Economic profit is the surplus generated by a business when its total revenue surpasses the sum of all explicit and implicit costs, reflecting a surplus beyond the normal profit. Unlike accounting profit, which accounts only for actual monetary costs and revenues, economic profit incorporates opportunity costs into its calculation.
Definition
Economic profit, also known as economic value added (EVA), is calculated as:
Explicit Costs
Explicit costs are direct, out-of-pocket expenses such as wages, rent, and materials.
Implicit Costs
Implicit costs, or opportunity costs, are the potential benefits lost when one option is chosen over another. These are not direct monetary expenses but reflect the value of the best alternative use of resources.
Calculation and Example
To better understand economic profit, let’s consider a simplified example:
- Total Revenue: $500,000
- Explicit Costs: $300,000 (salaries, rent, utilities)
- Implicit Costs: $50,000 (owner’s opportunity cost of capital and time)
Using the formula:
Thus, the economic profit is $150,000, indicating a surplus generated considering all costs.
Economic Profit vs. Accounting Profit
Understanding the distinction between economic profit and accounting profit is crucial:
-
Accounting Profit: Calculated as total revenue minus explicit costs only. It does not consider opportunity costs.
$$ \text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs} $$Using the example above:$$ \text{Accounting Profit} = \$500,000 - \$300,000 = \$200,000 $$ -
Economic Profit: Incorporates both explicit and implicit costs, providing a more comprehensive view of profitability.
Historical Context
The concept of economic profit has roots in classical economics, where figures like Adam Smith and David Ricardo introduced the importance of considering all costs, including opportunity costs, in understanding true profitability.
Applicability
Economic profit is crucial for:
- Business Analysis: Helps firms evaluate performance beyond conventional metrics.
- Investment Decisions: Assists investors in comparing potential returns against opportunity costs.
- Resource Allocation: Guides optimal allocation of resources considering alternative uses.
Related Terms
- Normal Profit: The minimum profit necessary for a company to remain competitive in the market, covering both explicit and implicit costs.
- Opportunity Cost: The cost of forgoing the next best alternative when making a decision.
- Explicit Cost: Direct, out-of-pocket expenses.
- Implicit Cost: Indirect costs representing the opportunity cost of using resources.
FAQs
What is the difference between economic profit and normal profit?
How does economic profit influence business strategy?
Why is economic profit important for investors?
References
- Smith, A. “The Wealth of Nations.”
- Ricardo, D. “Principles of Political Economy and Taxation.”
- Modigliani, F., & Miller, M. “The Cost of Capital, Corporation Finance and the Theory of Investment.”
Summary
Economic profit represents the true surplus of a business after accounting for both explicit and implicit costs, offering a deeper understanding of a company’s profitability compared to accounting profit. Its comprehensive nature makes it a vital tool for business analysis, investment decisions, and strategic resource allocation. Understanding economic profit aids in making more informed economic and business decisions by considering all potential costs and benefits.
