When starting a new business, like a restaurant, it’s important to understand the type of profit you’re making. This can be viewed through two different lenses: accounting profit and economic profit. While accounting profit is the more commonly known measure, economic profit gives a deeper insight into the business’s viability.
Accounting profit is the straightforward calculation of profit that most people think of when it comes to a business. It is calculated by subtracting the explicit costs from the revenue generated.
For example, let’s say the restaurant earns $500,000 in its first year. This figure represents the total amount customers pay for their meals, often called the “top line” of the income statement.
To calculate accounting profit, we need to consider the expenses:
Adding these expenses together gives a total of $450,000. The accounting profit, or pretax profit, is calculated as follows:
Accounting Profit = Revenue – Total Expenses = 500,000 – 450,000 = 50,000
This $50,000 represents the profit available to the owner, which can be reinvested in the business or used for personal expenses.
While accounting profit provides a clear picture of financial performance, economic profit offers a more comprehensive view by considering opportunity costs.
Economists define costs in terms of opportunity costs, which include both explicit and implicit costs. Explicit costs are direct monetary payments, while implicit costs represent the value of foregone alternatives.
In our restaurant example, the explicit opportunity costs are the same as the accounting expenses:
These costs total $450,000, just as in the accounting profit calculation.
Implicit costs, however, are often overlooked. For instance, if the owner previously held a job earning $150,000 annually, this amount represents an implicit cost—the wages foregone by choosing to run the restaurant instead.
To calculate economic profit, we subtract both explicit and implicit costs from the revenue:
Economic Profit = Revenue – (Total Explicit Costs + Implicit Costs)
Substituting in our numbers:
Economic Profit = 500,000 – (450,000 + 150,000) = 500,000 – 600,000 = -100,000
This results in an economic profit of -$100,000, indicating a loss when considering opportunity costs.
A negative economic profit does not mean the business is failing to generate cash flow. Instead, it suggests that the current business model may not be the most efficient use of resources.
In this case, the restaurant owner is effectively giving up $100,000 by choosing to run the restaurant instead of pursuing a more lucrative job. For a rational decision-maker focused on maximizing profit, this could indicate that operating the restaurant may not be the best choice.
Understanding the difference between accounting profit and economic profit is crucial for business owners. While accounting profit provides a snapshot of financial performance, economic profit offers a broader perspective by factoring in opportunity costs. This insight can guide owners in making informed decisions about the viability and direction of their business ventures.
Engage in a hands-on workshop where you will calculate both accounting and economic profits for a hypothetical business. Use real-world scenarios to identify explicit and implicit costs, and discuss how these affect business decisions.
Analyze a case study of a real or fictional business. Identify the explicit and implicit costs involved, and calculate the accounting and economic profits. Present your findings and discuss the implications of economic profit on business strategy.
Participate in a debate where you assume the roles of business owners, accountants, and economists. Argue the importance of accounting profit versus economic profit in decision-making, and explore how each perspective influences business strategies.
Conduct a research project on opportunity costs in various industries. Present your findings on how different businesses account for implicit costs and the impact on their economic profit. Discuss how this understanding can lead to better business decisions.
Participate in a simulation game where you manage a virtual business. Make decisions based on accounting and economic profit calculations, and observe the long-term effects on your business’s success. Reflect on how opportunity costs influenced your strategy.
Profit – The financial gain obtained when the revenue from business activities exceeds the expenses, costs, and taxes involved in sustaining the activity. – The company reported a significant increase in profit this quarter due to higher sales and reduced operational costs.
Accounting – The systematic process of recording, analyzing, and interpreting financial transactions and information for a business. – Accurate accounting is crucial for businesses to ensure compliance with financial regulations and to make informed strategic decisions.
Economic – Relating to the production, distribution, and consumption of goods and services, or the material welfare of a community. – The economic policies implemented by the government have a direct impact on the inflation rate and employment levels.
Revenue – The total income generated by a company from its business activities, usually from the sale of goods and services, before any expenses are deducted. – The new marketing strategy helped increase the company’s revenue by attracting more customers.
Costs – The monetary value of resources used or consumed in the production of goods or services, which can be fixed or variable. – Understanding the fixed and variable costs is essential for setting the right price for products.
Expenses – The outflow of money or assets to pay for goods or services, which are necessary for generating revenue. – The company needs to manage its expenses carefully to maintain profitability.
Opportunity – A set of circumstances that makes it possible to do something, often related to potential business ventures or investments. – The expansion into international markets presents a lucrative opportunity for the company to grow its customer base.
Implicit – Referring to costs or benefits that are not directly stated or recorded but are implied in the decision-making process, often related to opportunity costs. – The implicit costs of using the company’s own resources for production must be considered when evaluating project profitability.
Explicit – Referring to costs that are clearly stated and recorded in the financial statements, such as wages, rent, and materials. – The explicit costs of the new project include the purchase of equipment and hiring additional staff.
Business – An organization or enterprising entity engaged in commercial, industrial, or professional activities to produce goods or provide services for profit. – The success of a business often depends on its ability to adapt to changing market conditions and consumer preferences.
