Contents
What’s it: Economic profit is the difference between revenue and total costs (implicit costs plus explicit costs). This is another measure of profit besides accounting profit. Implicit costs represent opportunity costs when a firm chooses to use a particular factor of production.
Economic profit is lower than accounting profit. Accounting profit excludes implicit costs in the calculations. That’s the profit you see in the company’s financial statements.
Meanwhile, to get the economic profit, you have to calculate it yourself using several approaches such as economic value added (EVA).
Another term for economic profit is abnormal profit or supernormal profit.
Calculating economic profit
Economic profit takes into account both implicit and explicit costs. To calculate it, you can use the following formula:
Economic profit = Total revenue – Explicit costs – Implicit costs
Total revenue minus explicit costs are accounting profit. Therefore, we can rewrite the above formula to be:
Economic profit = Accounting profit – Implicit costs
What is the implicit cost
Implicit costs represent opportunity costs, which are the next best alternative that is lost when a company decides to choose a production factor.
Because firms account for implicit costs, companies may record zero or negative economic profit, even when their financial statements show positive accounting profit.
Opportunity cost is a trade-off when a company makes a decision. For example, a company has an alternative to the location of a production facility. The company decided to buy land instead of renting it. In this case, if the land lease is the next best alternative after purchase, then land rental cost represents an opportunity cost. Thus, companies will consider it when calculating economic profit.
What is the explicit cost
Explicit costs are business costs in the form of direct payments to input suppliers or decreased economic value of an asset. Examples are raw materials, salaries, and rent. You can see the details in the company’s financial statements.
The difference between economic profit and accounting profit
Accounting profit equals total revenue minus explicit costs. That is the profit that the company presents in the company’s income statement. To present it, the company adheres to applicable accounting standards.
Conversely, you will not find economic profit in the income statement. The company has no obligation to disclose it to external parties such as regulators, investors, or financial institutions.
Accounting profit tells you how profitable companies are using their current assets to produce goods and services. Meanwhile, economic profit incorporates an analysis of something that is not currently reflected in its assets. For this reason, companies may report positive accounting profit, but economic profit is negative.
Economic value added as an indicator.
Economic value added (EVA) is a measure of a company’s economic profit after deducted by the cost of capital financing.
The formula for EVA is:
Economic profit = Net operating profit after tax – (Capital investment x WACC)
You can find accounts for calculating net operating profit after tax (NOPAT) in the company’s income statement.
The capital invested is the same as the sum of the equity and the company’s interest-bearing debt.
The weighted average cost of capital (WACC) is the cost of funds that a company bears when using equity and debt as a source of funding.
The multiplication between the WACC and the capital investment represents the cost of capital invested in the company. This is the minimum return that investors require to be willing to provide funds to the company.
For example, ABC Company recorded a NOPAT of $3,000. Meanwhile, the total capital invested was $2,000. From a separate calculation, the WACC is around 5%.
Therefore, we can calculate economic profit as:
Economic profit = $3,000 – ($2,000 x 5%) = $2,900
From the result, we know that the company earns economic profit, which indicates that it makes enough profit to cover the capital cost invested by shareholders and creditors.
Why economic profit matters
Economic profit is important to show how appropriate the company’s decisions are in choosing and using resources to generate income. When economic profit is positive, the company can recoup lost opportunity costs when they choose existing resources. This implies that the company is making above average profits, which will attract new companies to enter the market.
Meanwhile, if economic profit is zero, the company has no incentive to enter or exit the market. If the company uses the resources for the next alternative, it will not result in better profits. Because implicit costs will equal the company’s current accounting profit.
Furthermore, if the economic profit is negative, the company will divert the use of current resources. It has an incentive to leave the market and use resources elsewhere.
Factors affecting economic profit
The two main factors affecting economic profit are the number of players in the market and the time period. The number of players is related to the market structure in which the company operates.
In a competitive market, the company may book short-term economic profit. But, the company will not be able to sustain it in the long term.
Economic profit is a signal of market entry or exit. If the existing company makes an economic profit, it invites other companies to enter. They bring new supplies to the market, causing prices to fall. A fall in prices reduces revenue and makes an economic profit equal to zero (normal profit).
Zero economic profit doesn’t mean the company is unprofitable at all. As I said earlier, it may still earn a positive accounting profit.
In imperfectly competitive markets, such as oligopoly and monopoly, firms are likely to get economic profit in the long run. How big is the economic profit and how long the company can sustain it depends on:
- Entry barrier. The higher barriers to entry mean, the greater the company’s chance to maintain an economic profit. The competitive pressure of new entrants is minimal.
- Monopoly power. Suppose it can influence the market price and set the selling price above the perfectly competitive market equilibrium price. In that case, the firm has a high opportunity to generate and maintain an economic profit. The chance is relatively low if the company operates in a monopolistic competitive market. It increases if the firm operates in oligopoly and monopoly markets.
