Terms related to finance will always sound strange to people whose field of study is not related to finance. One of the most popularly confusing finance terms is the meaning of economic profit.
The most valuable commodity to a business organization is the profit they make from every transaction. Profit is simply the unit of measurement that is used to measure the financial growth of every company or organization.
To laypeople, profit is profit; why add economic to it? Well, this article will give a detailed explanation of the meaning of economic profits and losses and even teach you how to calculate it.
In simple terms, economic profit is approximate profit minus implicit cost. I mentioned the approximate yield because people often jumble up the two meanings. I will explain the approximate profit first.
Approximate profit is the profit that is gotten from the difference between the total revenue realized in a business and direct costs. Explicit or direct costs are those physical expenses whose prices are directly written into a ledger book. These costs include straightforward or physical expenses like taxes, lease, wages, rent, and other tangible expenses of the company.’
Total revenue, on the other hand, is the total amount of physical profit that a company realized after carrying out a business. This is usually the money realized at the end of a transaction. In other words, the approximate gain is the profit that people usually calculate after carrying out a business. However, it is advisable to calculate both the physical profit and the unseen profit/loss. This will help a company to gauge their stand truly, business-wise.
I hope that you now understand what approximate profit means. I will now explain in detail what economic profit means.
As I said, economic profit is simply approximate profit minus implicit cost. Implicit cost, also called opportunity cost, is the imaginary wastage of resources that a company sustained when it choose a business opportunity over another. In simpler terms, it is the profits that a company missed because it decided one business opportunity over another. These costs are not physical and, therefore, cannot be added to the company’s ledger.
It is used by business people to make the right business choice in the future. It is then safe to say that the total cost of all input for every transaction is the addition of the unseen and the seen cost. That is the addition of the opportunity cost and the direct cost.
For instance, if company Z had two business opportunities to choose from, say opportunity A and option B. if, after the needed deliberation, they decided to take opportunity A, the company’s approximate cost is the total revenue they get from opportunity A minus the cost they incurred while taking opportunity A. On the other hand, their economic profit is their approximate profit minus the profit they would have made if they had chosen option B.
Business people use it to calculate and measure their business plans to avoid future mistakes. Without calculation of their opportunity cost and their economic profit as a whole, a business won’t know when it is making the right business decision or not.
You still don’t understand? Alright, let me explain how it is calculated; hopefully, you understand it better, ok?
How to calculate economic profit?
Economic Profit = (Total Revenue – explicit cost)– Implicit Costs (Opportunity Costs),
while Approximate Profit = Total Revenue – Explicit Costs
In other words, to calculate economic profit, a company must first know their approximate cost and their opportunity or implicit cost.
Let us use John the Engineer as an example. If John had a federal work that pays him $10,000 in a year, and he wasn’t happy with his job. He decided to quit and opened a private engineering firm. He started the firm with his savings of $30,000, and after a year, his business was able to make up to $50,000. To calculate his economic profit, he must first calculate his approximate profit.
Mr John’s approximate profit = $50,000 (total revenue from his private engineeting firm) – $30,000 (his explicit cost or in this case, his startup capital) = $20,000. This is his net income.
Now, to calculate his economic profit = $50,000 (total revenue from his private engineering firm) – $10,000 (his income per year if he was still working for the federal government) = $40,000.
If the economic cost is higher than the opportunity cost, then a company made the right decision in choosing that business opportunity. Comparing this with the illustration I gave above about John the Engineer. He made an extra $40,000 for choosing to open a private business over working as a federal employee.
Amy Fischer - Born and lives in Israel. Despite the fact that she is still young, she is a very experienced specialist who is well versed in economics and banking. Also in her spare time Amy shares her experience and interesting news with the readers of Bank Login Lab.