When you analyze the financial progress of a company, the simplest account of any business is to study the total revenue, cost and profit. Revenue is the total sum of money received for its production. Cost includes everything that contributed to produce them. Profit, then, equals total revenue subtract total cost.
What is it?
There is no satisfactory definition of the term profit. In simple terms, profit can be understood as all the revenue generated by an individual or company. Profit is the goal of any business. There is no business. There are two conceptions of profit, accounting profit and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between money brought in and money paid out. When calculating accounting profits, the things that are considered include leased assets, non-cash adjustments/transactions for depreciation, provisions, allowances and capitalizing development costs. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, it’s economic success depends on its economic profit. When calculating economic profits, several things, like opportunity costs, residual value, inflation level changes, tax rates, and interest rates on cash flow, are considered.
To better understand the difference between economic and accounting profit, assume the total revenue of X business is 400,000. The explicit cost (utility bill, interest payments, mortgage, raw material cost, transport, storage cost, packaging cost, labour cost and more) is 150,000. So, the accounting profit would 400,000 — 150,000 = 250, 000 (total revenue — total explicit costs) and the economic profits 400,000 — (150,000 + 200,000) (total revenue — (total explicit costs + total implicit costs)) is 50,000. The accounting profit is interested in earnings more than what is going on in the marketplace. In this case, X made 50,000 more than marketplace income, hence that is X’s economic profit. Accounting profits are simply what you take home after deducting your explicit costs from your company revenues.
The accountant and economist think differently. The accountant would consider production costs and how they affect company’s profitability. They would consider themselves as a production cost. On the other hand, when an economist describes the costs, they are more interested in how the company has decided to run the business or why they decided to imply a strategy and what impact those strategies will have on the rest of the economy.
In conclusion, one is taking the opportunity cost into consideration and while the other is not. The analysis of economic and accounting profit will help organizations understand their performance, future implementations, profitability, risk, market position and financial stability. It would also help stakeholders take critical decision like where to invest or how to get good returns.
Priyanka | DBPC Blog