Profit is a key metric used to assess a business's performance. It shows how much money a company earns after paying for expenses such as supplies, salaries, and taxes. However, there are two types of profit that people often discuss: Accounting Profit and economic profit. This blog will cover all about accounting, economics, and zero economic profit. Let us get started.
Key Points:
- Profit means the money a business makes after covering its costs.
- Economic Profit includes both real costs and hidden opportunity costs.
- Accounting Profit is just revenue minus the usual business expenses.
- To find Economic Profit, you subtract both explicit and implicit costs from total revenue.
- Businesses report Accounting Profit on income statements and for tax purposes.
Economic Profit – Easy Explanation
Economic Profit goes a step further. It also examines opportunity costs—this refers to the value of what the company gave up by using its resources in a certain way. So, it includes both regular (explicit) costs and hidden (implicit) costs.
Economic Profit is a way to see if a business is using its resources in the best way.
It looks at:
- Revenue (money the business makes)
- Explicit costs (actual business expenses like rent, wages, etc.)
- Implicit costs (what the business gave up, like other ways it could have used its money or time)
Simple Formula:
Economic Profit = Revenue – (Explicit Costs + Implicit Costs)
Example:
A paper company uses its own trees to make paper. If it could have sold the trees for money instead, that missed income is an implicit cost.
So, even if a business is making money, Economic Profit indicates whether it could have generated more by pursuing an alternative course of action.
It helps businesses choose the most effective way to utilize their time, money, and resources.
Accounting Profit (in simple terms)
Accounting Profit is the money a company has left after subtracting all the regular costs of running the business, like rent, wages, and materials. This is the profit you usually see on a company’s income statement and what they report to the tax office.
Accounting profit only considers actual, direct costs—expenses the company pays for directly, such as bills and salaries. These are called "explicit costs." It does not include other types of costs that contribute to economic profit.
A company can show a good accounting profit but still have zero economic profit if all its income is used to cover both its direct and opportunity costs. While accounting profit helps track a company's financial performance, it doesn't always provide the complete picture, as economic profit does.
Key Differences
- Economic profit and accounting profit are two distinct measures of a business's performance.
- Accounting profit is the actual money a company makes after paying all the clear and obvious costs, like employee wages, rent, and bills. This is the kind of profit businesses report to the IRS for taxes.
- Economic profit, on the other hand, also includes hidden or "what-if" costs. These are the things a business gives up when choosing one option over another, like choosing to rent a building instead of using it for something else. So, economic profit helps measure how well a company is using its resources.
- If a business earns zero economic profit, it means it is covering all its costs, including both the actual ones and the hidden ones. This doesn't mean the business is doing badly — it just means it's doing as well as it could with its current choices. Businesses often use economic profit to decide if they should stay in a market or try something new.
Key Differences Between Economic Profit and Accounting Profit
Economic profit and accounting profit show business earnings in different ways. Accounting profit is the money a business makes after subtracting its direct, out-of-pocket costs—such as salaries, rent, and materials. It follows official accounting rules (like GAAP), so it's clearly calculated, recorded in financial statements, and reported to tax authorities.
In contrast, economic profit also takes into account hidden or opportunity costs—such as what the business owner could have earned by using their time or money elsewhere. Since these costs are not always obvious, economic profit is based on estimates and isn't reported on official documents. While accounting profit shows financial performance, economic profit gives a deeper look into how well a business is really doing.
What’s the Difference Between Zero Accounting Profit and Zero Economic Profit?
Zero economic profit (also called normal profit) means a business is covering all its costs — both the obvious ones like rent and wages (called explicit costs) and the hidden ones like what the owner could have earned doing something else (called implicit costs). The business isn’t making extra profit, but it’s not losing money either. It’s just breaking even.
On the other hand, zero accounting profit means the business is actually losing money. It shows that the company’s total costs exceed the money it generates in revenue, so it’s not even covering its basic expenses.
How to Calculate Accounting Profit?
To figure out accounting profit, you take the total money a business earns (revenue) and subtract all the actual costs it had to pay. These costs can include things like materials, employee salaries, rent, and electricity bills. This profit is typically reported in the company’s financial statements, but businesses may occasionally calculate it differently for their own purposes.
Is Accounting Profit More Than Economic Profit?
Most of the time, accounting profit exceeds economic profit. This is because economic profit includes opportunity costs—what a business gives up by choosing one option over another. For example, if a company has $100,000 to invest and picks one project instead of another, the money it could have earned from the option it didn’t choose is counted as a cost in economic profit, but not in accounting profit. So, accounting profit usually shows fewer costs. However, in some cases, avoiding certain costs can also lower accounting profit, depending on the situation.
Why Is Economic Profit Better Than Accounting Profit?
Economic profit is often considered better than accounting profit because it gives a bigger picture of a company’s performance. Unlike accounting profit, which adheres to strict accounting rules, economic profit encompasses all business decisions—both those made and those not taken. It also looks at what the company gave up by choosing one option over another. This makes economic profit more comprehensive and helpful for understanding how well a company is actually performing.
The Bottom Line
There are various methods for determining a company's profit. Most experts examine accounting profit, which is the money a company earns after deducting its expenses, based on standard accounting principles. These expenses are usually clearly listed. Another method is economic profit, which also includes hidden or indirect costs—things that may not be reflected in the company’s records but still impact the profitability of a decision.
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