Which of the following best explains the difference between economic profits and accounting profits?

The term "profit" may bring images of money to mind, but to economists, profit encompasses more than just cash. In general, profit is the difference between costs and revenue, but there is a difference between accounting profit and economic profit. The biggest difference between accounting and economic profit is that economic profit reflects explicit and implicit costs, while accounting profit considers only explicit costs.

Explicit and Implicit Costs

Explicit costs are costs that involve direct monetary payment. Wages paid to workers, rent paid to a landowner, and material costs paid to a supplier are all examples of explicit costs.

In contrast, implicit costs are the opportunity costs of factors of production that a producer already owns. The implicit cost is what the firm must give up in order to use its resources; in other words, an implicit cost is any cost that results from using an asset instead of renting, selling, or lending it. For example, a paper production firm may own a grove of trees. The implicit cost of that natural resource is the potential market price the firm could receive if it sold it as lumber instead of using it for paper production.

Accounting Profit

Accounting profit is the difference between total monetary revenue and total monetary costs, and is computed by using generally accepted accounting principles (GAAP). Put another way, accounting profit is the same as bookkeeping costs and consists of credits and debits on a firm's balance sheet. These consist of the explicit costs a firm has to maintain production (for example, wages, rent, and material costs). The monetary revenue is what a firm receives after selling its product in the market.

Accounting profit is also limited in its time scope; generally, accounting profit only considers the costs and revenue of a single period of time, such as a fiscal quarter or year.

Economic Profit

Economic profit is the difference between total monetary revenue and total costs, but total costs include both explicit and implicit costs. Economic profit includes the opportunity costs associated with production and is therefore lower than accounting profit. Economic profit also accounts for a longer span of time than accounting profit. Economists often consider long-term economic profit to decide if a firm should enter or exit a market.

The biggest difference between economic and accounting profit is that economic profit takes implicit, or opportunity, costs into consideration.

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Economic profit is total revenue minus explicit and implicit (opportunity) costs. In contrast, accounting profit is the difference between total revenue and explicit costs- it does not take opportunity costs into consideration, and is generally higher than economic profit.

Economic profits may be positive, zero, or negative. If economic profit is positive, other firms have an incentive to enter the market. If profit is zero, other firms have no incentive to enter or exit. When economic profit is zero, a firm is earning the same as it would if its resources were employed in the next best alternative. If the economic profit is negative, firms have the incentive to leave the market because their resources would be more profitable elsewhere. The amount of economic profit a firm earns is largely dependent on the degree of market competition and the time span under consideration.

Competitive Markets

In competitive markets, where there are many firms and no single firm can affect the price of a good or service, economic profit can differ in the short-run and in the long-run.

In the short run, a firm can make an economic profit. However, if there is economic profit, other firms will want to enter the market. If the market has no barriers to entry, new firms will enter, increase the supply of the commodity, and decrease the price. This decrease in price leads to a decrease in the firm's revenue, so in the long-run, economic profit is zero . An economic profit of zero is also known as a normal profit. Despite earning an economic profit of zero, the firm may still be earning a positive accounting profit.

In the long run for a firm in a competitive market, there is zero economic profit. Graphically, this is seen at the intersection of the price level with the minimum point of the average total cost (ATC) curve. If the price level were set above ATC's minimum point, there would be positive economic profit; if the price level were set below ATC's minimum, there would be negative economic profit.

Uncompetitive Markets

Unlike competitive markets, uncompetitive markets - characterized by firms with market power or barriers to entry - can make positive economic profits. The reasons for the positive economic profit are barriers to entry, market power, and a lack of competition.

• Barriers to entry prevent new firms from easily entering the market, and sapping short-run economic profits.
• Market power, or the ability to affect market prices, allows firms to set a price that is higher than the equilibrium price of a competitive market. This allows them to make profits in the short run and in the long run. This situation can occur if the market is dominated by a monopoly (a single firm), oligopoly (a few firms with significant market control), or monopolistic competition (firms have market power due to having differentiated products). .
• Lack of competition keeps prices higher than the competitive market equilibrium price. For example, firms can collude and work together to restrict supply to artificially keep prices high.

In the long run, a monopoly, because of its market power, can set a price above the competitive equilibrium and earn economic profit. If price were set equal to the minimum point of the average total cost (ATC) curve, the monopoly would earn zero economic profit. If the price were set lower than the minimum of ATC, the firm would earn negative economic profit.

Difference Between Accounting Profit vs Economic Profit

The accounting profit can be described as the profit that is earned and reported on the income statement. The economic profit is defined as the profit that the business derives over and above the opportunity costs. The accounting profit can be found at the bottom line of income statement whereas economic profit has to be determined by determining the free cashflows.

The accounting profit can be defined as the profit that the business earns as per the book of accounts of the business. The accounting profit is determined as the difference of total sales generated by the business and the costs incurred by the business that could be accounted explicitly. The explicit costs may comprise of cost of goods sold, operational expenses and non-cash expense.

The revenues or sales are generally income that the business generates while performing business activities. The economic profit on the other hand is determined by taking the difference of revenues generated by the business and the sum of implicit and explicit costs generated by the business. The implicit costs are generally regarded to the opportunity costs that the business has to bear for foregoing an opportunity by selecting an alternative through the course of business. The business generally has access to the alternatives at hand basis which selection of any one of them results in commitment of organizational resources and the business cannot back track on their decisions as they would had exercised their choice or option of selecting the best alternative or course of action from the available choices at hand.

Head to Head Comparison between Accounting Profit vs Economic Profit (Infographics)

Below are the top 5 differences between Accounting Profit vs Economic Profit:

Key Differences between Accounting Profit vs Economic Profit

Following are the key differences between Accounting Profit vs Economic Profit:

• The accounting profit can be termed as the profit that the business realizes for a given financial year. Economic profit on the other hand defines as the profit levels that the business earns over and above the expenses that are generally termed as opportunity costs.
• The accounting profit is generally larger than the economic profit as economic profit is determined using multiple assumptions along with the re-use of multiple categories of income and expenses.
• The accounting profit is determined by deducting expenses arising from assets being leased, depreciation or non-cash expense, provisions for the development costs whereas the economic profit may comprise of opportunity costs, salvage or residual values, charges on inflation, taxation rates, and interest levied or applied on cashflows.
• The accounting profit can be defined as the revenue that is earned post deducting all costs of economic nature. The economic profit is achieved the revenues are earned over and above opportunity costs. The accountant generally relies on the accounting profit as it accounts for production costs and their overall impact on the earning potential.
• The economist always relies on the economic profit as it tells the economist how the business utilized their resources and assessed the opportunity costs to earn a positive economic profit. The business generally incorporates a vision to earn a higher economic profit. The economic profit is generally positive when the accounting profits are over and above the overall implicit costs.
• The business if has accounting profit to be below implicit costs then the business tends to earn a negative economic profit. If the business earns negative economic profits, it is generally recommended that the business divest itself.
• It is to be noted that the equilibrium is achieved for the economic profit if the business implicit costs are equivalent to the explicit costs wherein both debtholders and equity holders earn their required rate of return.

Accounting Profit vs Economic Profit Comparison Table

Let us look at the comparison table of Accounting Profit vs Economic Profit.

It is to be noted that the opportunity costs can never be negative as a general principle of economics and hence the economic profit has to exceed the accounting profit so that the opportunity costs tend to be positive. The reason as to why opportunity costs cannot be negative is that the business may not choose to act on the opportunities that they have on hand making them either avoid an opportunity to earn as well as to bear expenses.

Conclusion

A business would tend to exist only when the business is to generate economic profit that is more than accounting profit and it indicates the profit earnings capability of the business even in the near future as well as how they have performed in the past. For the shareholders, the accounting profit is regarded of the utmost importance as it presents a true picture of financial performance and generally, investors are not that much learned to compute economic profits by themselves. The economic profit is generally determined by economists and internal stakeholders to perform internal analysis by assuming assumptions and taking all opportunity costs into account as they are pursuing or chose to pursue certain activities. Economic profit can deliver approximation as to which desired direction the business has headed to.

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