Accounting profit measures the actual cash outlays and inflows, while economic profits incorporate a “what if” analysis. For this reason, an entity may report an accounting profit but realize an economic loss because resources could have been utilized better. An economic profit or loss is the difference between the revenue received from the sale of an output and the opportunity cost of the inputs used. In calculating economic profit, opportunity costs are deducted from revenues earned. Opportunity costs are the alternative returns foregone by using the chosen inputs, and as a result, a person can have a significant accounting profit with little to no economic profit.

How to calculate economic profit

It is a measure of true profitability that accounts for both explicit and implicit costs. Understanding the difference between economic and accounting profits is crucial for business owners. The best companies calculate economic profit to make informed business decisions and profitably allocate their resources. But because economic profit or loss is generally not disclosed, the metric isn't too helpful for deciding whether to buy a stock.

By incorporating opportunity costs, economic profit provides a more complete view of performance—one that acknowledges capital is not “free” even when it comes from shareholders rather than creditors. In such a case, the potential earnings that could be generated by introducing a new product are given up in exchange for the increased profits realized by cutting costs. Choosing not to pursue developing new product lines represents a lost opportunity. Hopefully, the company’s done a careful cost-benefit analysis and discovered that the largest potential profit increase would be derived from reducing operating costs.

What are the Other Terms for Economic Profit?

Large corporations and investors typically assess economic profit on a quarterly or annual basis to evaluate long-term financial health. The general assumption is that firms are producing goods to maximize profits. However, economists also assume that firms may aim to maximize revenue (profit is revenue – cost), maximize market share or achieve a pre-defined level of profit. Research suggests companies generating positive economic profit tend to outperform in the stock market over time, though this relationship isn’t always immediate or direct. InvestingPro does the heavy lifting for you with pre-calculated profitability metrics and capital efficiency ratios across thousands of companies. Economic profit (or loss) is what remains after deducting both normal accounting expenses and the cost of pursuing one business strategy instead of another.

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It can lead to various negative consequences, such as environmental degradation, lower wages, and exploitation of workers. Many business owners and potential investors should be aware of the misconception that economic profit economic profit definition determines success. Understanding the difference between economic and financial profit is vital for any business. Despite seeming similar on the surface, these two measures of success are distinct from each other. One common misconception about economic profit is that it equals financial profit—this could not be further from the truth.

Economic profit stands as one of the most powerful and theoretically sound metrics for evaluating business performance. By incorporating the full opportunity cost of capital, it provides a clearer picture of true value creation than traditional accounting measures. For managers, economic profit offers a superior framework for strategic decision-making, capital allocation, and performance measurement. For investors, it helps identify companies with sustainable competitive advantages capable of generating superior long-term returns. You estimate your implicit costs (opportunity cost of capital and foregone salary) to be $100,000. Your total costs would be $400,000 ($300,000 explicit + $100,000 implicit).

Economic profit considers explicit and implicit costs, while normal profit only considers explicit costs. Economic profit provides a more accurate representation of a business's actual financial performance. Calculating economic profit can provide invaluable insights into the efficiency and effectiveness of your business strategies.

Economic profit is estimated as the product of net operating profit after taxes (NOPAT) and (1 - cost of capital). Ignoring economic profit doesn’t always lead to failure, but it does increase the risk of wasted capital and missed opportunities. Understanding economic profit helps businesses make smarter financial decisions, avoid wasted investments, and focus on sustainable growth. Companies that leverage accounting automation platforms like Ramp can track expenses in real-time, reduce inefficiencies, and ensure that every dollar works toward maximizing long-term profitability. Economic profit is the difference between a company’s total revenue and the sum of its explicit and implicit costs.

Economic profit, in the long run, refers to the total revenue earned by a business, minus all of its costs, including both explicit and implicit costs. In the long run, businesses can adjust their inputs and outputs more flexibly. Accounting profit is the difference between total revenue and the direct costs the company is incurring. But, in economics, accounting for profit does not make sense because it does not ensure whether the business is making real profits. By accounting for implicit costs, economic profit offers insights that accounting profit often misses. For example, if you own a small business and decide to invest your time and capital into it, the implicit cost would be the salary you forego by not working elsewhere.

Roles of Economic Profit in Accounting

• Economic profit is best calculated over long time horizons because short-term economic losses often become long-term economic profits.
• The company has invested \$400,000 in fixed assets, and variable costs are \$50,000 per month.
• It can enable them to make more informed decisions and anticipate future outcomes.
• Economic profit considers current and potential gains or losses, allowing businesses to prioritize investments that offer the highest expected returns in the long term.
• By incorporating opportunity costs, economic profit provides a more complete view of performance—one that acknowledges capital is not “free” even when it comes from shareholders rather than creditors.
• One example of economic profit computation is a business that runs a famous soda stand near a local beach.

Unlike accounting profit, you can't get this figure from a corporate financial or income statement. Let's say a company earns revenue of $10,000 on sales of stuffed animals. In addition, the company could have produced a different product; by foregoing that opportunity, it declined $2,000 of income. Using the formula above, we can determine that the economic profit of producing these toys is $3,000 ($10,000 - $5,000 - $2,000).

Economic Profit vs. Other Financial Metrics

When you understand the actual cost of using your resources, you can make more informed choices about where to allocate them. This can lead to more efficient use of capital, labor, and other resources, ultimately boosting your business's overall performance. A company may choose Project A over Project B. The profit from Project A after deducting expenses and costs would be the accounting profit. While calculating economic profit presents certain challenges, the insights gained make it worth the effort. Companies that focus on economic profit rather than merely accounting profit typically make better strategic decisions, allocate capital more efficiently, and create more shareholder value over time.

• This is especially true for decisions with multiple variables that affect and do not affect accounting profit.
• They are not the same, as EP is a theoretical calculation based on what if scenarios; whereas, AP is based on what actually happened.
• Opportunity cost is the cost of missed opportunities when businesses use the resources in one activity over another.
• Investors, partners, and employees can see a clearer picture of how well the business is doing, making them more confident in its long-term prospects.
• Explicit costs are direct expenses such as wages, rent, raw materials, and utilities.

While this can be complex, the insights gained from understanding your true profitability can significantly enhance your business's financial health and strategic planning. Like economic profit, this figure also accounts for explicit and implicit costs. When a company makes a normal profit, its costs are equal to its revenue, resulting in no economic profit. Competitive companies whose total expenses are covered by their total revenue end up earning zero economic profit. Zero accounting profit, though, means that a company is running at a loss. Economic profit is total revenue minus explicit and implicit (opportunity) costs.

Economic profit is the total revenue of a company minus its explicit and implicit costs. They can quickly spot inefficiencies, avoid unprofitable ventures, and focus on strategies that generate real value. Investors also pay close attention to economic profit when assessing a company’s long-term potential.