How Do Economists Calculate Profit?

Don't forget opportunity cost.

Economic profit is the difference between the revenue received from a particular output and the opportunity cost of the inputs used.

Terminology

Economic profit is sometimes referred to as "economic value added" (EVA), and should not be confused with "accounting profit." Accounting profit is what most people mean when they say "profit" and is what is used to calculate gross and net profit margin.

Calculation

To find economic profit, deduct opportunity cost from revenues earned:
Revenue - Opportunity cost = Economic Profit

What is an Opportunity Cost?

An opportunity cost is the price of a foregone option. It represents all the value you could have had if you had pursued another option. Note that this is not the sum total of all other options, but only the cost of the best option you didn't choose.

Example

Let's say you work for a company and make $100,000 a year. You leave that company to start a website that sells cupcake-shaped gourmet dog biscuits. You invest a year's salary in your business. The idea is even better than it sounds, and a year later, you've raked in $120,000. This would make your financial profit $20,000. (revenue - cost = profit)
Your economic profit, however, includes all the money you gave up when you quit your job. that loss is added to your investment costs meaning you've actually taken a loss of of $80,000. (Revenue - costs - opportunity costs = Economic profit/loss)

Testing

It is common to find a entrepreneurial example like the one above on economics tests. Teachers include it to contrast the apparent allure of an opportunity gain (financial profit) without the context of the opportunities sacrificed (economic profit). Use caution. In order for this example to be illustrative, the question of whether a salaried employee should start their own business must be no.

References

• Investopedia: Economic Profit (Or Loss)
• Valuebasedmanagement.net: Calculating Economic Profit