1

Business vs Economic profit

UNIVERSITY OF THE PUNJAB

TOPIC: BUSINESS PROFIT VS

ECONOMIC PROFIT:
SUBJECT: MANAGERIAL ECONOMICS:
SECTION: A
DATE: 8-4-2020

SUBMITTED TO: MAM AYESHA SERFERAZ:

SUBMITTED BY: IQRA BATOOL (04)
AYESHA SHAFIQ (11)
KASHAF AMJAD ( 20)

Table of contents:
 2
Business vs Economic profit

Profit………………………………………………………………….……………3

Business profit……………………………………………………………......3

Explicit cost……………………………………………………………….…..…3

Formula…………………………………………………………………………….3

Normal rate of return……………………………………………………….4

Example…………………………………………………………………………...4

Economic profit…………………………………………………………..……4

Opportunity cost……………………………………………………….……..4

Implicit cost………………………………………………………………….…..4

Formula………………………………………………………………………….…5

Example…………………………………………………………………………….6

Business profit vs economic profit…………………………………….7

Conclusion……………………………………………………………….…….….8

References ………………………………………………………………………..8
 3
Business vs Economic profit

What is Profit?
“Profit simply means a positive gain generated from business operations or
investment after subtracting all expenses or costs”.
Formula:
Profit = Total revenue - Total cost

Business or Accounting Profit:

Definition:
The residual of sales revenue minus the explicit costs of doing business.
It is calculated by deducting all the explicit cost incurred which refers to monetary
cost from the revenue. Whatever is left after the payment of all cost.

Formula:
Here’s how we can write the formula of calculating the accounting profit:
Accounting profit = total revenue – Explicit costs

Explicit cost:
“Explicit Costs are the costs which involve an immediate outlay of cash from the
business.’’
The cost is incurred when any production process is going on, or activity is conducted
in the normal course of business. The cost is a charge for the use of factors of production like
land, labor, capital and so on. They are in the form of rent, salary, material, wages, and other
expenses like electricity, stationery, postage, etc. It is also called as Out of the Pocket Cost.

Normal Rate of Return:

“It is defined as the minimum return necessary to attract and retain the investment “

Normal rate of return is important because business profit can be converted into more
profit if you have some profit left.

Example:
Accounting profit is explained by taking a simple example. Let us suppose, the total
revenue of a furniture shop from the sale of furniture in 2019 is 500,000. Its costs on the
purchase of raw material is 150,000, payment of wages and other utilities is 200,000.
Calculate accounting profit of the company for the year 2019 based on the given information.

Solution:
First Explicit Costs is calculated using the formula given below;
 4
Business vs Economic profit

Explicit Costs = Cost of raw material + Payment of wages and other utilities
Explicit Costs = 150,000 + 200,000
Explicit Costs = 350,000

Explicit costs Amount in $

Cost of raw material 150,000
Payment of wages and utilities 200,000
Total explicit costs 350,000

Accounting Profit is calculated using the formula given below

Accounting Profit = Total Revenue – Explicit Costs

Total revenue 500,000

Total Explicit costs 350,000

Accounting Profit = 500,000 – 350,000

Accounting Profit = 150,000
Therefore, firm generated an accounting profit of 150,000 during the year 2019.

Economic Profit:
Before discussing the definition of economic profit, we have to understand the
concept of implicit cost and opportunity cost.
Opportunity cost is the loss of other alternatives when one alternative is chosen.
Opportunity lost is opportunity cost.
For example: At the ice cream shop, you have to choose between rocky road and
strawberry. When you choose rocky road, the opportunity cost is the enjoyment of the
strawberry.
Implicit cost does not involve a cash transaction, and so we use the opportunity cost
concept to measure them. Implicit costs are related to forgone benefits of any single
transaction. These are intangible costs that are not easily accounted for.
Example, the time and effort that an owner puts into the maintenance of the company rather
than working on expansion.
So, the
Economic profit is the difference between the total revenue received by a business
and the total implicit and explicit costs of a firm.
Economic profit is similar to accounting profit in that it deducts explicit costs from
revenue.
 5
Business vs Economic profit

Formulas:
Here's how you can write the formulas for calculating economic profit:

 Economic Profit = Accounting Profit - Implicit Costs

Another way people write this is:

 Economic Profit = Total Revenues - (Explicit Costs + Implicit Costs)

Example:
• Ali starts a restaurant business on his own land. In the first year, he makes a
revenue of Rs.550,000. Since he is new in this business, so he has to buy a new
food equipment and food and also, he has to hire the employee to run the
restaurant. He makes a scribbled note which looks as follows –
• Wages paid to employees – Rs.100,000
• Food items – Rs.200,000
• Equipment – Rs.50,000
• Using the information above, you need to find out the accounting profit of Ali in
the first year of his restaurant business. And also calculate economic profit (or
loss) due to his decision to start this business.
• From the information mentioned above, first, let’s find out the accounting profit
–
• Accounting Profit = Total Revenue – Explicit Costs
• So, we know the total revenue here, i.e. Rs.550,000.
• We need to compute the explicit costs –

Explicit Costs In Rs.

Wages paid to employees 100,000
Food item 200,000
equipment 50,000
 6
Business vs Economic profit

Total Explicit Costs 350,000

Revenue (A) Rs.550,000

(-) Total Explicit Costs (B) (Rs350,000)

Accounting Profit (A – B) Rs.200,000

Ali could earn Rs.250,000 by rented his place. We assume that if he would have not
started his business in this year, he could have earned Rs.250,000 by rent. That means
Rs.250,000 is his opportunity cost for starting off with this business.
Here’s the formula:

 Economic Profit = Accounting Profit – Opportunity Cost Foregone

 Economic Loss = Rs.200,000 – Rs250,000 = -Rs.50,000.

Business Profit Vs Economic Profit:

Business Profit or Accounting Profit:
Business profit is the monetary costs a firm pays out and the revenue a firm receives.
It is also called accounting profit, bookkeeping profit and financial profit.
Economic Profit:
Economic profit is the monetary costs and opportunity costs a firm pays and the
revenue a firm receives.

Which cost is included?

While calculating Business profit, only explicit or book costs, i.e., the cost recoded in
the books of accounts, are considered.
Economic profit takes into account also the implicit or imputed costs. The implicit
cost is opportunity cost.
Principle:
 7
Business vs Economic profit

Business profit is estimated by generally accepted accounting principles (GAAP)

while economic profit is estimated by economic principles.
Inclusion or exclusion of Opportunity cost:
Business profit is the difference between the total revenue and the total cost,
excluding the cost of the opportunity.
On the contrary, economic profit is the difference between the total revenue and the
total cost, including the cost of the opportunity.
Formula:
Business profit = total monetary revenue- total costs (explicit costs).
Economic profit = total revenue – total costs (explicit costs + implicit costs).
Which one is greater?
Business profit is greater than the Economic profit as the latter includes a few more
categories of income and expenses.
Relevance:
Business profit gives the true financial health of a company.
While economic profit may not give a true picture as certain parameters are
estimated.
Estimation
Business profit is easy to calculate while, it is difficult to accurately estimate
economic profit because opportunity cost of any business activity not pursued is difficult to
estimate accurately.
What Does It Tell?
Business profit tells about the profitability of a company.
Economic profit, on the other hand, tells whether or not the company is efficiently
allocating the resources.

Practical:
Business profit is more practical as it is based on what has actually happened
throughout the year or quarter.
Economic profit, however, is based on the assumptions and reflects the decisions that
a company could have taken.
Relevance in Long-Run:
 8
Business vs Economic profit

Business profit is basically a short-run phenomenon as it tells the financial health of a

company for that year.
Economists, on the other hand, use the economic profit for creating long-terms
strategies, such as whether or not a firm should enter or exit a market.
Conclusion:
The entire future of any company depends on the profit earning potential in the near
future and also how has it performed in the recent past. As a shareholder/investor, the
accounting or business profit is of importance as that will give the true picture of the financial
performance. Economic profit, on the other hand, could be used by management internally to
assess their decision on the projects foregone. Even though the calculation of economic profit
involves a few assumptions, it could give management an idea of where they are heading.
References:
 https://www.patriotsoftware.com/blog/accounting/what-is-p-l-management-profit-
loss-responsibilities/
 http://www.economicsdiscussion.net/profit/what-is-profit-firm-economics/25886
 http://www.economicsdiscussion.net/business-economics/accounting-profit-vs-
economic-profit/7126
 https://efinancemanagement.com/financial-accounting/accounting-vs-economic-profit
 http://www.differencebetween.net/business/finance-business-2/difference-between-
accounting-and-economic-profit/
 Difference Between Accounting and Economic Profit | Difference
Between http://www.differencebetween.net/business/finance-business-2/difference-
between-accounting-and-economic-profit/#ixzz6IdyJrf6p