What is Economic Profit (or Loss)?

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Definition:

Economic profit (or loss) expresses the total value of a business decision – It is calculated by taking the difference between revenue generated and both the explicit and implicit (aka opportunity) costs associated with it.

🤔 Understanding economic profit (or loss)

Economic profit (or loss) is the amount of money a company earns (or loses), after accounting for the direct and indirect expenses of doing business. Critically, the calculation factors in the indirect opportunity cost – the value of the alternative choice that the business could have made. Conversely, accounting profit only considers explicit costs (aka money paid to others for time or assets). Economic profit additionally includes the interest, rent, sales, and wages that weren’t earned because the company decided to allocate its resources elsewhere. It assigns a monetary value to unpursued routes, and allows a company to compare its decision to pursue its chosen path to what it may have otherwise done. These implicit costs don’t show up on the company’s financial statements and don’t have to be disclosed publicly, but they're costs nonetheless.

Example

The fictitious company Tally's T-shirts has a dilemma. It can't decide between 100% cotton or a cotton polyester blend for its shirts. If it sources 100% cotton, it can charge $30 per shirt, but its material cost per unit will be $5. If it sources the cotton polyester blend, its material cost per shirt would be $2.50, but it could only charge $20 per shirt. Either way, Tally's estimates it can sell 1000 shirts per month.

If Tally’s chooses 100% cotton, its monthly revenue would be $30,000. Once subtracting the explicit costs for materials of $5,000, the total monthly profit would be $25,000. However, if the business chooses cotton polyester, its monthly revenue would be $20,000. Once removing the explicit costs for materials of $2,500, the total monthly profit would be $17,500.

By choosing the 100% cotton material, Tally's can realize an economic profit of $7,500 — the cotton profit of $25,000 minus the opportunity cost of the cotton polyester profit of $17,500.

Takeaway

Calculating economic profit or loss is kind of like measuring the effectiveness of fertilizer…

If you use fertilizer on your tomatoes, there’s a good chance that you’ll end up with some large, juicy delicious tomatoes. But you won’t really know how much credit that fertilizer deserves unless you’re able to compare a tomato grown with the fertilizer to one grown without it. The difference between two tomatoes in size and juiciness is the extra boost that you can assign to the fertilizer. In the same way, economic profit or loss captures the difference in value between doing one thing versus another – It doesn’t look at profit in isolation, it also examines what the alternative profit would have been.

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What is Economic Profit (or Loss)?

Economic profit (or loss) expresses the total value of a business decision – It is the difference between revenue generated and the explicit and implicit (aka opportunity) costs associated with it.

Explicit costs refer to the easily quantifiable out-of-pocket expenditures made to produce something – These often include items like wages, rents, and raw materials. Meanwhile, implicit (aka opportunity) costs quantify the value of an alternative choice — These typically capture the amount of money that is sacrificed by choosing one path over another.

Calculating economic profit is useful for determining how much better (or worse) one business decision is over another. It’s a type of “what-if” analysis – Economic profit (or loss) compares the gains (or losses) from one choice to what would have happened if you had picked an alternative route.

For example, imagine a small electronics company has $4M in capital it wants to invest. If it loans out the money to others, it estimates its profits will be $1.6M after five years. If, however, it starts a new product line, the company estimates a return of $500K in revenue less explicit costs (labor, raw materials, etc.) of $200K for total profit of $300K per year. Over five years, its total profits would come to $1.5M with a new product. The company decides to loan out the money rather than start a new product line because the economic profit — taking into account the $1.5M in opportunity cost of not starting a new product line — is $100K with much less the effort.

Economic profit differs from accounting profit (aka total revenue minus explicit costs) because it also includes these implicit values for alternative paths that didn’t occur. These implicit costs are intangible and somewhat arbitrary based on market conditions and management calculations, so they don't show up on company financial statements. Economic profit is more of an internal metric that businesses use to ensure that managers are maximizing profits and choosing the most optimal path. Corporations don’t pay taxes on economic profit and investors don’t typically get to see this figure .

Economic theory suggests that competition should drive economic profit to zero — This is called normal profit. That is, the revenue minus the total cost (explicit plus implicit) equals zero. In this case, a company will likely continue to produce in the same manner as they have been since the decision to do so is as good as the next best alternative.

When a company makes a positive economic profit, it is called supernormal profits. Supernormal profits attract competition into the market – As more competitors enter, economic profit theoretically will eventually erode to zero.

Companies can still earn an accounting profit when economic profit is zero. When economic profit is zero, that just means that the profit the company is making isn’t higher than if it were doing something else with its capital.

For example, assume a company invests $1M into developing a new product. That product generates an accounting profit of $75,000 per year – a 7.5% return on investment. If the company could have earned the same 7.5% return on a product that would have been the best alternative, then its economic profit is zero even though its accounting profit is positive.

How do you calculate economic profit?

Calculating economic profit requires three pieces of information: total revenue, explicit costs, and implicit costs.

  • Revenue: For a business, total revenue is the total income it earns through all sales of its products and services. Simply put, it totals up what customers pay in exchange for the goods or services a company sells.
  • Explicit costs: These include tangible expenditures that require actual dollars to flow out of a company’s bank account. It’s the salaries, utility bills, insurance, rent, materials, and all other inputs that a company must pay to employees, suppliers, vendors, and service providers to create a product or service.
  • Implicit costs: Unlike explicit costs, implicit costs aren't money paid directly to others. Rather, an implicit cost is the opportunity cost of using an existing internal resource for producing one thing instead of another. Most typically, this is expressed as the forgone revenue that a business could have earned by using its resources for an alternative operation. For example, if a company owns the building where it operates, then it doesn’t pay any rent. But, by choosing to use the building for its operations, it loses the revenue it could have generated by leasing the building out to a different company. Those forgone rental payments are an opportunity cost. While the business that owns the building can’t subtract these implicit costs from its taxable income, they're costs nonetheless.

The economic profit formula combines the three components to calculate economic profit as follows:

Economic Profit (Loss) = Revenue – Explicit Costs – Implicit Costs

Consider this simple example. Joe decides to leave his job and open a coffee cart so he can start living life as his own boss. At the end of one year, Joe does his taxes and reports $100,000 in sales. The coffee grounds, paper cups, lids, coffee sleeves, flavoring, and other materials add up to $50,000. It looks like he made $50,000 in profit.

From a pure accounting profit perspective, that’s true. But, from an economic profit perspective, the story isn’t over.

To know whether Joe truly made a profitable decision, considering alternatives, you have to consider the implicit cost. Say Joe left a job that paid $60,000 a year – In this case, he didn’t actually make an economic profit. Had he never opened his business, he'd have earned $10,000 more than he did in year one. That means his economic profit from opening his coffee cart was actually -$10,000 in the first year – an economic loss.

The full calculation for the above example is as follows:

Economic Profit (Loss) = Revenues – Explicit Costs – Implicit Costs

Economic Profit (Loss) = $100,000 – $50,000 – $60,000

Economic Loss = -$10,000

Even though Joe had an economic loss in year one, there might be other intangible factors that should be considered here. For example, maybe Joe is perfectly willing to lose $10,000 a year for the personal satisfaction of running his own business. He may also make radically more in the second year, which could offset the short-term economic loss.

Although economic profit expresses amounts in dollars, the concept is meant to capture non-monetary costs and benefits. Ideally, you’re able to put a price on implicit costs and benefits when calculating economic profit. Of course, that’s not easy to do in practice and the value can differ by individual and business, depending on management and existing market conditions.

What are opportunity costs?

An opportunity cost is the value of an alternative choice that an individual, investor, or business misses out on when making another decision instead. That is, it's what you give up when you choose to do one thing instead of another. For instance, if you buy $1,000 of common stock, that means you’re not using that $1,000 to buy a bond. The money you don’t earn from the bond is the opportunity cost associated with buying the stock.

Opportunity costs extend to every aspect of life. Whenever you have to make a choice, you’re giving up the value of the path not taken and opportunity costs try to capture the monetary value of that alternative. Economic profit accounts for these opportunity costs via implicit costs to express how good one business decision is relative to another.

What is the difference between economic profit and accounting profit?

Accounting profit is what shows up on an income statement and what you most likely think of when you hear the term profit. Meanwhile, economic profit captures how good an investment really is as compared to its alternatives.

Accounting profit appears on a company’s financial statements. In short, it captures the amount of income generated after subtracting all explicit expenses from revenue generated over a given period of time. At the bottom of the income statement is net income, which subtracts all of the explicit expenses – This is also known as accounting profit.

However, financial statements don’t capture any implicit costs. In other words, they don’t factor in the lost earning power of capital while it’s invested elsewhere. Nor do they express how a company’s property, plant, and equipment (PP&E) could generate rent if those items were leased rather than used directly by the business.

Economic profit accounts for these invisible costs that don’t show up in the standard accounting profit. It is a truer measure of profit, considering alternatives, rather than a straightforward accounting of money. When a business understands implicit costs, it may seek creative ways to mitigate them. For example, a company might decide to move its operations to a warehouse with lower rent and lease out the warehouse it owns for a higher rent to recoup some of those opportunity costs.

Why is economic profit important?

Economic profit is important because it assigns an economic value to the choice a company didn’t make. While accounting records every monetary transaction, it misses unseen costs of pursuing one path over an alternative one. Not everything that matters involves dollars changing hands. A lot of things have economic value, even if they don’t come with a tangible price tag. Economic profit tries to capture those invisible costs and benefits by assigning a dollar value to them.

For instance, when you mow your lawn or wash your dishes, no money changes hands. So, there's no record of that activity in your bank account. But those things do have value. Economic profit tries to capture that fact. You might spend two hours mowing your lawn instead of paying the kid next door $20 dollars to do it for you. But if you're an accountant who charges $70 per hour, instead of saving $20 dollars, you're actually losing $120.

If you work for yourself, economic value says you should record a salary even if you don’t take a paycheck so that you can truly capture the economic value of your labor. If you own a piece of equipment, economic profit says you should charge yourself a rental fee to quantify the economic value of the equipment’s potential alternative use. And, if you use your life savings to invest in a business, economic profit believes you should account for the investment earnings you'd have made if you left it in a retirement account.

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