Question

What is the difference between zero accounting profit and zero economic profit?

Short answer

Zero accounting profit implies revenues equate to explicit costs and does not account for opportunity costs. Zero economic profit implies the firm is covering both explicit and implicit costs, indicating the firm is earning normal rate of return, hence it is indifferent between staying in business or using its resources elsewhere.

Step-by-step solution

Define Accounting Profit

Accounting profit is the total revenue minus explicit costs. Explicit costs are the actual out-of-pocket expenses for the input resources. When accounting profit is zero, that essentially means that the revenue generated equals the costs of goods sold.

Define Economic Profit

Economic profit is calculated by subtracting both explicit costs and implicit costs (opportunity costs) from total revenue. Opportunity costs represent the returns from the best forgone alternative. If economic profit is zero, this means that the company is making just enough to cover both explicit and implicit costs.

Comparison of Zero Accounting Profit and Zero Economic Profit

When accounting profit is zero, the firm is only covering its explicit costs and not its implicit costs. But when economic profit is zero, the firm is covering both explicit costs and implicit costs. This means the company is earning exactly the normal rate of return, which is the minimum amount needed to keep a company in its current business.

Key concepts

Accounting Profit

Understanding accounting profit is crucial in measuring a firm's financial performance using traditional accounting practices. It is calculated by taking the total revenue a business earns and subtracting its explicit costs. Explicit costs are the cash outflows that a business incurs directly due to its operations. These include wages, rent, materials, and utility bills.

Think of explicit costs as the bills and payments a company needs to make to keep running daily operations. When these costs are equal to the revenue, the accounting profit is zero. This means that all income generated precisely equals the expenses, suggesting the business is not incurring losses but also not making any additional profit.

Explicit Costs

Explicit costs are the tangible, out-of-pocket expenses required to run a business. These costs are easily identifiable and are recorded in the business's financial statements.

Examples of explicit costs include:

• Salaries and wages
• Supply purchases
• Rent
• Utilities
• Marketing expenses

Being directly paid and accounted for, they contrast with other types of costs that may not be as visible in accounting records, like implicit costs. Explicit costs are always crucial in calculating the accounting profit, as they represent the concrete expenses that directly impact a company's bottom line.

Implicit Costs

Implicit costs are often overlooked yet crucial in understanding the concept of economic profit. These are non-monetary opportunity costs that arise when a business uses its internal resources. Unlike explicit costs, implicit costs do not represent direct cash outflows and are therefore not included in financial records.

Examples include the income a business owner foregoes by working in their own business instead of earning a salary elsewhere, or the depreciation of owned machinery that is not accounted for as a cost.

Recognizing implicit costs is essential because they help in assessing the true economic viability of a business venture. By incorporating these costs, businesses can evaluate if the resources might yield better returns if employed elsewhere.

Opportunity Costs

Opportunity costs play a key role in determining economic profit. They represent the potential earnings lost when choosing one option over another. This originates from the notion that every choice involves a trade-off.

Here are some scenarios illustrating opportunity costs:

• Choosing to invest in new equipment may lead to improved productivity, but it also means forgoing potential gains from investing that money elsewhere.
• A business owner working exclusively in their enterprise might give up a salary they could otherwise earn in a different job.

Integrating opportunity costs into financial analysis enables businesses to make informed decisions and ensure resources are allocated towards the most beneficial alternatives. An economic profit of zero indicates a business is perfectly covering both explicit and opportunity costs, ensuring resources are being used optimally for the current operation.