Difference Between Accounting and Economic Profit
Understand the key differences between accounting profit and economic profit. Learn how each metric impacts financial analysis, decision-making, and long-term business strategy with practical examples.
Mridula Sharma31 Jul, 2024
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Accounting profit and economic profit are key metrics in financial analysis, each providing insights into a company's financial health. Knowing the differences between these two types of profit is essential for making smart business decisions and improving financial performance. This article will explain the differences between accounting profit and economic profit for CA Exams .
What is Accounting Profit?
Accounting profit, also known as net income, is a crucial financial metric that measures a business's profitability over a specific period, such as a quarter or a year. It is determined by subtracting total explicit costs from total revenues generated from business operations. Explicit costs, also known as operating expenses, include all direct costs related to the production and sale of goods or services, such as the cost of goods sold (COGS), salaries, utilities, rent, and marketing expenses.Calculation of Accounting Profit
Let's learn how to calculate accounting profit. The formula for accounting profit is: Accounting Profit = Total Revenues − Total Explicit CostsExample:
Consider a company, ANC Corp, that manufactures eco-friendly packaging. In the fiscal year 2023, ANC Corp reported total revenues of $500,000. The explicit costs, including materials, labor, rent, utilities, and other operational expenses, amounted to $350,000.Using the formula:
Accounting Profit = $500,000 − $350,000 = $150,000 Therefore, ANC Corp's accounting profit for the fiscal year 2023 is $150,000. This figure will be reported on their income statement and used to evaluate the company's financial performance over that period.Importance of Accounting Profit Analysis
Accounting profit analysis plays a crucial role for several reasons:- It provides a clear picture of a company's financial performance, aiding in quick operational decisions.
- It helps evaluate how effectively a company generates profit from its core activities.
- Investors use accounting profit to gauge a company's profitability and its potential for distributing dividends.
- It is used to assess management's operational efficiency, while economic profit evaluates strategic effectiveness.
- It serves as a tool for comparing a company's performance against industry standards and competitors.
Also Check: How to Use Balanced Scorecard for Performance Management?
What is Economic Profit?
Economic profit is a performance metric that reflects an enterprise's true profitability by accounting for both explicit and implicit costs, including opportunity costs. Unlike traditional accounting profit, it includes the cost of forgoing the next best alternative, providing a more comprehensive view of profitability.Calculation of Economic Profit
To calculate economic profit, use the following formula: Economic Profit = Total Revenues − (Explicit Costs + Implicit Costs)Example:
Let's apply this to ANC Corp. Suppose the company had explicit costs of $350,000 and missed out on an investment opportunity that could have earned $50,000. This missed revenue represents an implicit cost (opportunity cost) of choosing not to invest in the alternative project.Using the formula:
Economic Profit = $500,000 − ($350,000 + $50,000) = $100,000 So, ANC Corp's economic profit for the fiscal year 2023 is $100,000. This figure includes both the actual expenses and the cost of not taking a potentially profitable opportunity.Importance of Economic Profit
Economic profit analysis is crucial for several reasons:- It helps in making better decisions by evaluating the opportunity costs, ensuring resources are used where they create the most value.
- Analyzing economic profit provides insights into the company’s ability to sustain and grow its value over time.
- It highlights missed opportunities, aiding in more effective resource distribution.
- Economic profit can indicate potential for future growth and competitive edge, attracting investors.
- It helps businesses assess their market position by comparing not just revenues and costs but also alternative investment opportunities.
Difference Between Accounting Profit and Economic Profit
Accounting profit is the amount of money a business earns after deducting its total explicit costs from its total revenues. In contrast, economic profit goes a step further. It’s calculated by subtracting both explicit and implicit costs from total revenues. Let’s explore the key differences between economic and accounting profit:Difference Between Accounting and Economic Profit FAQs
What is accounting profit?
Accounting profit is the net income after deducting explicit costs from total revenues, reflecting a company's short-term financial performance.
How is economic profit different from accounting profit?
Economic profit accounts for both explicit and implicit costs, including opportunity costs, providing a more comprehensive view of a company’s true profitability.
Why is accounting profit important for businesses?
It helps assess a company's immediate financial performance and operational efficiency, and is used for reporting and dividend distribution.
What does economic profit indicate about a company?
Economic profit shows how well resources are allocated and whether the company is achieving the best possible return on its investments, considering missed opportunities.
Investors use accounting profit to gauge current profitability, while economic profit helps evaluate the company’s long-term value and potential for growth.
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