Question

Explain the difference between accounting and economic profit. Would zero economic profit be an acceptable situation for a firm, or would they be unwilling to stay in business? Explain your answer.

Answer 1

Accounting profit uses realized or actual gains and losses and is calculated according to generally accepted accounting principles (GAAP). It is a company's total revenue reduced by the explicit costs of producing goods or services. These explicit costs involve direct monetary movement and include expenses such as the cost of raw materials, employee wages, transportation, rent and interest on capital. Usually, accounting profit is limited to time periods, such as a fiscal quarter or year. Accounting profit computations are primarily used for income tax purposes, financial statement preparations and to review financial performance.

Economic profit is determined by economic principles, not GAAP. Just like accounting profit, costs are deducted from revenues. Economic profit uses implicit costs, not just explicit costs. Implicit costs are considered opportunity costs and are normally the company's own resources. Examples of implicit costs include company-owned buildings, equipment and self-employment resources. Economic profit computations are not normally limited to time periods like accounting profit computations are. Economic profit is used more to judge total value of the company somewhat like the performance metric economic value added (EVA) would and is helpful in calculating total production costs.

For example, if a company had $150,000 in revenues and $50,000 in explicit costs, its accounting profit would be $100,000. The same company also had $25,000 in implicit, or opportunity costs. Its economic profit would be $75,000.

A firm stays in business if it is earning zero profits. When firm is earning zero profits, it is able to cover the average cost. So it stays in business.