An accounting profit equals a company's total revenue minus its explicit costs. Unlike economic profits, accounting profits do not include opportunity costs.
There are two ways to calculate a company’s profits - accounting profits and economic profits. Accountants focus on accounting profits, while economists emphasize economic profits. Implicit costs are excluded from an accounting profit but included in an economic profit. Implicit costs are opportunity costs and do not require an outlay of money. Economists believe businesses and individuals weigh their options when making financial decisions, and there is an implicit cost of not pursuing an option. Economists include a business’s cost when an investment in time or money prevents it from engaging in another opportunity. Accounting profits include only explicit costs, which are easily identified because they require spending money. Examples of explicit costs include but are not limited to, rent, plant and equipment, wages, raw materials, utilities, and insurance. Generally, the difference between total revenues (sales) and explicit costs equals the accounting profit.
For example, Marcia is a computer programmer earning $70,000 per year. She has always wanted to run her own business and is considering opening an ice cream parlor. Marcia expects sales of $250,000 a year and projects explicit costs of $197,000. Her direct expenses include rent, labor, raw materials, insurance, and utilities, so Marcia’s accounting profit would be $53,000. Should Marcia start her business? Her business would be profitable. Economists would say, “No” because Marcia should consider what she would give up. These are her implicit or opportunity costs. One cost is her $70,000 salary. (Marcia would work full time and quit her current job.) Assume that Marcia must invest $100,000 to start her business. She would give up the opportunity to invest $100,000 in another investment, such as a CD (Certificate of Deposit). Suppose the CD earns $2,000 in interest annually. Another implicit cost is $2,000, the interest income she would give up if she opened her ice cream parlor. Marcia’s projected economic profit equals a $19,000 loss, her accounting profit less the implicit expenses of $72,000. Clearly, Marcia would be better off financially if she did not open Marcia’s Ice Cream Parlor. The two profit and loss statements below summarize the difference between her projected accounting and economic profits.
The only difference between an economic and accounting profit is in the inclusion of implicit costs, so the accounting profit will always be greater than the economic profit. The economic loss does not mean Marcia is losing money, but she would be financially better off using her time and resources as a computer programmer. An interesting note is that if Marcia borrowed money to finance her business, the interest paid on the debt would be considered an explicit cost and included in the accountant’s and economist’s profit and loss because the company pays interest.
Now assume that George is interested in opening an ice cream parlor. George recently retired and would like to return to work. George and Marcia’s accounting profits would be equal, but George’s economic profit would be $51,000, assuming his only implicit cost is the interest income he would forgo when he invests $100,000 in his new business. These scenarios illustrate how two individuals owning the same business would have equal accounting profits but different economic profits because of their differing circumstances.
Small business owners frequently say, “I am making a profit, but not enough money to justify remaining in business.” In these cases, the business owners would be earning an accounting profit, but they would have an economic loss because the accounting profit is not large enough to absorb the opportunity cost of another job and the other implicit costs.
Opportunity Cost – The Cost of Every Decision
Entrepreneurs – Their Vital Role in The Economy
Changes in Supply – When Producer Costs Change
Market Structures I – Perfect Competition and Monopoly
