If a baker sells a brownie at a dollar that it cost him just 10 cents to make, many would say the baker earned 90 cents in profit. However, this is not true under certain definitions of profit. Profit is defined differently in the field of economics. Though the differences between economic profit and accounting profit are subtle, these distinctions have an influence on how people make business decisions.
Accounting profit is calculated subtracting the total revenue generated from the sale of an item with its explicit cost of production. Explicit costs include tangible costs such as materials, advertising expenses, factory upkeep costs, utilities and wages. Companies must report accounting profits by the Generally Accepted Accounting Principles.
Economic profit adds one more component to the well-understood “total revenue minus total cost” equation: An additional cost that must be subtracted from the revenue is the implicit cost, or, opportunity cost. Robert Carbaugh, author of “Contemporary Economics: A Practical Approach” explains how the calculation for accounting profit overestimates earnings because it ignores these extra costs. Carbaugh also explains that making zero dollars in economic profit is not bad, but perfectly normal: This indicates that switching to a new business brings no extra revenue, nor will it incur any losses.
To better understand economic profit, imagine you are a recent college graduate with a degree in engineering. For the past two years, you have worked as a DJ earning $400 a month and given the limited number of gigs, this is all you can expect to earn. Because your explicit costs are just $100, you technically earn $300 in (accounting) profit. However, your newly earned degree promises a job that pays $1,200 a month with no extra costs. This alternative engineering job you could pursue instead is an implicit cost, which must be considered in order to calculate the economic profit. Though the accounting profit for DJ’ing is $300, the economic loss is $1100. If, however, you earn $1,300 from being a DJ, your economic profit is zero. Essentially, you earn just enough to decide which profession derives the most satisfaction.
No business allows economic profit to be reported on its books. In fact, the concept of economic profit is mostly used for internal decision-making purposes for a person or within a corporation. For instance, if one line of makeup has the potential to earn $10,000 but it is estimated to cost $8,000 to develop and maintain, the business may want to stick with advertising a line of nail polish that consistently earns $5,000. Sometimes, the opportunity cost is just an estimate and can be difficult to calculate.