Simply speaking, the difference between economic profit and accounting profit is that economic profit accounts for the opportunity cost of producing a good or service whereas accounting profit does not. Loosely speaking, Economic profit incorporates the value of your time when determining how much profit you make.
What needs to be understood to grasp this concept
- Opportunity Cost
The term profit has a completely different meaning to economists than what it does to the general public or even accountants.
When most people thinking profit they think of "how much money they made when they sold a good or a service". This is what economist would refer to as accounting profit and is defined as:
Profit = Revenue - Costs
where Revenue is how much you made from selling a good or a service and Costs is how much it cost to produce that good or service.
For example, a donut vendor who sells a donut for $3 has revenue of $3. If he had to spend $2 on flour, water and sugar to make this donut, then the costs are $2. The profit in this case is simply $2.
When economist think of profit, they think of economic profit. Economic profit is different in that it factors in the opportunity cost when determining the profit. It is defined as:
Profit = Revenue - Costs - Opportunity cost
Suppose in the above example the donut vendor could have earned 50 cents working elsewhere in the time that it took him to make the donut. We would define this as his opportunity cost, which in this case is the next most profitable thing he could be doing with his time. We could also think about opportunity cost as how much money could be made if he did not make the donut.
Using the above equation and our new information, it can be worked out that the economic profit is only 50 cents now.
What is the importance of economic profit?
Economic profit is an important concept as it measures the "true benefit" that someone receives from working.
Suppose you find out that your uncle earns $80,000 a year working as a school teacher and his only directly related costs are $5000 in transport a year. This would mean his accounting profit is $75,000 a year which make sound pretty good. However, if he is a qualified economist 🙂 and could earn $200,000 working on wall street then his economic profit is - $135,000 and it seems a lot less impressive.
(obviously there may be a consumption element as to why he chooses to be a teacher instead of working on wall street, but this still paints an important picture)
Therefore, economic profit shows the true profitability of a venture.
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