Understanding Profit: Accounting vs. Economic

1. The Tale of Two Costs: Explicit vs. Implicit

The core difference between how accountants and economists calculate profit lies in how they define costs.

• Explicit Costs: These are the direct, out-of-pocket payments a firm makes to others. They are tangible and easily quantifiable. Think of them as the costs that would appear on a company's expense report or income statement. Examples include:

  • Wages paid to employees
  • Rent for office space
  • Cost of raw materials
  • Utility bills

• Implicit Costs: These are the opportunity costs of using the resources that the firm already owns. They do not involve a direct cash payment. Instead, they represent the income or value forgone by not using those resources in their next-best alternative. Examples include:

  • The salary an entrepreneur could have earned working for another company.
  • The interest or rental income the owner could have earned by investing their capital or renting out their own property instead of using it for the business.

Economists consider both explicit and implicit costs because they are interested in the full opportunity cost of a decision. Accountants, who are primarily concerned with financial reporting according to established principles (like GAAP), focus only on explicit costs.

2. Accounting Profit vs. Economic Profit

With our two types of costs defined, we can now define the two main types of profit.

Accounting Profit

This is the figure most people think of as "profit." It is the total revenue minus the explicit, tangible costs of doing business. It's the number you find on a company's official financial statements, often called "net income."

$\text{Accounting Profit}=\text{Total Revenue}-\text{Explicit Costs}$

Economic Profit

This is a more theoretical measure used for decision-making. It is the total revenue minus all costs, both explicit and implicit. It measures the financial gain relative to the next-best alternative.

$\text{Economic Profit}=\text{Total Revenue}-(\text{Explicit Costs}+\text{Implicit Costs})$

From these formulas, we can derive a crucial relationship:

$\text{Economic Profit}=\text{Accounting Profit}-\text{Implicit Costs}$

This shows that economic profit will always be less than or equal to accounting profit.

The following diagram provides a clear visual breakdown of how accountants and economists view a firm's total revenue differently.

To see these concepts applied with a simple example, let's watch a short video.

As the video shows, a business can be profitable from an accounting perspective but unprofitable from an economic one. A positive economic profit means you are earning more than you would in your next-best alternative, making your current business a wise choice. A negative economic profit suggests your resources could be better used elsewhere.

For a deeper dive and a handy comparison table, the following reading from Investopedia is an excellent resource.

3. Normal Profit: The Economist's Break-Even Point

What happens if a firm's economic profit is exactly zero? This special case is called normal profit.

Normal Profit occurs when:
$\text{Economic Profit}=0$
This means:
$\text{Total Revenue}=\text{Explicit Costs}+\text{Implicit Costs}$

Achieving zero economic profit is not a bad outcome. It means the firm is earning just enough revenue to cover all its explicit costs and to compensate the owner for all their opportunity costs (like their forgone salary and the return on their capital). In other words, the firm is doing exactly as well as its next-best alternative. Normal profit is the minimum level of profit needed to justify keeping the business running in the long term.

It's critical to distinguish this from zero accounting profit.

• Zero Economic Profit (Normal Profit): The business is viable. You are covering all costs, including your own opportunity cost. You are still earning an accounting profit.
• Zero Accounting Profit: The business is in trouble. If TR - Explicit Costs = 0, then your economic profit is negative (since Economic Profit = 0 - Implicit Costs). You are not covering your opportunity costs and would be better off pursuing another venture.

Let's watch a final clip that explains normal profit in the context of a competitive market.

4. Summary and Practice

Let's consolidate these three key concepts.

Practice Question:

An individual quits her job, where she was earning a salary of $80,000 per year, to start her own consulting business. In the first year, her business generates $200,000 in revenue. She incurs $100,000 in explicit costs for rent, supplies, and a part-time assistant.

1. What is her accounting profit?
2. What is her economic profit?
3. Is she earning more or less than a normal profit?

Conclusion

In this lesson, we have dissected the concept of profit into three distinct categories crucial for the CFA exam.

Key Takeaways:

• Accounting Profit is a measure of historical performance based on explicit costs (TR - Explicit Costs).
• Economic Profit is a forward-looking measure for decision-making that includes all opportunity costs (TR - All Costs).
• Normal Profit is the condition of zero economic profit, where a firm is earning exactly enough to cover its explicit and implicit costs, making it the long-run break-even point for an economist.

These distinctions are not just semantic; they are at the heart of understanding a firm's behavior. A firm making decisions based only on accounting profit might fail to see that it could be doing better elsewhere, while a firm that understands economic profit makes choices that ensure the most efficient use of its resources.

Preview of the Next Lesson:

Now that we have a solid understanding of how economists view costs and profit, we will begin to explore the production process itself. In the next lesson, we will cover the learning outcome: Define and calculate total product, average product, and marginal product of labor. This will allow us to analyze how a firm's output changes as it adds more inputs, a key step toward understanding its cost structure.