, decision making becomes difficult.

Example of Economic Profit

Let’s say an employee works for a firm for an annual CTC of $100k. He decided to start his own business. Here, employee is the input.

Details of the startup:

Total cost incurred in the year= $150k

Revenue generated in the first year= $300k

Profit made= $150k (Revenue –Cost)

This is the Accounting Profit for the employee.

He left his previous job which earned him $100k. This is the Opportunity Cost.

Actual or effective Profit to the individual= $50k (Accounting Profit-Opportunity Cost)

This is the Economic Profit for the employee.

Suppose the company could use this cost of $150k in an alternative project which gives a revenue of $400k. So, the associated profit would be $250k.

The Economic Profit for the Company= Revenue – Opportunity Cost= $400k – $300k = $100k

Hence, this concludes the definition of Economic Profit along with its overview.

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