Question

Accounting profit includes “profits as shown on a company’s financial statements,” and it takes into consideration explicit costs, while economic profit is a broader measure of profit that includes the recognition of both explicit and implicit costs (like the cost of equity capital) (Froeb et al., 2018). A specific value to review to determine a firm's accounting profit is net income, which is referred to as “the bottom line” by accountants. A net income value can be found on a firm’s income statement. (Note that income statements for publicly traded firms within the United States can be found for free through an internet search.) A positive net income value would indicate that the firm is indeed generating accounting profit, while a negative net income value would indicate that the firm is not generating accounting profit. Economic profit is harder to measure since it also includes implicit costs, some of which can be difficult to measure since they are not necessarily easy to quantify. _____________________ 1. Select a U.S. publicly traded company. What level of net income did the firm achieve during the last year or period that you found (the value should be from the last 18 months)? Did the firm earn an accounting profit? Explain. 2. Assume the firm was unable to earn an economic profit? What does this mean for the firm you selected? 3. Explain why it is important for any firm to earn both an accounting profit and economic profit, and why any firm that only earns an accounting profit will likely not stay in business very long.

Answer 1

Profit means different things to different people. To a layman, profit means all income that flow to the investors.

The two important concepts of profit that figure in business decisions are ‘economic profit’ and ‘accounting profit’. It will be useful to understand the difference between the two concepts of profit. As already mentioned, in accounting sense, profit is surplus of revenue over and above all paid-out costs, including both manufacturing and overhead expenses. Accounting profit may be calculated as follows. Accounting profit = TR – (W + R + I + M) where W = wages and salaries, R = rent, I = interest, and M = cost of materials.

The concept of ‘economic profit’ differs from that of ‘accounting profit’. Economic profit takes into account also the implicit or imputed costs. In the context of profit, implicit cost is essentially the opportunity cost. Opportunity cost is defined as the payment that would be ‘necessary to draw forth the factors of production from their most remunerative alternative employment’. Alternatively, opportunity cost is the income foregone which a businessman could expect from the second best alternative use of his resources. For example, if an entrepreneur uses his capital in his own business, he foregoes interest which he might earn by purchasing debentures of other companies or by depositing his money with joint stock companies for a period. Furthermore, if an entrepreneur uses his labour in his own business, he foregoes his income (salary) which he might earn by working as a manager in another firm. Similarly, by using productive assests (land and building) in his own business, he sacrifices his market rent. These foregone incomes—interest, salary and rent—are called opportunity costs or transfer costs. Accounting profit does not take into account the opportunity cost.