Accounting profit and economic profit are two different ways of measuring a company’s profitability. Accounting profit is the difference between a company’s total revenue and its explicit costs, while economic profit takes into account both explicit and implicit costs.
Explicit costs are costs that a company pays out in cash, such as wages, rent, and materials. These costs are included in accounting profit. Implicit costs, on the other hand, are costs that a company incurs but are not paid out in cash, such as the opportunity cost of using its own capital or the value of the owner’s time. Economic profit subtracts both explicit and implicit costs from total revenue.
For example, suppose a small business owner invests $100,000 of her own money into her business and earns a total revenue of $150,000 in the first year. Her explicit costs for the year are $50,000, including wages, rent, and materials. Her accounting profit would be $100,000 ($150,000 – $50,000).
However, her economic profit would take into account the implicit cost of using her own money instead of investing it elsewhere, such as in stocks or real estate. If the opportunity cost of her investment is 10% per year, then her implicit cost would be $10,000. Her economic profit would then be $90,000 ($150,000 – $50,000 – $10,000).
Investors should prefer economic profit over accounting profit because it gives a more accurate picture of a company’s profitability by taking into account all costs, including implicit costs. If a company is generating a high accounting profit but a low economic profit, it may not be a good investment because the owner is not being compensated for their implicit costs.
In contrast, if a company is generating a high economic profit, it is a good indicator that the company is generating value and has a competitive advantage. A company that is consistently generating a high economic profit is likely to be a good investment because it is creating value for its owners.
In conclusion, while accounting profit and economic profit are both important measures of a company’s profitability, economic profit provides a more accurate picture of a company’s value creation and should be preferred by investors when evaluating potential investments.