Question

What is the difference between accounting and economic profit?

Short answer

The difference between accounting and economic profit lies in the consideration of opportunity costs. Accounting profit, which is total revenue minus explicit costs, is the profit reported on financial statements and used for tax purposes. Economic profit, on the other hand, is total revenue minus total opportunity costs, which include both explicit and implicit costs. In some cases, a business may have a positive accounting profit but a negative economic profit if the implicit costs are greater than the accounting profit.

Step-by-step solution

1. Define Accounting Profit

Accounting profit is the difference between total revenue and explicit costs. Explicit costs are the actual out-of-pocket expenses incurred by a business, such as wages, rent, and materials. This is the profit that is usually reported on financial statements and used for tax purposes.

2. Define Economic Profit

Economic profit is the difference between total revenue and total opportunity costs. Opportunity costs include both explicit costs (as in accounting profit) and implicit costs. Implicit costs are the foregone benefits or opportunities that a person or business would have received if they had used their resources in a different way, such as the salary an owner could have earned if they worked for another company instead of running their own business.

3. Understand the Main Difference

The main difference between accounting profit and economic profit lies in considering opportunity costs. Accounting profit only considers explicit costs, while economic profit takes into account both explicit and implicit costs. This means that in some cases, a business may have a positive accounting profit, but a negative economic profit if the implicit costs are greater than the accounting profit.

4. Example: Comparing Accounting Profit and Economic Profit

Let's consider a simple example. Suppose a person decides to start their own business, and during the first year they generate total revenue of \(200,000. The explicit costs of running the business, including wages, rent, and supplies, are \)150,000. If the business owner had chosen to work for another company, they could have earned a salary of $60,000. Accounting Profit: \(Total Revenue - Explicit Costs = \$200,000 - \$150,000 = \$50,000\) Economic Profit: \(Total Revenue - (Explicit Costs + Implicit Costs) = \$200,000 - (\$150,000 + \$60,000) = -\$10,000\) In this case, the business has a positive accounting profit of \(50,000 but a negative economic profit of -\)10,000. This means that based on the economic perspective, the business owner would have been better off working for another company instead of running their own business. By following these steps, we can determine the differences between accounting profit and economic profit, which helps in making better-informed decisions about resource allocation and business performance evaluation.