The Accounting Profit vs Economic Profit
When you reach a point of studying higher studies of business, you would find that profit, as a measure of operational success, is measured in more than one way. Profit analysis requires looking at returns in more than one way to get different perspectives on how this was earned, and how future operations can be improved. Two of the most used terms in profit analysis are accounting profit and economic profit.
The Accounting Profit vs Economic Profit
Accounting profit refers to the explicit or monetary quantification of returns on investment. In simpler terms, this connotes the amount of money earned during a period of operations. "Accounting", being a fundamental word in this terminology, requires recording of actual amounts in monetary terms. Consider a textile store selling its products at $5 with a total cost of $4. If the sales for the period are at $50,000, with the cost of $40,000, and the expenses at $6,000, the accounting profit would be $4,000. Accounting profit refers to the simpler understanding of profit we have in everyday transactions.
Economic profit, on the other hand, includes implicit costs in the form of opportunity costs in its computational model. When making one choice between two options, you effectively discard the potential benefits of the other option. The discarded potential benefit in the option not chosen is the opportunity cost. Economic profit represents a computational model that includes the losses incurred by making the wrong choices. Consider a production facility with the option of buying a new machine or just repairing the old one. A new machine would cost $10,000. Repairing the old machine would cost $2,000. If they repair the old machine, the production would run 20% slower than if a new machine was bought. Let's assume that this 20% difference would cost the company around $10,000 in sales profits. Suppose the company chose to go for the repair instead of the purchase transaction. A simple analysis would tell you that a repair would be cheaper. However, since you chose this option, you effectively lost $10,000 in potential profits. This becomes the opportunity cost. You would then end up with zero economic profits in this particular transaction since the $8,000 saved on the repair would be offset by the $10,000 in lost potential profits if the purchase transaction was chosen.
Basically, economic and accounting profits are only made distinct by the use of opportunity costs. However, this difference gives an entirely different perspective when it comes to earnings. Accounting profits answer the question, "How well did we do this period?". Economic profits, on the other hand, answer the question, "If we chose this, how much do we earn?". If you look closely at the purpose of each, you would observe that they would be more appropriately used on different decision timeframes. Accounting profit is used to evaluate past performance to determine the success of operations. Economic profit is used to evaluate current decisions before they are made, to determine if one choice would be more valuable over another. In simpler terms, accounting profit is used as a control, and economic profit is used as a criterion.
The differences between accounting and economic profit are a representation of how different perspectives allow businesses to look at problems more effectively. By using both methods, we can evaluate performance and create plans to further the success of our businesses.
How does one identify opportunity costs?
When identifying opportunity costs, one must look at the point of the difference between the two choices. In the example above, for instance, the difference between the two choices lies in the lost revenues. When weighing two choices, ask yourself what aspect of the option would change if the other is chosen, and vice versa. Since opportunity costs represent a subjective value, analysis of the matter may be needed.
What basic requirements are needed to compute either value?
Accounting profit requirements are always in company books. These are fairly straightforward. Economic profits, on the other hand, would require different calculations and estimates for different situations. For instance, analyzing the time value of money based on life expectancy may require the help of an actuary. Estimating costs of repairs in buy-or-repair transactions may require a rigorous amount of information from the business. This could be extracted from past experience, best practices, and industry standards.
Is there an objective way to evaluate opportunity cost?
While economic profit has a simple formula, getting the opportunity costs present a real challenge. Since there is no real objective way to quantify opportunity costs, looking into historical data, best practices, and industry standards would be the best option at the moment.