Accounting Profit vs. Economic Profit: Formulas and Differences

Profit is arguably one of the most important metrics a business can track. It serves as a fundamental measure of a business’s ability to function efficiently. Profit is calculated in two ways:

• Accounting profit
• Economic profit

But isn’t all profit the same? Not quite. While the principle behind accounting and economic profit may be similar, there are important differences. Accounting profit is the net income of a company, calculated as revenue minus explicit costs, such as operating expenses, depreciation, and taxes. Economic profit, on the other hand, includes opportunity costs in its calculation and is a key concept in microeconomics.

In a simple example, if accounting profit is the revenue made from selling paper minus the cost of raw wood and other inputs, economic profit also factors in the money that could’ve been made by selling the wood instead of processing it to make paper.

This article explains the two types of profit, how to calculate them, and the key differences between them. Understanding these concepts is crucial for effective decision-making and evaluating financial performance.

What is accounting profit?

Accounting profit, also known as net income or the bottom line, is the difference between total revenue and total costs over a specific period. It’s an important factor in determining whether a company can pay dividends to shareholders, as dividends are typically paid from retained earnings accumulated from accounting profits

In other words, your net income is the money left after subtracting your explicit costs—such as operating expenses, taxes, and amortization—from your total revenue. Unlike cash flow, which tracks actual cash movement, net income includes non-cash items like depreciation and amortization.

Accounting profit reflects how well your business is performing financially. You can also use this number to compare your business to other companies in your industry.

How to calculate accounting profit

Calculate your business’s accounting profit by subtracting explicit costs incurred from total revenue earned in a given period. Explicit costs include any and all operational and material expenses incurred during the relevant period.

Accounting profit formula

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Elements of the formula

• Total revenue is the sum of all the money you earn by selling goods and services. You can calculate it by multiplying the number of products sold by the price of each product. For example, if your business sells 100 pens for $5 each, your total revenue would be 100 x $5 = $500.
• Explicit costs are the operational costs you pay for running a business. These appear on the business ledger and directly affect your profit. Common examples include equipment, rent, cost of goods sold (COGS), and insurance.

Accounting profit example

Let’s assume you own a T-shirt business. Your explicit costs include:

• $70,000 for raw material costs
• $10,000 in payroll
• $8,000 for factory rent per year

Your total explicit costs equal $88,000 ($70,000 + $10,000 + $8,000).

Assuming, for the year, you sold 5,000 units of T-shirts for $30 each. Your total revenue would be $150,000 (5,000 x $30).

To calculate your accounting profit for the year, just plug your numbers into the following equation.

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Accounting profit = $150,000 - $88,000 = $62,000

So, your business has a net income of $62,000.

What if you want to look at different alternatives for the business that would change some of your costs? This is where calculation of theoretical economic profit comes in.

What is economic profit?

Economic profit is similar to accounting profit. It subtracts explicit costs from total revenue; however, it also factors in implicit costs, which are the costs of your business’s resources. Economists use this concept to analyze market efficiency and resource allocation.

Economic profit measures how efficiently your company allocates its assets to maximize revenue. When you have zero economic profit, it’s known as normal profit, indicating that resources are being used efficiently in their current application.

How to calculate economic profit

Follow a few steps to calculate economic profit for alternative projects or scenarios.

1. Determine your business’s expected total revenue or income on sales of goods and services, which is essentially the quantity sold multiplied by the price per product.
2. Define your total explicit costs, including raw materials, payroll, rent, etc.
3. Identify your implicit costs (or total opportunity cost).
4. Subtract the sum of explicit and implicit costs from the total revenue; the resulting amount is your economic profit for each alternative.‍

‍The economic profit formula

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Elements of the formula

The calculations for revenue and explicit costs are the same for accounting and economic profit, but economic profit also considers implicit costs.

Your implicit or opportunity cost is the revenue lost from other alternatives when you choose one option over another. Your implicit cost won’t appear on any financial statements since it’s a theoretical estimate used to compare alternatives.

For example, an implicit cost could be the amount of money you could earn if your business invested in stocks instead of putting that money toward equipment for business operations.

Economic profit example

Let’s say a company XYZ has the option of making products A and B with its raw materials. For some reason, it can’t do both.

Upon choosing to make product A, the business makes an accounting profit of $50,000 for the financial year. If it had chosen B, it would make an accounting profit of $62,000 instead.

The economic profit for manufacturing and selling product A or B is:

Economic profit (A) = $50,000 - $62,000 = -$12,000

Economic profit (B) = $62,000 - $50,000 = $12,000

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This means that choosing to make product B—in other words, capitalizing on opportunity B instead of A—would have helped the business make $12,000 more. In this case, choosing option A results in an economic loss.

In this example, we calculated the actual cost of choosing to adopt business operation A over other available options, as opposed to just the cost of running operation A. This helps you get a more comprehensive perspective on your business operations and how they end up using your resources.

Understanding and using project budgeting can help you project expected costs so you can use economic profit calculations to determine the best path forward.

Calculating your economic profits can help you make asset and budget allocation decisions that maximize revenue. There are also numerous finance apps and financial accounting software available to assist you with budgeting and making your income statement.

4 key differences between economic and accounting profit

Accounting and economic profits may seem similar, but there are some differences between the two.

• Type of costs involved. Accounting profit considers only your explicit costs, such as payroll and rent. On the other hand, economic profit considers your explicit and implicit costs, including the cost of idle resources you could put to better use.​​
• Uses. ​​Accounting profit helps determine how profitable your business is. The IRS and financial analysts use this information to assess your company’s tax liability and financial health. In contrast, economic profit accounts for opportunity costs, in other words, the profit you could make by pursuing different business decisions. It’s primarily used to determine investments and decide when to enter or exit a market.
• Reporting profits to the IRS. You only have to report your accounting profits to the IRS; there’s no regulated use for economic profits. Economic profits are used internally to make investment decisions.
• Financial principles. Accounting profits are calculated according to Generally Accepted Accounting Principles (GAAP), while economic profits follow general economic principles.

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Learn how to apply accounting and economic profit calculations to your business

Accounting profits are important to shareholders since they appear on the company’s balance sheet and impact potential rate of return. On the other hand, economic profits are valuable for a business’s internal use to determine investment decisions for alternative uses of resources. A positive economic profit indicates a business is outperforming its competitors, while zero economic profit suggests the firm is operating at a level consistent with perfect competition.

Determining economic profits can be confusing for small business owners, which is why we recommend engaging experts to help with the calculations. It’s simple, cost-effective, and quick to hire the best freelance accountants through Upwork.

The right professionals can help you make the best financial decisions and ensure you’re achieving your business goals and objectives.