There are two ways of measuring profit. The first way is to measure it based on what we actually receive and the other is to trade off what we actually received with what we could have received. Confused? Let me break it down into parts to make this clearer.
Understanding Accounting Profit
Now if you are a student of accounts or business, you undoubtedly know what accounting profit is from the bookkeeping results in the balance sheet. But just to make this matter clear, an accounting profit is the excess of business income over the business expenses. The business earns money after selling their goods or services. If the money they earn is more than the money they spend for making/providing the goods/services, it is said that the business has made an accounting profit. Accounting expenses don't only include the tangible money that was spent by the business, but also includes any provision for losses or depreciation that the business makes over an accounting period. So once all these costs are reduced from the total income earned by a business enterprise, if the remaining amount is positive, it is an accounting profit. If the remaining amount is negative, it is known as an accounting loss, which means that the business has spent beyond its earning capacity in the accounting period. Thus we can say that an accounting profit is the excess of accounting income over accounting expenses.
Accounting Profit = Total Income - Total Expenses
Understanding Economic Profit
So now that we got what is accounting profit out of the way, let us come to what is economic profit. An economic profit is a slightly complicated concept, and I'm going to have to break it down in order to explain it. Let us start with what is an opportunity cost.
You know that you have only so many resources and so many things you can do with that much money. Suppose you have two investment options. You invest the money in option A and totally forgo option B. The opportunity cost lost, is the return you would get in case you had invested in option B. Suppose both investment options cost $100,000. Simultaneously you track the progress of option B, although you haven't invested a cent in it. At the end your investment, option A, earns $150,000 while option B earns $120,000.
The accounting profit formula will tell you that by investing in option A, you have made yourself a tidy profit of $150,000 - $100,000 = $50,000. Had you invested in option B, you would have made an accounting profit of $120,000 - $100,000 = $20,000. So basically, you have earned some money, but you have forgone the option of investing in B. The $20,000 which you didn't get is the opportunity lost cost or simply, opportunity cost of not investing in option B.
Now I know what you're thinking. You made a larger profit by investing in option A. And quite a large profit at that! $30,000 more! Exactly.
Now let me come to what is economic profit. It is not just the excess of total accounting income over the total accounting expense. To the cost of an investment, it also adds the opportunity lost cost of another investment option. Thus an economic profit means that not only did you make a profit on your investment, but you made more profit than you would have made otherwise! How much more? $30,000 more of course!
Economic Profit = Total Income - Total Expenses - Opportunity Lost Cost
= $150,000 - $100,000 - $20,000
= $30,000
Conversely, had you invested in option B, you would have made a lesser accounting profit and hence, you would have made an economic loss! You may also take a look at our glossary of accounting terms to understand the details a little better.
I hope by now that the concept is reasonably clear. By comparing the accounting profit and economic profit on an investment, we can see that an economic profit in the long run will quite often be less than the accounting profit, because of the additional consideration of opportunity lost cost. Unless of course, the other investment makes a loss!
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