Why Two Profit Measures?
A business can report revenue greater than its cash expenses and still be using its resources less profitably than the alternatives available to its owner. The difference is that accounting profit subtracts explicit costs, while economic profit also recognizes the opportunity cost of resources supplied by the owner. Keeping these measures separate helps distinguish a positive accounting result from whether the business is the best use of those resources.
For this comparison, use a single defined period and the same revenue measure in both calculations. Treat explicit costs as costs paid to others and recorded for that period. Treat implicit costs as the value of the best alternative use forgone for resources the business obtains without an explicit payment. These are economic measures for decision analysis, not a claim about the format of any particular financial statement.
Here, \(TR\) is total revenue for the period, \(C_E\) is the total of explicit costs, and \(C_I\) is the total of implicit costs. Both profit measures are expressed in dollars for that same period. A resource's implicit cost is not every conceivable alternative use added together: it is the value of the best alternative the owner gives up.
How to Identify Costs in a Business Decision
Payments for purchased materials, rent paid to an outside landlord, wages paid to employees, and interest paid to a lender are examples of explicit costs in a basic business calculation. By contrast, an owner who works in the business without drawing a market wage gives up the wage available from the best alternative job. An owner using a building or funds in the business may also give up rental income or investment returns.
The same resource should not be counted as both an explicit and an implicit cost for the same use. If the business pays a hired manager's salary, that payment is explicit. If the owner instead performs that work without a salary, the forgone value of the owner's best alternative work can be an implicit cost. The correct classification depends on who supplies the resource and whether the business pays for it.
A useful way to calculate the measures is to first total revenue and explicit costs, then calculate accounting profit. Next, list the owner-supplied resources and value each at its best alternative use. Subtract the total implicit cost from accounting profit to obtain economic profit. This sequence makes the difference between the measures visible and reduces the risk of leaving out or double-counting a resource.
Use total revenue earned over the same period as the costs being considered.
The result is accounting profit under the simplified comparison used here.
For each resource, identify the best alternative use forgone and calculate its value for the period.
This gives economic profit, which includes the opportunity costs missing from the accounting-profit calculation.
Worked Calculations
Worked Example: An Owner's Consulting Practice
A consultant's hypothetical practice earns \( \$180{,}000 \) in revenue during a year. It pays \( \$62{,}000 \) in business expenses. The owner left a job that would have paid \( \$72{,}000 \) for the year, uses an office that could instead be rented out for \( \$18{,}000 \) per year, and invests \( \$50{,}000 \) of personal funds in the practice. Those funds could earn 5% for the year in the best available alternative investment. Calculate both profit measures.
Method. First calculate accounting profit using only payments made by the practice. Then calculate the opportunity cost of each owner-supplied resource and subtract those costs. The key is not to treat the owner's foregone salary, office rent, or investment return as cash expenses paid by the practice.
Step 1: Accounting profit. Total revenue is \( \$180{,}000 \), and explicit costs are \( \$62{,}000 \). Therefore:
Step 2: Implicit costs. The foregone job income is \( \$72{,}000 \). The office's forgone rental income is \( \$18{,}000 \). The alternative investment return on the owner's funds is \( 0.05 \times \$50{,}000 = \$2{,}500 \). Thus:
Step 3: Economic profit.
The practice has positive accounting profit of \( \$118{,}000 \) and positive economic profit of \( \$25{,}500 \). The check is that total revenue less all costs is \( \$180{,}000 - \$62{,}000 - \$92{,}500 = \$25{,}500 \), matching the result. A common mistake is to call the accounting profit the owner's full return; that ignores the income and return forgone by using the owner's time, office, and funds in the practice.
Worked Example: A Bakery Using an Owner's Building
A hypothetical bakery earns \( \$240{,}000 \) in annual revenue. It pays \( \$124{,}000 \) for ingredients and other supplies, \( \$36{,}000 \) in employee wages, and \( \$24{,}000 \) to rent equipment. The owner works full-time without taking a salary. The best alternative job for the owner would pay \( \$42{,}000 \) annually. The owner also uses a building that could be rented to another business for \( \$20{,}000 \) per year. Calculate accounting and economic profit.
Method. Add the bakery's actual payments to obtain explicit costs. Then separately value the owner's unpaid work and the building use. The building is owned by the owner, so no rent payment by the bakery is included in explicit costs.
Step 1: Total explicit costs.
Step 2: Accounting profit.
Step 3: Implicit costs. The owner's forgone wage is \( \$42{,}000 \); the building's forgone rental income is \( \$20{,}000 \). Therefore \( C_I = \$42{,}000 + \$20{,}000 = \$62{,}000 \).
Step 4: Economic profit.
The check using all costs is \( \$240{,}000 - \$184{,}000 - \$62{,}000 = -\$6{,}000 \). The bakery has positive accounting profit but negative economic profit: its revenue covers its explicit costs, but falls \( \$6{,}000 \) short of covering the stated opportunity costs as well. The mistake to avoid is subtracting the building's rental value as an explicit payment. It is an implicit cost here because the bakery does not pay rent to an outside landlord.
Worked Example: Comparing the Profit Measures Across Two Periods
A hypothetical repair shop has annual revenue of \( \$310{,}000 \) and annual explicit costs of \( \$205{,}000 \). Its owner supplies labor and personal funds. The owner's best alternative job pays \( \$68{,}000 \) annually. The funds used in the shop are \( \$120{,}000 \), and the best alternative investment earns 5% per year. Calculate both profit measures and their difference.
Method. Calculate accounting profit first. Then calculate the annual return forgone on the funds using the stated annual rate and add it to the forgone wage. All figures are annual, so there is no need to convert periods.
Step 1: Accounting profit.
Step 2: Annual opportunity cost of funds.
Step 3: Total implicit costs.
Step 4: Economic profit and difference.
The difference between the measures is \( \$105{,}000 - \$31{,}000 = \$74{,}000 \), exactly the total implicit cost. The independent check is \( \$310{,}000 - \$205{,}000 - \$74{,}000 = \$31{,}000 \). A common error is to subtract the \( \$120{,}000 \) principal as though it were an annual cost. The opportunity cost specified here is the annual return forgone, \( \$6{,}000 \), not the principal invested.
Why the Difference Holds
The relationship between the two measures follows directly from how economic costs are defined. Economic cost includes the explicit payments already deducted in accounting profit and adds the opportunity cost of owner-supplied resources. Starting with the accounting-profit expression and subtracting those implicit costs gives the economic-profit expression:
This also gives a useful check: under the stated definitions and for nonnegative implicit opportunity costs, economic profit cannot exceed accounting profit. It is equal to accounting profit only when implicit costs are zero. If accounting profit is positive, economic profit can still be positive, zero, or negative depending on the size of implicit costs. If economic profit is negative, revenue does not cover all the costs of the resources used, even if revenue exceeds explicit payments.
| Accounting profit | Implicit costs relative to accounting profit | Economic profit |
|---|---|---|
| Positive | Smaller | Positive |
| Positive | Equal | Zero |
| Positive | Larger | Negative |
| Zero or negative | Nonnegative | Zero or negative |
Common Mistakes and Interpretation
- Subtracting only cash outlays and calling the result economic profit. That calculation gives accounting profit under this comparison. Economic profit also subtracts the opportunity cost of owner-supplied resources.
- Counting every possible alternative. For each resource, use the value of its best alternative use forgone, not the sum of several alternatives the owner could not pursue simultaneously.
- Subtracting an asset's full value as a period cost. If the question supplies an annual rate of return for funds invested, the annual opportunity cost is the funds multiplied by that rate. Do not subtract the principal as if it were an annual expense.
- Double-counting a resource. If the business already pays an explicit cost for a resource, do not also count the same use as an unpaid owner-supplied resource.
- Using inconsistent periods. Annual revenue should be compared with annual costs; a monthly wage or return must be converted to an annual amount before it is combined with annual figures.
For a business decision, the economic measure is useful because it includes what the owner gives up by committing resources to the business. The accounting measure remains useful for describing revenue after recorded explicit costs. A positive value for one therefore does not, by itself, establish that the business produces a positive value after all stated opportunity costs.
These distinctions and calculations are aligned with the SOA VEE Economics (Validation by Educational Experience) syllabus.
Check Your Understanding
For each problem, calculate the requested values using the stated period and opportunity costs.
- A hypothetical tutoring service earns \( \$96{,}000 \) in a year and pays \( \$31{,}000 \) in explicit costs. Its owner gives up a job paying \( \$48{,}000 \) per year. Find accounting profit and economic profit. (Answer: accounting profit \( \$65{,}000 \); economic profit \( \$17{,}000 \))
- A hypothetical food cart earns \( \$150{,}000 \) annually and has explicit costs of \( \$92{,}000 \). Its owner uses personal equipment that could be rented out for \( \$9{,}000 \) annually and works without pay, giving up a \( \$44{,}000 \) job. Find both profit measures. (Answer: accounting profit \( \$58{,}000 \); economic profit \( \$5{,}000 \))
- A hypothetical studio has quarterly revenue of \( \$82{,}000 \) and quarterly explicit costs of \( \$57{,}000 \). The owner gives up quarterly wages of \( \$18{,}000 \) and uses funds of \( \$40{,}000 \) that could earn 2% per quarter. Find economic profit for the quarter. (Answer: \( \$6{,}200 \))
- A hypothetical farm earns \( \$275{,}000 \) in a year and has explicit costs of \( \$198{,}000 \). The owner forgoes a \( \$52{,}000 \) annual salary and uses land that could be rented for \( \$28{,}000 \) annually. Calculate accounting and economic profit, and state whether the signs agree. (Answer: accounting profit \( \$77{,}000 \); economic profit \(-\$3{,}000\); the signs do not agree)
- A hypothetical design business earns \( \$420{,}000 \) in a year, pays \( \$286{,}000 \) in explicit costs, and has implicit costs of \( \$47{,}000 \) for owner labor and \( \$15{,}000 \) for funds invested. Find both profit measures and verify their difference. (Answer: accounting profit \( \$134{,}000 \); economic profit \( \$72{,}000 \); difference \( \$62{,}000 \), equal to implicit costs)