Question

Businesses employ resources to use in the production and sale of a good or service. Accounting profit is typically used as a way of evaluating the success of a business, but economists argue that economic profit is more relevant to determining whether a business should continue to operate. What is the difference between these two measures of profit? Explain why accounting profit is usually greater than economic profit. (Please write out answer versus charting it)

Answer 1

Accounting Profit and Economic Profit are two different measurables that gauge the performance of a company’s financial assets. They yield differing but important insights into company’s short-term financial health and prospects for positive long-term growth.

In accounting sense, profit is surplus of revenue over and above all paid-out costs, including both manufacturing and overhead expenses. While calculating accounting profit, only explicit or book costs, that is the costs recorded in the book of accounts, are considered. It is the bookkeeping profit, and it is higher than economic profit.

The point to be noted is that economic profit takes into account also the implicit or imputed costs. The implicit cost is the opportunity cost, that is 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 time period. Economic Profit, also known as pure profit makes provisions for (a) insurable risks (b) depreciation (c) necessary minimum payment to shareholders to prevent them from withdrawing their capital.

It thus may be defined as ‘a residual left after all contractual costs have been met’.

DIFFERENCE BETWEEN ACCOUNTING PROFIT AND ECONOMIC PROFIT

BASIS FOR COMPARISON :

1. MEANING

Accounting Profit - It is the net income of the company earned during a particular accounting year.

Economic Profit - It is the remaining surplus left after deducting total costs from total revenue.

2. CALCULATION

Accounting Profit= Total Revenue- Total Explicit Costs

Economic Profit = Total Revenue – (Total Explicit Costs + Total Implicit Costs)

3. ADVANTAGES

Accounting Profit - Reflects profitability of the company

Economic Profit - Shows how well the company is allocating its resources.

3. HIGH/LESS

Accounting Profit - Always higher than economic profit.

Economic Profit- Always lesser than accounting profit.

4. DETERMINATION

Accounting Profit- It is calculated according to the Generally Accepted Accounting Principles. (GAAP)

Economic Profit - Economic profit is determined by economic principles, not GAAP.

5. USES

Accounting Profit - Primarily used for income tax purposes, financial statement preparations and to review financial performance.

Economic Profit - Used to judge total value of the company and is helpful in calculation of production costs.

• WHY IS ACCOUNTING PROFIT HIGHER THAN ECONOMIC PROFIT?

Accounting Profit is usually higher than economic profit because it takes into consideration only the explicit costs, or the actually paid-out costs. It ignores implicit costs. Economic profit is lower because economic cost is the sum of explicit and opportunity/ implicit cost. Thus, due to this accounting profit is higher, because the implicit costs are not deducted from revenue.