The word “PROFIT” is a part of our daily lives but have you ever thought that the profit we talk about is in terms of accounting or economics?
Here’s a brief explanation of both the profits, which will help you understand which profit you are dealing with.
But before dealing with the profits we need to understand some basic terminologies:
Opportunity cost – the loss that occurs from other alternatives when one alternative is chosen.
Let us understand opportunity cost with an example:
On a piece of land a farmer can produce 50 kgs of Rice (ON) or 40 kgs of wheat (OM) in his land. Now, if he chooses to produce Rice then he cannot produce Wheat and vice versa. Therefore, the OC of 50 kgs of Rice is 40 kgs of wheat. Also, the farmer can choose and produce any combination of the two crops along the production possibility curve MN as shown below :
Now suppose a farmer decides to produce a combination at point B (from the above graph). So he can produce OF amount of Rice and OE amount of Wheat. This means that to increase the production of Rice, the farmer needs to sacrifice the EC amount of Wheat. Therefore, Opportunity cost = EC amount of Wheat which the farmer cannot produce now.
Opportunity cost = forgone of the next best alternative as a result of the decision to choose one best alternative.
Now, let us understand the economic profit and accounting profit.
ECONOMIC PROFIT – Economic profit is the difference between the revenue received after the cost incurred on factor inputs (land, labor, capital) and non-factor inputs (raw materials) for the production of a commodity.
A simple formula to calculate economic profit is:
Economic profit = total revenue – (implicit cost + explicit cost)
Total revenue refers to what an owner earns by selling his/her products or services in the market. Implicit cost refers to the cost of the self-owned factor of production owned by the producer itself. Example – interest on own capital invested, rent of own land, etc. Explicit cost refers to the actual cost incurred for hiring factor services from outside. Example – interest on the loan, salary paid to employees, etc.
How Does Economic Profit Works?
Economic profit is also known as economic value-added. Economic profit is important for any business as it indicates how profitable projects of a company and is, therefore, it serves as an important reflection of how management is performing. Economic profit is the attempts that try to prove that businesses are truly profitable if and only when they create wealth for the stakeholders.
How Opportunity Cost Comes Into Play?
Opportunity costs are a type of implicit cost determined by management and will vary in different situations and scenarios. In terms of opportunity cost, economic profit is the difference between the revenue generated from the sale of a product and the costs of all inputs used and any opportunity costs.
Accounting profit is calculated as the difference between total revenue earned by a business and the total cost of the inputs. Accounting profit is a term that is calculated by using the General Accepted Accounting Principles (GAAP). A simple formula to calculate accounting profit is:
Accounting profit = total revenue – explicit cost
It includes explicit costs of doing business, such as operating expenses, depreciation, interest and taxes.
From the above explanation and formula, we can understand accounting profits are almost the same as bookkeeping costs and contain credits and debits on a balance sheet of a business. Although accounting profits are important for any business at the same time it is also limited in its temporal scope, generally accounting profits only consist of the cost and the revenue of a single period such as a fiscal quarter or year.
Opportunity Cost in Accounting Profit
The opportunity cost is not a concept of accounting and therefore, it does not appear in the financial records of the business. It is strictly restricted to the area of financial analysts.
CONCLUSION - Accounting profit vs Economic profit
Accounting profit is not always exhaustive. You need to think through the opportunity cost as well. Like accounting profit, economic profit deducts the explicit costs from revenue. But the difference is economic profit also uses implicit costs, the various opportunity costs a company incurs when allocating resources elsewhere.
Therefore, we can say that, The opportunity cost of any decision taken is equal to what has been given up as a result, due to that decision. Opportunity cost includes both explicit as well as implicit costs. Opportunity cost helps calculate a firm's economic profit. Accounting profits are calculated by only using the explicit cost. Therefore, A firm's Accounting Profits are always higher than Economic Profits.