How can you be sure that you make the best financial decision when evaluating whether to take a job or invest in a new business opportunity? Your friends might tell you to calculate the Profit you think you can make in both opportunities and compare them to see which is better.
What they are most likely referring to is accounting profit. But unfortunately, they don’t realize there is another way to analyze your situation that considers the alternatives you may be giving up. The other way is to calculate the economic Profit of the two scenarios.
Economic Profit is the difference between the total revenue received by a business and the total implicit and explicit costs of a firm. It’s often the extra Profit left over after considering the next best alternative investment and can be either positive or negative in value.
Economic Profit vs. Accounting Profit
Economic Profit should not be confused with accounting profit, a firm’s revenue minus its explicit costs. Explicit costs are what most people think of as regular business expenses. These are payments to others for running a business, such as paying rent, wages, utilities, and purchasing IT equipment.
Economic Profit differs from accounting profit because it also includes implicit costs, which are the opportunity costs equal to what a business or individual gave up to do something else. These costs are deducted from revenues and are the alternative returns you decided not to pursue. Adding implicit costs to your profit calculation gives you another way to compare financial alternatives.
So, is it possible to have a positive accounting profit and a negative economic profit for a business? The answer is yes. A negative economic profit implies that you could be financially better off by engaging in a different opportunity. A positive economic profit means that no available or comparable opportunities are more financially profitable because you have already factored those into your calculation. Let’s look at the formula and an example of calculating economic Profit to clarify it.
Formulas: Economic Profit and Accounting Profit
Here’s how you can write the formulas for calculating accounting and economic Profit:
- Accounting Profit = Total Revenues – Explicit Costs
- Economic Profit = Accounting Profit – Implicit Costs
Another way people write this is:
- Economic Profit = Total Revenues – (Explicit Costs + Implicit Costs)
Example: Economic Profit
You invest Rs 5 Lakhs of your savings in starting a new business. In the first year, you earn Rs 10 Lakhs in revenue. Therefore, your accounting profit would be Rs 5 Lakhs, which is Rs 10 Lakhs in revenue minus Rs 5 Lakhs in explicit costs. Now, let’s assume that you could have done a different business with the same investment of Rs 5 Lakhs and earned annual revenue of Rs 9 Lakhs or an accounting profit of R 4 Lakhs. This Rs 4 Lakhs accounting profit from the alternate business is your lost opportunity or implicit cost in the first scenario.
To compare options, see if you can figure out how to use the simple economic profit formula to determine if you were better or worse off opening your own business.
Economic Profit in Scenario 1
Economic Profit = Accounting Profit – Opportunity Cost,
= Rs 5 Lakhs – Rs 4 Lakhs
=Rs 1 Lakh
Economic Profit in Scenario 2
Economic Profit = Accounting Profit – Opportunity Cost
= Rs 4 Lakhs – Rs 5 Lakhs
= – Rs 1 Lakh
For scenario 2 to be profitable, an alternate business must generate a higher revenue than the business in scenario 1
Bottom-line: Use Economic Profit for Investment Evaluation
economic Profit or loss captures the difference in value between doing one thing versus another – It doesn’t look at a profit in isolation; it also examines what the alternative Profit would have been. While investing in economic Profit plays an important role, for example; if you are considering investing in a growth stock giving a high annualized return of 15% p.a., You should take a decision based on the opportunity cost of investing in this growth stock, i.e., what returns others stocks in the same industry or sector are giving. If returns from other stocks are 12%, then the growth stock’s economic return would be 3 %.
In a nutshell, economic Profit should be used for comparison while investing. The objective should be to get an alpha.
