What is Economic Profit?
Ahead of discussing how to calculate economic profit, first, lets begin by defining it and then talk of what it involves. Profit is an essential business outcome, and generating it is often the primary purpose of operating a business.
In order to evaluate a company’s financial success, accounting and finance professionals typically calculate the economic and accounting profit. An economic profit is the difference between the revenue received from the sale of an output and the costs of all inputs used and any opportunity costs.
Factors that Influence Economic Profit.
- Production unit. A production unit refers to a process, method, activity, or technique for production. With more units and stable demand, a company can increase the profit it makes.
- Demand. A product’s or service’s demand may change various aspects of a company’s profit.
- Management. A knowledgeable management team can help a business generate more revenue, which can increase the profit it makes.
- Competition. Companies producing similar goods or services can also influence a business’s profitability.
Importance of Economic Profit.
- Companies calculate economic profit to make informed business decisions and profitably allocate their resource.
- Economic profit is important because it is used as an indicator of how profitable company projects are and it therefore serves as a reflection of management performance.
- You can use the economic profit concept to determine whether to start a business.
- This concept can be used in other ways when deciding how to spend or invest your money
- Considering economic profit or loss can help you make better long-term financial decisions.
Limitations of Economic Profit
The limitations of economic profit are:
- Economic profit is only valid for one year.
- Employees bring value to an organization; economic profit does not consider this value in the calculation.
- There are no profit ratios considered when calculating economic profit.
Formula to calculate economic profit.
An implicit cost represents an opportunity cost that arises when a company uses internal resources toward a project without any explicit compensation for the utilization of resources.
Explicit costs are normal business costs that appear in the general ledger and directly affect a company’s profitability. Examples include wages, raw materials, and other direct costs.
Example:
A company has a total revenue of $200,000 and explicit costs of $150,000. Calculate the economic profit of the company if the implicit costs are $30,000.
Therefore, the company earned economic profit of $20,000.
