When it comes to measuring the success of a business, there are two types of profits that are commonly used: economic profit and accounting profit. Though both are useful in their own ways, they have distinct differences that are important to understand.
What is Accounting Profit?
Accounting profit is the most basic measure of a company’s profitability. It is calculated by subtracting the total expenses from total revenue. This includes all costs associated with running the business, such as salaries, rent, utilities, and supplies. Accounting profit is usually reported on a company’s income statement and is used for tax purposes and to determine dividends for shareholders.
What is Economic Profit?
Economic profit takes into account the opportunity cost of doing business. It is calculated by subtracting all explicit and implicit costs from total revenue. Explicit costs are the same as accounting costs and include all the expenses associated with running the business. Implicit costs, on the other hand, are the opportunity costs of forgoing other opportunities to pursue the business. This includes the cost of capital and the owner’s salary. Economic profit is a more accurate measure of a company’s profitability because it takes into account the full cost of doing business.
The Differences between Economic Profit and Accounting Profit
Though both economic profit and accounting profit are measures of a company’s financial success, they differ in several ways:
- Economic profit takes into account implicit costs, while accounting profit only considers explicit costs.
- Economic profit includes the opportunity cost of doing business, while accounting profit does not.
- Economic profit is a more accurate reflection of a company’s profitability, while accounting profit is a more basic measure.
- Economic profit is often lower than accounting profit because it accounts for all costs, including opportunity costs.
Why is Economic Profit Important?
Economic profit is important because it gives a more accurate measure of a company’s financial success. It takes into account the opportunity cost of doing business, which is often ignored in accounting profit. By including implicit costs, economic profit provides a more realistic picture of a company’s profitability and helps business owners make better decisions about their future.
Though both economic profit and accounting profit are useful in their own ways, economic profit is the more accurate measure of a company’s financial success. It takes into account all costs associated with doing business, including opportunity costs, and provides a more realistic picture of a company’s profitability. By understanding the differences between economic profit and accounting profit, business owners can make better decisions about their future and ensure their success for years to come.
