What is Accounting Profit?

The economic profit of a company reflects economic principles more than accounting principles. Like accounting profit, economic profit deducts the costs of operation from total revenue, but unlike accounting profit, it also considers the opportunity cost of certain actions to determine whether or not the most profitable route was chosen.

Part of how economic profit works is the introduction of what is known as implicit costs. Implicit costs are the cost of a company's resources. While this concept also exists in accounting, the economic model for profit factors in alternative uses of these implicit costs.

As an example, let's say you work for a company that creates construction materials such as concrete. In order to make concrete, your company owns a section of desert where sand is harvested that you then sell to contractors to make the concrete. In this example, your implicit cost is the sand, which you sell raw to another company that makes concrete rather than using it to make concrete yourself.

In more abstract examples, such as those that may exist at major corporations, implicit costs are applied to the projects that you choose, or do not choose, to undertake. For example, if you choose to work with Client 1 rather than Client 2 on a particular project, your economic profit will reflect how much more revenue would have been generated had you chosen to work with Client 2.

Accounting profit is only concerned with actions that happened and ignores actions that did not take place but could have. Economic profit, on the other hand, incorporates those theoretical actions.

Generally, companies will use both types of profit calculations to get a complete assessment of their organization’s health. For instance, if economic profit and accounting profit are both weak, then management may be able to determine that there are flaws in their decision-making process that can be re-evaluated. On the other hand, if accounting profits are bad while economic profits indicate that the correct decisions surrounding implicit costs were made, the company may be in trouble from an operational standpoint.

It's important for accountants and businesspeople to understand the implications of each profit model so that they can ensure the company is using its resources effectively at any given time.

The equation used to calculate accounting profit is relatively simple, especially when compared to the more theoretical economic profit model. Accounting profit is calculated using the following formula:

Accounting profit = total revenue – total costs

Of course, to get all of the numbers that you need in order to calculate the accounting profit of an organization, you need to carefully track information over a predetermined time period and perform several other additional calculations to get each individual variable.

Let's take a look at an example of how accounting profit plays out when using actual numbers for each variable:

Company A produces iron used in construction. Over the course of the year, they were able to generate revenue of $1.5 million by spending $1 million on all the costs associated with the generation of their product. As you can see from this example, Company A managed to generate an accounting profit of $500,000, which is worked out below:

$1,500,000 - $1,000,000 = $500,000