Accounting Profit vs. Economic Profit

Accounting Profit vs. Economic Profit:

The two important concepts of profit that figure in business decisions are ‘economic profit’ and ‘accounting profit’. It will be useful to understand the difference between the two concepts of profit.

In accounting sense, profit is surplus of revenue over and above all paid- out costs, including both manufacturing and overhead expenses.

Accounting profit may be calculated as:

Accounting Profit = TR – (W + R + I + M)

where TR = total revenue,

W = wages and salaries,

R = rent,

I = interest, and

M = cost of materials.

Obviously, while calculating accounting profit, only explicit or book costs, i.e., the cost recoded in the books of accounts, are considered. The concept of ‘economic profit’ differs from that of ‘accounting profit’. Economic profit takes into account also the implicit or imputed costs. The implicit cost is opportunity cost. Opportunity cost is defined as the payment that would be ‘necessary to draw forth the factors of production from their most remunerative alternative employment.

Alternatively, opportunity cost is the income foregone which a businessman could expect from the second best alternative use of his resources. For example, if an entrepreneur uses his capital in his own business, he foregoes interest which he might earn by purchasing debentures of other companies or by depositing his money with joint stock companies for a period.

Furthermore, if an entrepreneur uses his labour in his own business, he foregoes his income (salary) which he might earn by working as a manager in another firm. Similarly, by using productive assets (land and building) in his own business, he sacrifices his market rent. These foregone incomes-interest, salary and rent-are called opportunity cost or transfer costs. Accounting profit does not take into account the opportunity cost.

It should also be noted that the economic or pure profit makes provision also for:

(a) Insurable risks,

(b) Depreciation, and

(c) Necessary minimum payment to shareholders to prevent them from withdrawing their capital.

Pure profit may thus be defined as ‘a residual left after all contractual costs have been met, including the transfer costs of management, insurable risks, depreciation and payments to shareholders sufficient to maintain investment, at its current level.

Thus:

Pure profit = Total revenue – (explicit costs + implicit costs)

Pure profit so defined may not be necessarily positive for a single firm in a single year- it may be even negative, since it may not be possible to decide beforehand the best way of using the resources. Besides, in economics, pure profit is considered to be a short-term phenomenon-it does not exist in the long run, especially under perfectly competitive conditions.