Key Takeaways
– Economic profit = Revenue − Explicit costs − Opportunity costs. It goes beyond accounting profit by including the value of foregone alternatives.
– Accounting profit (net income) appears on financial statements; economic profit is an internal decision tool and is not reported to regulators.
– A positive economic profit indicates a choice produced more value than its next best alternative; zero economic profit (normal profit) means resources earned just as well as the next best use.
– Opportunity costs are implicit and subjective — estimate them carefully and test alternatives with sensitivity analysis.
– Use economic profit for “what‑if” planning, product mix decisions, venture evaluation, and resource allocation, but adjust for risk, time value of money, and measurement uncertainty.
Understanding Economic Profit
Economic profit measures the true economic value created by a decision after accounting not only for explicit cash costs but also for the value of opportunities given up. Because it subtracts opportunity costs (implicit costs), economic profit can differ substantially from accounting profit.
– Explicit costs: actual outlays recorded on the income statement (COGS, wages, rent, depreciation, interest, taxes).
– Implicit costs (opportunity costs): the value of the next best alternative use of the same resources (e.g., salary forgone by an owner, profit forgone by using equipment for Product A instead of Product B).
How to Calculate Economic Profit
Basic formula:
Economic profit = Total revenue − Explicit costs − Opportunity costs
If you omit opportunity costs, the result is accounting profit (net income):
Accounting profit = Total revenue − Explicit costs
Practical numeric examples:
– Startup example:
– Revenue = $120,000; explicit costs = $100,000 → accounting profit = $20,000.
– Owner’s forgone salary at prior job = $45,000 → economic profit = $120,000 − $100,000 − $45,000 = −$25,000 (an economic loss).
– Interpretation: Although positive accounting profit, resources would have been worth $25,000 more in the prior job.
– Product mix (per‑unit) example:
– T‑shirts: revenue $10, cost $5 → gross profit per unit = $5.
– Shorts (next best alternative): revenue $10, cost $2 → gross profit per unit = $8.
– Opportunity cost of producing a t‑shirt = $8 (forgone profit from shorts) → economic profit per unit for t‑shirt = $5 − $8 = −$3 (economic loss).
Economic Profit vs. Accounting Profit
– Accounting profit (net income):
– Defined by GAAP/IFRS.
– Appears on income statements.
– Used by investors, lenders, tax authorities.
– Economic profit:
– Not reported on financial statements.
– Used internally for decision making.
– Incorporates non‑recorded opportunity costs, making it better for comparing alternatives.
Advantages and Disadvantages of Economic Profit
Advantages
– More complete evaluation of resource use: captures forgone alternatives and reveals hidden costs of decisions.
– Useful in strategic planning: helps decide between projects, product lines, and capital allocation.
– Indicates economic value creation beyond accounting measures; can show when accounting profit is misleading.
Disadvantages
– Opportunity costs are subjective and hard to measure precisely.
– Sensitive to assumptions about the next best alternative and time horizon.
– Does not replace accounting measures required for reporting, tax, or compliance purposes.
– Requires adjustments for risk and discounting (present value) in multi‑period decisions.
Special Considerations
– Time value of money: For multi‑period decisions convert future cash flows and opportunity costs to present value (use discounting).
– Risk and uncertainty: Adjust expected revenues and opportunity costs for probability and risk preferences (expected economic profit).
– Sunk costs: Ignore sunk costs — they are past expenditures that cannot be recovered and should not affect current economic profit calculations.
– Normal profit: When economic profit = 0, a firm earns normal profit (i.e., returns equal to opportunity cost); this is not a loss in economic terms.
– Scale and granularity: Calculate at the relevant level (per unit, product line, division, whole firm) depending on the decision.
Opportunity Costs — Definition and Estimation
What is an opportunity cost?
– The value of the next best alternative you forgo when you choose a course of action. It is not a cash outlay but a real economic cost.
How to estimate opportunity costs (practical steps):
1. Define the decision scope and identify the constrained resources (capital, labor, equipment, time).
2. List feasible alternatives and their expected returns (use best available data).
3. Quantify the best alternative’s returns as the opportunity cost (use per‑unit or aggregate basis as appropriate).
4. For uncertain outcomes, use expected values (probability‑weighted outcomes).
5. Discount future opportunity costs to present value if the horizon spans multiple periods.
6. Document assumptions and run sensitivity analyses (best/worst/case) to see how outcomes change.
Examples of Economic Profit (Scenarios and Interpretation)
1. New product launch:
– Compute incremental revenue and explicit incremental costs.
– Estimate alternative uses of factory capacity (opportunity cost).
– If economic profit > 0, the launch adds value relative to alternatives.
2. Outsourcing decision:
– Compare in‑house production profit to the best outsourcing alternative.
– Include managerial time and oversight (implicit cost) if applicable.
3. CEO choosing to run a small family business vs. working elsewhere:
– Compare business net income to forgone salary and benefits.
4. Per‑unit switching:
– Use per‑unit economic profit to set product mix and pricing.
Why Economic Profit Is Important
– Reveals whether resources are creating value relative to their next best use.
– Helps managers allocate scarce resources among competing uses.
– Detects strategic misalignments where accounting profit masks opportunity losses.
– Supports long‑term planning by incorporating alternative investment returns.
Practical Steps for Managers: How to Use Economic Profit in Decisions
1. Define the decision and time horizon (short run vs long run).
2. Identify explicit costs attributable to the decision.
3. Identify constrained resources and list the next best alternatives for those resources.
4. Quantify revenues and explicit costs for each option.
5. Estimate opportunity costs (use market rates, historical returns, or managerial estimates).
6. If outcomes occur over time, discount cash flows to present value.
7. Calculate economic profit for each alternative:
Economic profit = PV(expected revenue) − PV(explicit costs) − PV(opportunity costs)
8. Compare alternatives using economic profit and other metrics (NPV, IRR).
9. Perform sensitivity analysis on key assumptions (prices, volumes, discount rates).
10. Make a decision, document assumptions, and track actual outcomes versus estimates.
When to Use Economic Profit vs. Accounting Profit
– Use accounting profit for financial reporting, tax compliance, and external investor communication.
– Use economic profit for internal capital allocation, product mix, and strategic decisions where alternatives exist.
– Use both: accounting profit shows current statutory performance; economic profit shows whether that performance is the best use of resources.
Common Pitfalls and How to Avoid Them
– Pitfall: Misidentifying the true next best alternative. Remedy: list realistic alternatives and justify choice.
– Pitfall: Treating sunk costs as relevant. Remedy: ignore sunk costs.
– Pitfall: Failing to discount future opportunity costs. Remedy: apply appropriate discount rates.
– Pitfall: Overconfidence in point estimates. Remedy: use ranges, expected values, and sensitivity analysis.
The Bottom Line
Economic profit is a decision‑focused measure that shows whether a choice produces returns above the best forgone alternative. It supplements accounting profit by introducing opportunity costs and therefore yields deeper insight into resource allocation. Use it routinely for strategic decisions, but estimate opportunity costs carefully, adjust for time and risk, and document assumptions.
Sources and Further Reading
– Investopedia, “Economic Profit,” Mira Norian. https://www.investopedia.com/terms/e/economicprofit.asp
– Additional recommended reads on related concepts: N. Gregory Mankiw, Principles of Economics (for opportunity cost and profit concepts); corporate finance texts on capital budgeting and opportunity cost measurement.
Related Articles (topics to explore)
– Accounting Profit vs Economic Profit
– Opportunity Cost: Definition and Examples
– Normal Profit and Economic Loss
– Net Present Value (NPV) and Discounted Cash Flow (DCF) Analysis
If you’d like, I can:
– Walk through a spreadsheet template you can use to calculate economic profit and run scenarios.
– Build a step‑by‑step worksheet for a specific decision (e.g., product launch or outsourcing) with sample numbers.