Except you run a non-profit business, the sole motive of each company is to make a profit. While your intentions might be to add value to the world and economy, without profit; eventually, your ability to offer that value will be burdened.
Now, apart from adding value to society, each business wants to earn a profit. Nothing is more exciting for a business owner than getting vast values after deducting total costs from total revenue.
The higher the difference, the greater the company’s profitability. But differentiating between the two is a great way to measure the financial health of a business.
In this blog, we shall spot the significant difference between accounting profit and economic profit, and you shall get everything here to know about them. Let’s get started.
Economic Profit V/S Accounting Profit
Economic profit and accounting profit are similar, but they have a dash of difference between them. While they are both financial, one speaks about the profit of an organization, and the other speaks about the economy.
Learning about the difference between the two profits requires an understanding of two major cost types. These are implicit costs and explicit costs. In short, economic profit involves both implicit costs and explicit costs, while accounting profit involves only explicit costs.
Overview of Accounting V/S Economic Profit
Profit is one of the most wanted financial criteria in assessing a firm’s financial health. It is the monetary income earned by any commercial activity that exceeds all the expenses, taxes, and other costs. To put it in simple words, profits are revenue minus costs. Profits are classified into two types: economic profit and accounting profit.
Economic profit is defined as the total income from sales minus all opportunity expenses. Accounting profits is defined as the firm’s overall earnings, including explicit costs.
Economic profit is a type of profit obtained from the production of goods and services while accounting for alternative use of a company’s resources. This subtracts explicit expenditures from income and accounts for opportunity costs endowed during that time frame. Implicit costs of a company’s resources are also included in the calculation.
The implicit costs, for example, are the marketed price at which a corporation which could sell a natural resource rather than eating up that resource. A paper firm owns a tree. They fell trees and made paper goods. Their implicit cost is timber, which might get sold at market price.
Profit in Accounting
Accounting profit, also known as earned profit, as opposed to economic profit, is recorded on a firm’s income statement. It is the profit gained after deducting different costs and expenses from total revenue in accordance with the generally accepted accounting rules (GAAP). These expenses include:
- Wages and salaries.
- Any manufacturing inventory.
- Raw ingredients.
- Costs of transportation and storage.
- Overhead and production expenses.
- Sales and marketing expenses.
Accounting profit is the amount of money left over after subtracting the business’s explicit costs. Explicit costs are the detailed quantities paid by a corporation for various expenditures during that period, such as wages.
What are Explicit Costs?
Explicit costs are the costs that are expressly identified and readily calculable. They are the monetary costs that directly leave the business. When a firm pays for using its factors of production, that cost is explicit.
It is a subset of cash outflow and is usually expressed on the firm’s account sheets. Explicit costs directly affect the firm’s ability to gain profit since the business has to now pay for them.
What are Implicit Costs?
Implicit costs are the costs that are not easily calculable because of their implied nature. They are referred to as opportunity costs, which are forgone alternatives. Because implicit costs tend to be unclear, they are not easily calculable. As a result, they need to serve authentic measures for accounting.
Difference Between Accounting Profit and Economic Profit
What is Accounting Profit?
As the name depicts, it is a more accurate measure for the financial accounting of a business. It is the financial information that government organizations such as the IRS are more interested in.
The formula for accounting profit:
Total monetary revenue generated – Total monetary costs incurred
This formula makes use of the generally accepted accounting principles (GAAP).
What is Economic Profit?
Economic profit is obtained from the difference between the total firm’s revenue and the total firm costs. The sum of the firm’s explicit and implicit costs gives the firm’s total costs.
The formula for economic profit:
Economic profit = Total revenue generated – Total costs incurred
Total costs incurred = explicit costs incurred + implicit costs incurred
Advantages of Economic Profit
Detects Business Opportunities: This serves as the best marker for detecting business opportunities rather than analyzing business economic profit. Just because it is positive, negative, or zero, it is helpful for predicting market entry. When it is zero, there is no incentive for the business to enter or leave the market. Regardless of whether the business enters or leaves the market, it will still be earning the same as when its resource is alternatively invested.
Measures Business Success Relative to Alternatives: Both economic profit and accounting profit are helpful for measuring the success of a business. However, while accounting profit measures the success of a business related to finances. Economic profit measures the success of a business related to its alternatives. This is so because it considers opportunity costs.
Disadvantages of Economic Profit:
It is not a Definite Metric for Measuring Business Profitability: This is because it needs to take each financial aspect of the business into account. It is not time-bounded since running an economic profit analysis over a short time is impossible.
Not Easily Measurable: Economic profit deals with implicit and explicit costs; the implicit costs make it difficult to calculate. It has no actual mathematical value, only an estimated value.
So, here it is economic vs accounting profit. Now, you have mastered the art of accounting and economic profit. If you want to create paystub, then eFormscreator is your tool.