Question

What is the difference between accounting and economic profit?

Short answer

In short, the difference between accounting and economic profit lies in the consideration of implicit costs. Accounting profit only accounts for explicit costs, while economic profit considers both explicit and implicit costs (opportunity costs). Economic profit provides a more complete understanding of a firm's true profitability and value creation.

Step-by-step solution

Define Accounting Profit

Accounting profit is the profit calculated by subtracting explicit costs from a firm's total revenue. Explicit costs are the actual monetary payments made by a firm for resources such as labor, capital, and raw materials. Mathematically, accounting profit can be defined as: Accounting Profit = Total Revenue - Explicit Costs

Define Economic Profit

Economic profit considers both explicit and implicit costs. Implicit costs are the opportunity costs of using resources that a firm already owns or could have used for alternative purposes. For example, the wages forgone by the owner when they decide to work in their own business instead of working for another company. Economic profit can be defined as: Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)

Compare Accounting and Economic Profit

The difference between accounting and economic profit is the consideration of implicit costs. Accounting profit does not take into account the opportunity costs associated with the resources used, whereas economic profit accounts for both explicit and implicit costs. In other words, economic profit provides a more comprehensive measure of a firm's actual profitability, while accounting profit focuses on the monetary outflow for resources. When comparing the two, if a firm has a positive economic profit, it means it is earning more than its opportunity costs and creating value beyond just covering its monetary expenses. To conclude, The main difference between accounting and economic profit is that accounting profit only considers the explicit costs, while economic profit takes into account both explicit and implicit costs (opportunity costs). Economic profit provides a more comprehensive view of a firm's profitability and the value it creates.