Difference between Accounting Profit and Economic Profit

This article will help you to learn about the difference between Accounting Profit and Economic Profit.

Difference between Accounting Profit and Economic Profit

Since every subject has its own language the accounting definition of profit differs from its eco­nomic definition. The accounting definition of profit is: total revenue minus explicit costs. Total revenue is simply the total income of the firm in an accounting period.

Explicit costs include wages and salaries, rent, interest, taxes and the cost of all raw materi­als, intermediate goods and services purchased by a firm. In short, explicit costs include payments for all inputs except management. What is left at the end, if anything, is treated as accounting profit.

Economists adopt a different view, economic profit is defined as: total revenue minus explicit costs plus the wages of management. Under some circumstances, an accountant would say that a firm has earned a profit, while an economist would con­tend that it has suffered a loss. This may be illus­trated by a simple example.

Example:

Consider the case of a retail service station. The service station business is quite competitive whether there is active price cutting or not. Let us assume, however, that this filling station is successful largely because of a good location and efficient manage­ment.

The last assumption is important since we must also assume that if he were not running the filling station, the manager would be employed else­where. To be specific, assume that the manager had been offered a job in a local manufacturing firm at an annual salary of Rs. 10,000 but he preferred to ‘run his own business’, even though it meant work­ing longer hours than he would have to as someone else’s employee.

At the end of the year, the manager finds that annual revenue was Rs. 60,000, while his total ex­penses amounted to Rs. 51,000. His accounting profit for the year is Rs. 9,000. The manager could, however, have earned Rs. 10,000 by working at the factor)’ and this represents his opportunity cost. Since the wages of management are determined by opportunity cost, the firm has incurred a loss of Rs. 1,000.

In corporation and in other large firms, man­agers are paid salaries. But if the wages of manage­ment are less than managements’ opportunity cost, a difference between accounting and economic profit still exists.

On the contrary, if a firm’s manager is paid more than his opportunity cost, part of his pay­ment is to be treated as economic rent. Empirically, the functional share that we call “profits” is a com­bination of normal profits, excess profits, wages of management and economic rent.

If there is freedom of entry in an industry, it is quite unlikely that economic profits will persist indefinitely. Without barriers to entry, profits will attract new competitors. Where profits remain con­sistently high as they do in a number of large firms in this country, it is reasonable to suppose that these firms are closer to the monopolistic than to the com­petitive end of the market spectrum.

There is controversy regarding the definition of profit, too. The public at large and the business community in general follow the accounting con­cept, and define profit as the residual of sales rev­enue minus the explicit (accounting) costs of doing business. It is the amount available for distribution as dividend to shareholders after all other resources used by the firm have been paid. This is accounting or business profit.

The economist also defines profit as the excess of total revenue over total cost. But the economist relies on the opportunity cost of resources in measur­ing profit. It is because the inputs provided by the firm’s owner(s), including entrepreneurial effort and capital, are resources that must be paid for if they are to be employed in that use as opposed to some other.

Thus, the economist includes a normal rate of return on equity capital and on opportunity cost for the effort of the owner-entrepreneur, as costs of do­ing business, just as the interest paid on borrowed money and wages paid to labour are treated as costs in calculating business profit.

We have noted that the normal risk-adjusted rate of return on equity is considered to be the minimum return necessary to obtain and maintain investment for a particular use.

In a like manner, the opportunity cost of owner effort is determined by the value that could be received in an alternative activity. Profit to an economist, then, is business profit, net of the implicit costs of equity, or other inputs provided by owners and used by the firm. This type of profit is often treated as economic profit and differs from true business profit.

Thus, it is clear that the concept of economic profit is often misunderstood and it is frequently confused with the firm’s business or accounting profit. The net income or loss shown on the ac­countant’s income statement is usually the difference between the total income of the business and its to­tal expenses in an accounting year.

The accountant generally lists only the explicit costs of operating the business. These costs consist of actual payments of cash or of bookkeeping entries for the expenses accounts, such as wages, materials and capital con­sumption (depreciation).

In order to find the true economic profit, however, the economist also consid­ers any implicit costs involved. These costs consist of allowances for the owner’s own factors of pro­duction, such as labour power, land or capital that are used in operating the business. This is necessary for reducing any income to a true economic profit.

The concepts of business profit and economic profit help to sharpen our focus on the issue of why profits exist, and what is their role in a non-socialist economy. The economist recognizes the need to pay a minimum sum to owner-provided inputs.

There is a normal rate of return, or profit, for example that is the minimum sum necessary to induce individ­uals to invest some of their funds in one activity, rather than to invest them elsewhere or spend them for current consumption.

This normal profit is sim­ply the minimum supply price of capital. It is not fundamentally different from the price of other re­sources, such as labour, raw materials and land.

A similar price exists for the entrepreneurial effort of a firm’s owner-manager, or for other resources own­ers bring to the firm. These opportunity costs for owner-provided inputs provide the primary justifi­cation of the existence of business profit.

The various concepts and techniques involved in the proper measurement of profits are of value to all groups with an interest in the economic health of the business firm.

Profit is used as a yardstick for measuring the validity of past decisions and in evaluating the potential of future decisions. Finan­cial institutions use profits to determine appropriate financial terms for lending to a firm; individual in­vestors use profits to assess the potential worth of the firm.

The Income Tax Department requires the measurement of profits for tax purposes; likewise, various government agencies require financial data to ensure full financial disclosure for widely held companies.

An examination of these groups and their spe­cific needs for measures of profits arises from their diverse requirements. Our objective here is not to suggest that either the accountant’s or the econo­mist’s view of profits is incorrect.

Rather, our basic purpose is to suggest that each view has a different purpose. Needless to say, a recognition of the differ­ences between the economist’s and the accountant’s measure of profit is a basic ingredient for any profit analysis.

One may note at the outset that the true prof­itability of any business entity is known only af­ter the firm has terminated operation. Thus, all at­tempts to measure profit are estimates, and some subjective and arbitrary decisions have to be made.