Economic Profit

What is Economic Profit?

An economic profit or loss is regarded as the difference between the revenue collected from a sale of an output and the expense of all inputs used along with opportunity costs.

While calculating economic profit, explicit and opportunity costs are subtracted from the earned revenue.

Explaining Economic Profit or Loss

Often, economic profit is analysed in combination with accounting profit, which is the profit a company puts on its Income statement. Basically, Accounting profit is a part of financial transparency and helps to evaluate the real inflow and outflow.

And, economic profit doesn’t get recorded in the financial statement of a company; neither it has to be disclosed to financial institutions, investors or regulators. Moreover, individuals and companies may choose to regard economic profit upon facing different options that involve the level of production or other alternatives related to the business.

Also, economic profit can offer a proxy for profit considerations that have foregone. The economic profit calculation varies as per the situation and the company. Generally, it can be evaluated as:

Economic Profit = Revenues – Explicit Costs – Opportunity Costs

In this equation, by taking out the opportunity costs, it will result in the accounting profit. However, by subtracting the opportunity costs, it can still offer a proxy for comparing other options that could be considered.

Economic Profit Example

Let’s take an economic profit example here. Suppose a person begins a business and has Rs. 100,000 as his startup cost. During the initial five years, the business manages to earn a revenue of Rs. 120,000. This will make the accounting profit as Rs. 20,000.

However, if the person would have continued his job, instead of running a startup, he would have made Rs. 45,000. Thus, herein, the economic profit of this person would be:

Rs. 120,000 – Rs. 100,000 – Rs. 45,000 = Rs. 25,000

Also, this calculation only takes the first year of business into consideration. In case, after the first year, the cost reduces to Rs. 10,000; then the outlook of the economic profit will enhance for future years. And, if the economic profit turns zero, the business will be in the situation of normal profit.

By comparing gross profit to the economic profit, the person can look into a variety of scenarios. Herein, gross profit gets the attention, and the company would subtract its Opportunity Cost per unit. Thus, the equation would be:

Economic Profit = Revenue per unit – COGS per unit – Unit opportunity cost