Economic and Accounting profit formula

Accounting profit formula

A firm’s accounting profit is the difference between the amount of revenue that a firm earns subtracted from all their explicit costs:

\quad \text{Accounting Profit} = \text{Revenue} - \text{Explicit costs}

An explicit cost is, in essence, anything that involves the exchange of money for a good or service. The following are a list of explicit costs that a firm may face:

  • Wage bill paid to labour
  • Rent paid for a building
  • Utility costs such as electricity
  • Costs for raw materials
  • Taxes that are paid by the firm

Revenue is how much a firm earns for selling their goods and/or services. For example, if a cake shop sells 200 cakes for $2 their revenue would be $400.

To determine the accounting profit we just subtract that $400 from the total costs. For example, if the firm employed one worker for $20, hired the building for $80 and the cost of flour etc. was $20 and electricity was $10, their accounting profit would be:

\text{Accounting profit} = $400 - $20 - $80 - $20 - $10

\text{Accounting profit} = $270

 Economic profit formula

Implicit costs are those costs which are incurred but where no money is exchanged. We call these costs the opportunity cost. For example, consider the above example: suppose that the firm owner does some administrative duties for the business. This would be a cost for him the firm owner since he could be earning income with the time. However, since there would be no money being exchanged, it is an implicit cost. Economic profit is the same as accounting profit, except that it incorporates these “implicit costs”

\text{Economic Profit} = \text{Revenue - Explicit Costs - Opportunity}

\text{Economic Profit} = \text{Accounting profit - opportunity cost}

Recall that opportunity cost is what you give up to attain something. In this case, the firm owner is giving up the potential income to do the administrative work. Let’s suppose that with the time spent doing administrative work, he could have been earning $50. In this case, the opportunity cost is $50 or the implicit cost is $50. They’re both the same.

If we wished to calculate the economic profit, we could just subtract $50 away from the accounting profit such that:

\text{Economic Profit} = \text{$270 - $50}

\text{Economic Profit} = $220

This allows us to draw the following conclusions:

Economic profit will always be equal to or less than accounting profit as it’s incorporating opportunity cost.

Economic costs are always higher than accounting costs since they also include opportunity costs.