Economic Profit vs Accounting Profit

While profit could be looked at as a straightforward concept that involves how much is spent and how much is made, this does not tell the full story. The full story can only be understood once we consider all other things that are lost as part of the cost incurred. This sums up the concept of accounting profit versus economic profit. Accounting profit simply looks at how much is spent and how much you gain back, whereas economic profit looks at everything you lost and everything you gained. Read on as we tell you all about this!

Economic Profit vs Accounting Profit Definition

We need to first understand the concept of profit to provide the definitions of economic profit vs accounting profit.

It is important to note that profit is calculated the same way in both economics and accounting. The main difference between profit in accounting and profit in economics lies in the costs included. So first, what is profit? Profit simply consists of all the money spent by the firm subtracted from all the money made by the firm. All the money spent by the firm is referred to as total production costs, and all the money made by the firm is referred to as total revenue. Therefore, profit refers to the total revenue minus the total production costs.

You can think of profit as the extra money made from one's money, as illustrated in Figure 1 below.

Fig. 1 - Profits

Mathematically, this is written as:

\(Profit=Total\ Revenue\ (TR)-Total\ Producti\ on\ Costs\ (TC)\)

In economic terms, total production costs refer to all the costs the firm incurs to employ inputs. On the other hand, total revenue refers to the quantity of products sold by the firm multiplied by the price per unit of product.

Mathematically, total revenue is written as:

\(Total\ Revenue=Price\ (P)\times Quantity\ (Q)\)

So, where do we begin to see the difference between economic profit and accounting profit? When we look at what accountants consider as costs and what economists consider as costs!

There are two types of costs: implicit costs and explicit costs. Accountants only look at explicit costs, whereas economists look at both explicit costs and implicit costs. So, what do these costs refer to? Explicit costs simply refer to the money we give out to acquire a good, whereas implicit costs refer to costs that do not require giving out money.

The concept of implicit costs can be confusing, so let's explain it with an example.

Now that we have defined the types of costs in economics, we can go ahead and differentiate between economic profit and accounting profit. Accounting profit refers to total revenue minus explicit costs. On the other hand, economic profit refers to total revenue minus explicit cost and minus implicit cost.

What about economic profit?

Here, economists subtract both explicit cost and total implicit cost from the total revenue. By doing this, economists are subtracting the opportunity cost from the total revenue. This is because opportunity cost includes everything the firm has to forgo to produce goods. So, this includes both outlays of money (explicit costs) and costs that do not require an outlay of money (implicit costs). Since opportunity cost includes everything the firm forgoes, economists say that opportunity cost includes all implicit and explicit monetary and non-monetary costs.

Let's explain opportunity cost using an example.

Based on the above, we can also say that economic profit refers to total revenue minus total opportunity cost.

Economic Profit vs Accounting Profit Formula

Now let's look at how accountants and economists represent profits mathematically.

First, we will look at the formula for accounting profit.

\(Accounting\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)\)

Shall we try our hands on an example?

Now we will look at the formula for economic profit.

\(Economic\ Profit=Total\ Revenue\ (TR)-Explicit\ Costs\ (EC)-Implicit\ Costs\ (IC)\)

Let's use this formula in an example.

Economic Profit vs Accounting Profit Relationship

So, what is the relationship between accounting profit and economic profit? Well, the main relationship between accounting profit and economic profit is that they both include explicit costs. This is because while accounting profit only looks at the outlay of money given to produce a given good, economic profit looks at both explicit and implicit cost, which come together to form the total opportunity cost of producing the good. Therefore, the common element between economic profit and accounting profit is explicit cost.

Economic Profit vs Accounting Profit Differences

So, what are the differences between economic profit and accounting profit? Well, aside from the obvious, which is that accounting profit is used by accountants whereas economic profit is used by economists, accounting profit only looks at explicit cost, whereas economic profit looks at both explicit cost and implicit cost.

• Accounting profit only looks at explicit cost, whereas economic profit looks at both explicit cost and implicit cost.

Due to the differences in the costs accounted for in economic profit and accounting profit, economic profit usually tends to be lower than accounting profit. Let's see how this happens. Consider the example below.

As you can see, since Ava's accounting profit does not include the extra revenue Ava could have generated from running a house cleaning service instead of a painting business, her accounting profit is higher than her economic profit.

It is important to note that since firms aim to make as much profit as they can, the firm will stay in business as long as it is making a positive or zero economic profit.

Economists say that a firm is making normal profit when the economic profit is equal to zero. Normal profit means that the firm has put its resources to the best possible use at the time, and this means normal profit is not necessarily a bad thing.

Economic Profit vs Accounting Profit Example

Now, let's look at an example involving both economic profit and accounting profit.