Economic Profit (or Loss)

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Economic Profit (or Loss)

Economic profit is the amount remaining after subtracting both explicit costs (actual cash outlays) and implicit costs (opportunity costs) from a firm’s revenue. It gauges whether a firm’s choices earn more than the next-best alternative.

Key takeaways

  • Economic profit = Revenue − Explicit costs − Opportunity costs.
  • Opportunity costs are the forgone earnings from the best alternative not chosen.
  • Accounting profit = Revenue − Explicit costs; it appears on financial statements.
  • Economic profit is theoretical and used for internal decision-making and scenario analysis.
  • If economic profit = 0, the firm is earning a “normal profit” (no better or worse than the best alternative).

How economic profit is calculated

Economic profit = Revenues − Explicit costs − Opportunity costs

  • Explicit costs: direct, out-of-pocket expenses such as wages, materials, rent, and depreciation reported on financial statements.
  • Opportunity costs (implicit costs): the income or benefits foregone by choosing one option over another (e.g., salary you gave up to start a business).

Accounting profit omits opportunity costs; economic profit includes them to measure the true economic benefit of a decision.

Economic profit vs. accounting profit

  • Accounting profit (net income)
  • Reported on income statements and used for tax and investor reporting.
  • Calculated by subtracting explicit costs from revenue.
  • Economic profit
  • Not reported on financial statements.
  • Subtracts estimated opportunity costs in addition to explicit costs.
  • Useful for evaluating strategic choices and resource efficiency.

Advantages and disadvantages

Advantages
* Helps compare alternative business ventures by accounting for forgone opportunities.
* Aids management in assessing resource allocation and long-term strategy.
* Useful both prospectively (what-if analyses) and retrospectively (lessons learned).

Disadvantages
* Relies on assumptions about opportunity costs, which are inherently uncertain.
* Short-term economic profit can be misleading; some ventures incur short-term losses before long-term gains.
* Less precise than accounting profit because implicit costs are estimated.

Special considerations

  • Opportunity costs vary with managerial estimates and market conditions; they are not directly observable.
  • Economic-profit analysis is most informative when used over appropriate time horizons and when comparing plausible alternatives.
  • It can be applied at different levels (per-unit, product line, or overall firm) for targeted decisions.

Examples

  1. Small-business example
  2. Startup costs (explicit): $100,000
  3. First-year revenue: $120,000
  4. Accounting profit = $120,000 − $100,000 = $20,000
  5. Opportunity cost (foregone salary): $45,000
  6. Economic profit = $120,000 − $100,000 − $45,000 = −$25,000

  7. Interpretation: an economic loss in year one, though future years may improve if costs decline or revenue rises.

  8. Per-unit production example

  9. Sell t-shirts: revenue/unit = $10; cost/unit = $5 → gross profit/unit = $5
  10. Alternative (shorts): revenue/unit = $10; cost/unit = $2 → forgone profit/unit = $8
  11. Economic profit for t-shirt = $10 − $5 − $8 = −$3 per unit
  12. Interpretation: producing t-shirts yields an economic loss relative to producing shorts by $3 per unit.

Bottom line

Economic profit incorporates opportunity costs into profitability analysis and helps managers evaluate whether current actions truly outperform alternative uses of resources. Accounting profit remains essential for reporting and compliance, while economic profit offers a broader economic perspective for strategic decision-making.