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Economic Profit vs Accounting Profit Definition
We need to first understand the concept of profit to provide the definitions of economic profit vs accounting profit.
It is important to note that profit is calculated the same way in both economics and accounting. The main difference between profit in accounting and profit in economics lies in the costs included. So first, what is profit? Profit simply consists of all the money spent by the firm subtracted from all the money made by the firm. All the money spent by the firm is referred to as total production costs, and all the money made by the firm is referred to as total revenue. Therefore, profit refers to the total revenue minus the total production costs.
You can think of profit as the extra money made from one's money, as illustrated in Figure 1 below.
Fig. 1 - Profits
Profit is defined as total revenue minus total production cost.
Mathematically, this is written as:
\(Profit=Total\ Revenue\ (TR)-Total\ Producti\ on\ Costs\ (TC)\)
In economic terms, total production costs refer to all the costs the firm incurs to employ inputs. On the other hand, total revenue refers to the quantity of products sold by the firm multiplied by the price per unit of product.
Total cost refers to all costs the firm incurs to employ inputs.
Total revenue refers to the price per product multiplied by the quantity of the product sold.
Mathematically, total revenue is written as:
\(Total\ Revenue=Price\ (P)\times Quantity\ (Q)\)
So, where do we begin to see the difference between economic profit and accounting profit? When we look at what accountants consider as costs and what economists consider as costs!
There are two types of costs: implicit costs and explicit costs. Accountants only look at explicit costs, whereas economists look at both explicit costs and implicit costs. So, what do these costs refer to? Explicit costs simply refer to the money we give out to acquire a good, whereas implicit costs refer to costs that do not require giving out money.
The concept of implicit costs can be confusing, so let's explain it with an example.
Kris is a trained video editor who can work as a video editor for $50 per hour. However, he currently works as a delivery guy, and this means each hour he works as a delivery guy comes at an implicit cost of $50.
An explicit cost refers to an outlay of money.
An implicit cost refers to an input cost that does not require an outlay of money.
Now that we have defined the types of costs in economics, we can go ahead and differentiate between economic profit and accounting profit. Accounting profit refers to total revenue minus explicit costs. On the other hand, economic profit refers to total revenue minus explicit cost and minus implicit cost.
Accounting profit refers to total revenue minus explicit cost.
What about economic profit?
Economic profit refers to total revenue minus total explicit costs and minus total implicit costs.
Here, economists subtract both explicit cost and total implicit cost from the total revenue. By doing this, economists are subtracting the opportunity cost from the total revenue. This is because opportunity cost includes everything the firm has to forgo to produce goods. So, this includes both outlays of money (explicit costs) and costs that do not require an outlay of money (implicit costs). Since opportunity cost includes everything the firm forgoes, economists say that opportunity cost includes all implicit and explicit monetary and non-monetary costs.
Opportunity cost refers to all the benefits the firm forgoes to produce a good.
Let's explain opportunity cost using an example.
Kris runs a business making birthday cards. He spends $70 on workers and machines and earns $100 a day. However, since Kris's business works with paper, he could decide to run a business making toilet paper instead, which pays $120 a day, but uses the same $70. By choosing to run a birthday card business, Kris is forgoing the $120 from toilet paper, minus the $100 he actually makes (which gives $20). He is also forgoing the $70 he spends on workers and machines. Therefore, Kris's opportunity cost is as follows:
Explicit cost: $70
Implicit cost: $20
\(Opportunity\ Cost=Explicit\ Cost+Implicit\ Cost\)
\(Opportunity\ Cost=\$70+\$20\)
\(Opportunity\ Cost=\$90\)
Based on the above, we can also say that economic profit refers to total revenue minus total opportunity cost.
Read our article on Opportunity Cost to learn more!
Economic Profit vs Accounting Profit Formula
Now let's look at how accountants and economists represent profits mathematically.
First, we will look at the formula for accounting profit.
\(Accounting\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)\)
Shall we try our hands on an example?
Clifford produces 20 shoes at a cost of $220 and sells all 20 shoes for a total of $300. Calculate Clifford's accounting profit.
Solution:
\(Accounting\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)\)
\(Accounting\ Profit=\$300-\$220\)
\(Accounting\ Profit=\$80\)
Now we will look at the formula for economic profit.
\(Economic\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)-Implicit\ Costs\ (IC)\)
Let's use this formula in an example.
Clifford produces 20 shoes at a cost of $200 and sells all 20 shoes for a total of $300. Clifford could have produced 20 belts instead of shoes and would have made $50 more. Calculate Clifford's economic profit.
Solution:
\(Economic\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)-Implicit\ Costs\ (IC)\)
\(Economic\ Profit=\$300-\$200-\$50\)
\(Economic\ Profit=\$50\)
Economic Profit vs Accounting Profit Relationship
So, what is the relationship between accounting profit and economic profit? Well, the main relationship between accounting profit and economic profit is that they both include explicit costs. This is because while accounting profit only looks at the outlay of money given to produce a given good, economic profit looks at both explicit and implicit cost, which come together to form the total opportunity cost of producing the good. Therefore, the common element between economic profit and accounting profit is explicit cost.
Economic Profit vs Accounting Profit Differences
So, what are the differences between economic profit and accounting profit? Well, aside from the obvious, which is that accounting profit is used by accountants whereas economic profit is used by economists, accounting profit only looks at explicit cost, whereas economic profit looks at both explicit cost and implicit cost.
- Accounting profit only looks at explicit cost, whereas economic profit looks at both explicit cost and implicit cost.
Due to the differences in the costs accounted for in economic profit and accounting profit, economic profit usually tends to be lower than accounting profit. Let's see how this happens. Consider the example below.
Ava runs a painting business. She spends $100 a day on workers and machines and makes a revenue of $150 a day. Instead of the painting business, Ava could have operated a home cleaning service and spent the same $100 each day on workers and machines. However, the home cleaning business would have made Ava $50 more each day.
Let's find Ava's accounting profit and economic profit.
Total Revenue: $150
Explicit cost: $100
Implicit cost: $50
\(Opportunity\ Cost=Explicit\ Cost+Implicit\ Cost\)
\(Opportunity\ Cost=\$100+\$50\)
\(Opportunity\ Cost=\$150\)
\(Accounting\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)\)
\(Accounting\ Profit=\$150-\$100\)
\(Accounting\ Profit=\$50\)
\(Economic\ Profit=Total\ Revenue\ (TR)-Opportunity\ Costs\ (OC)\)
\(Economic\ Profit=\$150-\$150\)
\(Economic\ Profit=\$0\)
As you can see, since Ava's accounting profit does not include the extra revenue Ava could have generated from running a house cleaning service instead of a painting business, her accounting profit is higher than her economic profit.
It is important to note that since firms aim to make as much profit as they can, the firm will stay in business as long as it is making a positive or zero economic profit.
Economists say that a firm is making normal profit when the economic profit is equal to zero. Normal profit means that the firm has put its resources to the best possible use at the time, and this means normal profit is not necessarily a bad thing.
Economic Profit vs Accounting Profit Example
Now, let's look at an example involving both economic profit and accounting profit.
Kent runs a shoe company that sold 200 pieces at $5 a piece in the year under review. Kent's company owns all its equipment and spent a total of $500 to produce the shoes. He conducts an assessment and finds out that his machines depreciated by $100. He has also been looking into the belt business, and would have made about $300 more had he manufactured and sold belts instead of shoes.
a. What is Kent's accounting profit?
b. What is Kent's economic profit?
Solution:
First, let's find the total revenue using:
\(Total\ Revenue=Price\ (P)\times Quantity\ (Q)\)
\(Total\ Revenue=\$5\times 200\)
\(Total\ Revenue=\$1000\)
a. Let's find the accounting profit using:
\(Accounting\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)-Depreciation\)
\(Accounting\ Profit=\$1000-\$500-\$100\)
\(Accounting\ Profit=\$400\)
b. Let's find the economic profit using:\(Economic\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)-Implicit\ Costs\ (IC)\)\(Economic\ Profit=\$1000-\$500-\$300\)\(Economic\ Profit=\$200\)Read our article on Costs in Economics to learn more!
You can also check out our article on Total revenue, total cost, and profit.
Accounting Profit Vs Economic Profit - Key takeaways
- Profit in economics is defined as total revenue minus total production cost.
- Accounting profit refers to total revenue minus explicit cost and minus total depreciation.
- Economic profit refers to total revenue minus total explicit costs and minus total implicit costs.
- The main relationship between accounting profit and economic profit is that they both include explicit costs in their calculation.
- The main difference between economic profit and accounting profit is that economic profit calculation subtracts opportunity costs from total revenue, whereas accounting profit subtracts explicit costs only.
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Frequently Asked Questions about Economic Profit vs Accounting Profit
How do you calculate accounting profit and economic profit?
Accounting Profit = Total Revenue - Explicit Costs - Depreciation
Economic Profit = Total Revenue - Explicit Costs - Implicit Costs
What is the difference between accounting profit and economic profit?
The main difference between economic profit and accounting profit is that economic profit looks at opportunity cost, whereas accounting profit looks at explicit cost and depreciation.
Is accounting profit always higher than economic profit?
Accounting profit is often higher than economic profit, since economic profit considers both explicit and implicit costs.
What does accounting profit include?
Accounting profit includes what's left after subtracting explicit costs and depreciation from total revenue.
What is the relationship between economic profit and accounting profit?
The main relationship between accounting profit and economic profit is that they both include explicit costs in their calculation.
Why is economic and accounting profit important?
Economic and accounting profit provide information about the profitability of a firm. Economic profit is used by economists, whereas accountants use accounting profit.
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