Economic and Accounting Profit

Profit is the goal of the firm in the standard economic model. But what is profit? Economists and accountants understand it differently. This difference is critically important for business and investment analysis.

Accounting Profit
Accounting Profit = Revenue − Explicit Costs

Explicit costs: actual cash payments for resources—wages, materials, rent, interest on loans, taxes.

Characteristics:

Reflected in financial statements
Basis for taxation
Regulated by standards (GAAP, IFRS)
Does not account for opportunity costs

Economic Profit
Economic Profit = Revenue − (Explicit Costs + Implicit Costs)

Implicit (opportunity) costs:

Foregone income from alternative use of resources
Opportunity cost of the owner's capital
Alternative salary for the entrepreneur
Foregone rental income from own premises

Economic Profit = Accounting Profit − Implicit Costs

Normal Profit
Normal Profit—the minimum profit required to keep resources in this use. Equals the opportunity costs of the entrepreneur and capital.

When Economic Profit = 0:

The firm covers all costs, including opportunity
Accounting Profit = Normal Profit = Implicit Costs
No incentive to leave or enter the industry

When Economic Profit > 0:

Supernormal (abnormal) profit
The firm earns more than in alternative uses
Attracts new entrants

When Economic Profit < 0:

Economic losses
Better to use resources otherwise
Exit incentive

Example of Calculation

The entrepreneur opened a cafe:

Revenue: 5,000,000 rub/year
Explicit costs: 3,500,000 rub (salaries, products, rent, utilities)
Accounting profit: 1,500,000 rub
Implicit costs:
- Salary he could earn: 1,200,000 rub
- Return on invested capital (alternatively): 300,000 rub
Total implicit: 1,500,000 rub
Economic profit: 1,500,000 − 1,500,000 = 0 rub

Conclusion: accounting profitable, economically—barely. Resources are used about as efficiently as in alternatives.

Why distinguish?

For decision making:

Accounting profit can mask economic losses
Positive accounting profit with negative economic profit—a signal to review

For competition analysis:

Supernormal profits attract competitors
In long-run equilibrium of perfect competition, economic profit = 0

For investment evaluation:

Economic profit takes into account cost of capital
Positive economic profit = value creation (ROIC > WACC)

Economic Value Added (EVA)

Practical application of the economic profit concept: EVA = NOPAT − (WACC × Invested Capital) Where NOPAT is net operating profit after taxes, WACC is weighted average cost of capital.

EVA > 0: company creates value—earns more than the cost of capital.
EVA < 0: destroys value—investors are better off investing elsewhere.

For the investor

Accounting profit ≠ value creation:

A company can be profitable according to the books, but not create value
Need to compare ROIC with WACC

Profit sustainability:

Supernormal profits are sustainable only with barriers to entry
Without barriers—competition will drive to zero

Profit quality:

Cash vs accrual
Operating vs non-operating
Recurring vs one-time