Accounting Profit vs Economic Profit

What is Economic Profit vs. Accounting Profit?

Accounting profit is simply revenue minus the costs a company records in its accounts (wages, rent, materials, depreciation, etc.). Economic profit is a bit more comprehensive in that it also subtracts the opportunity cost of the owners' time and money. So it will also deduct the salary the owners could have earned elsewhere or the return they could have made on their money in other investments.

Accounting profit = Total revenue - Explicit costs

Economic profit = Total revenue - Explicit costs - Implicit costs

Two businesses can end up with the same profit and yet be in very different positions because accountants and economists go about the calculation of cost in different ways.

Revenue on its own isn't profit, and neither is the cash remaining after dividends have been paid. Dividends are paid out of profit, which has already been earned, so they don't feature in either of those calculations.

This guide looks at both measures, runs through one business on both measures, and shows how corporate finance takes economic profit and turns it into economic value added (EVA).

What is Accounting Profit?

Accounting profit is revenue less the costs that appear in the accounts. The term is often used to mean net income (the bottom line of the income statement), but profit appears at a number of different levels: gross profit, operating profit and net income. At each level, only the costs that are in the accounts are deducted.

The vast majority of those costs are explicit (i.e., the company pays them out in cash) in the form of wages, rent, materials and utilities. Depreciation is the one exception. It's a non-cash charge: the cost of an asset that was purchased in a previous period being apportioned across its useful life. It's a non-cash charge, but it is still a charge to accounting profit.

Companies report accounting profit to their investors and lenders under either GAAP or IFRS. Tax is a separate exercise. Taxable income is derived from accounting profit and then subject to a series of tax adjustments (e.g. different depreciation rules).

Fixed and variable costs. Costs also behave differently as output changes:

• Variable costs go up and down with volume. Raw materials, most direct labor, sales commissions, and the utility cost element that varies with production are all examples.
• Fixed costs remain pretty much the same over a normal range of output. Rent, insurance, the salaries of the permanent staff, and the depreciation of plant and equipment are all examples. You're paying them whether or not you're producing anything.

The split is important as fixed costs are what turn a good month into a loss when you're down on volume.

Accounting profit example. Take a small business with the figures below, all for one month. It has no debt, so interest is zero.

• Revenue: $50,000 (quantity sold times price)
• Cost of goods sold (COGS): $15,000
• Wages: $15,000
• Rent: $3,000
• Utilities: $1,000
• Depreciation: $500
• Tax rate: 20%

The business earns $15,500 before tax and $12,400 after tax. Every cost in the table is one the company recorded, which is why this is accounting profit. To build statements like this from scratch, try WSO's Financial Statement Modeling Course.

What is Economic Profit?

Economic profit is accounting profit minus implicit costs. Implicit costs are the opportunity costs of resources the owners already have and are using in the business: their own time, their own money, and their own assets. Nobody sends an invoice for these, so they never reach the income statement. They are real, though. Every hour the owner works here is an hour not spent earning a salary somewhere else.

Strictly speaking, every cost has an opportunity cost, explicit ones included. Implicit costs are the ones the books miss. That's why economists treat opportunity cost as the broader idea and implicit cost as the slice of it that never shows up in the accounts.

Typical implicit costs include:

• The salary the owner gives up by running the business instead of taking a job elsewhere
• Rent the company could collect by leasing out premises or equipment it owns instead of using them
• The return the owners' invested money could earn in the next-best investment

Add those up, and you get the minimum the business has to earn to be worth running. Economists call that a normal profit. A firm earning exactly that amount has zero economic profit. It covers every cost, including what its owners could have earned elsewhere.

Anything above that is economic profit. Anything below it is an economic loss, even if the accounts show a profit.

The extra step is worth taking because a business can look healthy on the income statement while quietly underpaying its owner. A café owner who nets $40,000 a year but could earn $70,000 as a manager is running an economic loss of $30,000, before counting any return on the money invested. (The figures are illustrative.)

Economic profit prices what owners give up, but it still measures money. It doesn't capture non-financial factors such as reputation or employee morale, which come up again later in this guide.

Worked Example: Same Business, Two Profits

Take the business from the accounting example: same month, same numbers. The owner works in it full-time and owns the machinery. In the other scenario, the owner could be earning $5k a month as an employee and then renting out the machinery for $2k a month.

We compare on a pre-tax basis, as the opportunity costs are pre-tax amounts as well. At 20% tax on the result, you get $6,800 after tax. If you just subtract the $7,000 straight out of net income, you're mixing a pre-tax cost with an after-tax profit, and you're going to understate the answer.

Now change one number. Suppose the owner's best outside offer is a $14,000 per month salary. The implicit costs are now $16,000, and economic profit is $15,500 − $16,000 = −$500.

The books are still making a profit. The owner would be better off shutting the business down and taking the job.

A full analysis would also charge the owner's own capital. If $40k of personal savings could earn 8% elsewhere, that's another $3,200 a year or around $267 a month.

You'd only do that if the $40k is the capital of the machinery you've already included in your calculation; otherwise, you'd be double counting it.

Three points to take from the example:

1. Accounting profit is the figure that tells you the business has made a profit.
2. Economic profit tells you whether that money has outperformed the owner's best alternative.
3. The alternative you choose (the $5k job or the $14k job) can actually change the answer, so you need to state your assumption.

Note what the example doesn't require at all: any change to the accounts. The income statement was exactly the same in both cases, and the only thing that changed was the assumption about the owner's alternative. That is the entire difference between the two measures in a single paragraph.

Differences Between Accounting Profit and Economic Profit

The table summarizes where the two measures differ.

Both measures start from the same results, so "backward-looking vs. forward-looking" is a loose way to describe them. Accounting profit reports what happened. Economic profit takes those results and asks whether the choice was worth making, which is why people use it to guide decisions.

Think of the gap as the price of the owner's alternatives. In the example above, the gap between $15,500 and $8,500 is the $7,000 of forgone salary and rent. The higher the owner's outside offer, the wider the gap will be, and the income statement is unaffected.

Which is larger? Accounting profit is normally the larger figure, as implicit costs are almost always negative. The difference between the two is the implicit cost. When implicit costs are small, the two figures are very close together. When implicit costs are large, then you can have a very healthy accounting profit and a negative economic profit.

A very common misconception. Accounting profit is not "false," and economic profit is not "true." They are simply answering different questions. Accounting profit is the amount of profit the company has made according to the accounting rules. Economic profit is the amount of profit the company has made, taking into account the opportunity cost of using those resources in that particular way.

Which do you use? For tax and reporting purposes, you use accounting profit. For strategy and capital allocation, you use economic profit. Most finance work uses both.

How to Measure Economic Profit With Economic Value Added

Because economic profit isn't reported, analysts build it themselves. The standard method in corporate finance is economic value added (EVA), also called residual income.

Economic profit = NOPAT - Invested capital × cost of capital

NOPAT is net operating profit after tax (i.e., EBIT times (1 minus the tax rate)). The capital charge is the return that investors expect on the capital employed in the business. In practice, that will be the company's WACC.

Worked example: A company has $150k of EBIT, a 20% tax rate, $800k of invested capital, and a 10% cost of capital.

NOPAT = $150,000 × (1 − 0.20) = $120,000

Capital charge = $800,000 × 10% = $80,000

Economic profit = $120,000 − $80,000 = $40,000

Another way to look at it: ROIC is NOPAT divided by invested capital, which is $120,000 divided by $800,000 = 15%. The spread over the 10% cost of capital is 5%, and 5% of $800,000 is $40,000. Same answer.

Economic profit = ROIC - Cost of capital × Invested capital

Positive economic profit means the business earns more than investors could expect elsewhere. A company can post a healthy net income and still destroy value if its ROIC sits below its cost of capital. To see how the cost of capital is built, look at WSO's DCF Modeling Course.

Because economic value added charges for capital, it discourages managers from tying up money in projects that earn less than the money costs. Take a division with $5 million of NOPAT and $60 million of invested capital at a 10% cost of capital. The capital charge is $6 million, so economic profit is $5 million − $6 million = -1 million. The division looks profitable and still destroys value.

Scenario analysis. Since the inputs are estimates, run the calculation under a base, upside, and downside case. It shows how sensitive economic profit is to your assumptions about growth, margins, and the cost of capital.

How Economic Profit Shapes Business Decisions

Economic profit is the one that really matters when you have a finite amount of resources and have to make a choice. That's where opportunity cost comes in. If you can afford to fund every single good idea, then you're not giving up anything. If you can only fund one, then the profit from the idea you pass on is the opportunity cost of the one you do go with.

Example: stores or automation? A retailer has $1m to spend and two options. The numbers are just for illustration.

Both projects are profitable in the accounts. The retailer can only fund one of them, though, so the choice of stores is a choice of giving up $180k. Automation is the best use of the cash.

• Hurdle rates: In practice,e that's what it amounts to in this discipline. You've got a hurdle rate. The project has to beat the return that the firm's capital could earn elsewhere (usually its cost of capital). Suppose it does that; it adds economic profit. If it doesn't,  it destroys it.
• Margin vs. return: A low margin is not necessarily a low return. The supermarket will have very thin margins on each individual sale but will turn its stock over very quickly so its return on the capital tied up in stock can be higher than that of a high-margin boutique. You have to compare what each product earns on the scarce resource (be that capital, shelf space, or staff time), not what it earns per sale.
• Non-monetary factors: Neither of the measures assigns a value to reputation, employee morale, or sustainability, all of which can in themselves be drivers of future profit. Spending on training, on customer service, on brand building, etc is generally expensed in the year it's incurred, so the accounting profit is reduced in that year, and the benefit comes later in the form of lower turnover or higher sales. 

The same is true of any corporate social responsibility project. Economic profit helps a little as it enables you to compare the expenditure against the next best alternative use of that money. It's still all based on estimates so again treat these as inputs to your assumptions rather than as an extra line in the calculation.

Measuring and Reporting Economic Profit

As economic profit isn't reported, you'll have to work it out yourself. The standard method in corporate finance is Economic Value Added, which is also known as Residual Income:

Economic profit = NOPAT − (invested capital × cost of capital)

NOPAT is net operating profit after tax (i.e., EBIT times (1 minus the tax rate)). The capital charge is the return that investors expect on the capital tied up in the business.

A company with $150k of EBIT and a 20% tax rate has NOPAT of $120k. It has $800k of invested capital and a 10% cost of capital, so the capital charge is $80k. Economic profit is $40k. Another way to look at it is that its return on invested capital is 15% (i.e., 150K / $1M); the spread over the cost of capital is 5%, and 5% of $800k is $40k. Positive economic profit means the business is making more than investors could expect to make elsewhere.

The method has limits. The cost of capital and the “next-best alternative” both take judgment, so two analysts can reach different answers.

Limitations of Each Measure

Neither figure tells the whole story, and each in its own way has its drawbacks.

Accounting profit depends on accounting choices:

• Depreciation methods and asset lives will affect reported profit without in any way affecting cash.
• The timing of when you recognize revenue can move profit from one period to another.
• It charges for debt (interest) but not for equity, so a company can report a profit whilst earning less than the shareholders would require.
• It makes no adjustment for risk, so a stable business and a speculative business with the same net income are exactly the same.
• It has depreciation on the past purchases (a sunk cost), and that tells you very little about what the asset could be earning today.

Economic profit depends on assumptions:

• The owner's next best salary is of course unobservable, so two analysts could well come up with different figures.
• The cost of capital is an estimate and a small change can swing the result.
• Small businesses generally have no idea what their implicit costs are and so are forced to guess.
• It's just a snapshot of one period, so a growth project can have negative economic profit in the early days and then turn positive.
• It's not standardized or audited, so comparisons between companies are only really valid if everyone is using the same methodology.

The practical answer is to use both. Accounting profit is the figure that the company reports and that lenders, investors and tax authorities all work with. Economic profit is the figure that tells you whether that profit was actually sufficient.

When they're in disagreement, the gap is a pointer to the assumptions that are worth looking at. What is the owner's real alternative? What return do the investors actually require? Those two questions usually tell you more than either profit figure in isolation.

One caveat for students: a negative economic profit is not in itself a reason to cease operations. A new business can run an economic loss for years as it builds up its customer base, and a sensible entrepreneur can quite reasonably accept that if the expected payoff is sufficient. Economic profit is a criterion to be applied with judgement rather than a rule which automatically leads to closure.

Conclusion

Accounting profit is what the business has made. Economic profit is the question of whether that was sufficient to justify the business being run at all. A company can easily pass the accounting profit test and fail the economic profit test, and that gap is the one that the finance student is looking for when assessing a project, a product line or indeed the whole firm.

A quick way to apply both measures:

1. Start with the accounting profit from the income statement (before tax).
2. List what the owners' time, money, and assets could earn in other investments.
3. Subtract those implicit costs to get economic profit.
4. For the company, switch to NOPAT less a charge for invested capital.
5. Run a downside case before you put any faith in the answer.

To get a feel for how to build the statements and the cost of capital that underpins these numbers, check out WSO's Financial Statement Modeling course and DCF Modeling course.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Accounting
• Accounting Profit
• Expenses
• Income vs Revenue vs Earnings
• Profit