Difference between Accounting Profit and Economic Profit

The term ‘profit’ is originated by the Latin work and its meaning is ‘to make progresses’. The word ‘profit’ has different meaning to different people like businessmen, accountants, tax collectors, workers and economists. The term is often used in a loose polemical (emotional) sense that hides its real significance. In a general sense, profit is regarded as income accruing to the
equity holders, in the same sense as wages accrue to the labour; rent accrues to the owners of rentable assets; and interest accrues to the money lenders. To a layman, profit means all income that flow to the investors. To an accountant, profit means the excess of revenue over all paid-out costs including both manufacturing and overhead expenses. It is more or less the same as net profit. For all practical purposes, profit or business income means profit in accounting sense plus non-allowable expenses. Economist’s concept of profit is of ‘Pure Profit’ called ‘economic profit’ or ‘just profit’. Pure profit is a return over and above the opportunity cost, i.e. the income which a businessman might expect from the second best alternative use of his resources. These two concepts of profit are discussed below in detail.

Business Versus Economic Profit

It is necessary to know the nature of profits because profit influences business activities. How do profits arise, what determines the volume of profits or stream expected future profits are important issues that need explanation. Profits or expected profit stream from a productive activity or an investment project play a crucial role in decision making by managers. But, as mentioned earlier, the term profits, as used in economics, differs from that generally used by business community. Therefore, it is necessary to explain first the difference between business profits and economic profits.

A business profit is an accounting concept of profit and represents the residual sales revenue to the owners of the firm after making payments to all other factors or resources the firm uses. These payments to hired factors include the wages to hired labour, interest on borrowed capital, rent on land and factory buildings and expenditure on raw materials used by the firm. The expenditures on these factors or resources hired on purchased by the firms are call explicit costs. Business profit refers to the sales revenue of the firm minus its explicit costs. In accounting sense, profit is defined as the residual of sales revenue minus the explicit accounting costs (or out-of-pocket expenditures of doing business). It is the amount available to provide rewards to the shareholders who have supplied the firm’s equity capital after payment for all other resources the firm uses. The explicit costs are the costs like wages, rent fuel, raw materials, interest on loans and depreciation. Thus,

Business Profits = Total sales revenue – Explicit costs

It is the concept of business profits that is generally used by the business community and accountants.

Economists also define profit as the excess of revenue over the cost of doing business. However, economists include the implicit costs of the inputs provided by the owners including entrepreneurial effort and capital in calculating profit. Economic profit is the difference between total revenues and total economic cost (including the economic or opportunity cost of owner-supplied resources such as capital and time). Economic cost or opportunity cost is the highest valued alternative opportunity that must be sacrificed or foregone as a result of choosing an alternative. The owner-entrepreneur uses his own capital for which he/she should be paid. The normal rate of return on capital is to be given to the owner as the minimum return necessary to attract and continue investment. Similarly, the opportunity cost of owner effort is determined by the value that could be received in an alternative activity. Hence, economic profit is business profit minus the implicit costs of capital and any other owner-provided inputs used by the firm.

In their calculation of economic profit, economists deduce not only explicit costs but also implicit costs from the sales revenue of the firm. The implicit costs refer to the opportunity costs of the resources provided by the firm’s owners themselves including capital and entrepreneurial ability. These self-owned factors must be paid if they are to be employed by the firm in its own production process otherwise they will be employed elsewhere on hired basis. Thus, economists take into account the normal rate of return on capital used by the owner of the firm in its own business and the transfer earnings of the owner-entrepreneur as costs of doing business.

The economic profit represents the sales revenue of the firm in excess of both explicit and implicit costs. Therefore,

Economic Profits = Sales revenue – Explicit costs – implicit costs

While explaining maximization of short-run profits or present value of the steam of expected future profits, economists assume that it is economic profits that owner-entrepreneur or managers of corporations seek to maximize. The concept of economic profits brings into sharp center the questions: why the profit which is over and above the normal rate of return on equity capital and reward for entrepreneurial ability in case of owner-entrepreneur exists and what is its role in a free enterprise system. In long-run equilibrium economic profits will be zero if all firms work in perfectly competitive market. Then, how do economic profits, positive or negative, come into existence. The various theories of profit provide explanation for the existence of economic profits.

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