Problem 11 What is the difference between a... [FREE SOLUTION]

Chapter 7: Problem 11

What is the difference between accounting and economic profit?

Short Answer

Expert verified

The main difference between accounting and economic profit lies in the types of costs they consider. Accounting profit only accounts for explicit costs (monetary payments such as salaries, rent, and raw materials) to determine a firm's financial performance. On the other hand, economic profit considers both explicit and implicit costs (opportunity costs of using resources), offering a more comprehensive view of a firm's performance by evaluating its potential and efficiency in resource utilization. Accounting profit is calculated using: $ Accounting\ Profit = Total\ Revenue - Explicit\ Costs $. Economic profit is calculated using: $ Economic\ Profit = Total\ Revenue - (Explicit\ Costs + Implicit\ Costs) $.

Step by step solution

1. Define Accounting Profit

Accounting profit is the difference between a firm's total revenue and its explicit costs. Explicit costs are the actual monetary payments a firm incurs while producing goods or services, such as salaries, rent, and raw materials. The accounting profit is calculated as follows: $ Accounting\ Profit = Total\ Revenue - Explicit\ Costs $ Accounting profit is commonly recorded in a company's financial statements and is used to determine the financial performance of a business.

2. Define Economic Profit

Economic profit considers both explicit and implicit costs. Implicit costs represent the opportunity cost of using resources that the firm already owns rather than selling or renting these resources to others. Economic profit is a better indicator of a firm's opportunity cost and is calculated as follows: $ Economic\ Profit = Total\ Revenue - (Explicit\ Costs + Implicit\ Costs) $ The economic profit offers a more comprehensive view of a firm's performance, taking into consideration the value of alternative uses of its resources.

3. Illustrate the Differences with an Example

Let's consider a simple example to illustrate the differences between accounting and economic profit: Suppose there's a small bakery that has a total revenue of $150,000 per year. The explicit costs, such as ingredients, labor, and rent, amount to $100,000. The bakery owner also had the option to work as a manager in another company, earning $60,000 per year. To determine the accounting profit, we only consider explicit costs: $ Accounting\ Profit = \$150,000 - \$100,000 = \$50,000 $ For the economic profit, we must also include the implicit cost of the bakery owner's forgone salary: $ Economic\ Profit = \$150,000 - (\$100,000 + \$60,000) = -\$10,000 $ The economic profit is negative, which indicates that the owner would have been better off working as a manager in the other company.

4. Summarize the Differences between Accounting and Economic Profit

Accounting profit only takes explicit costs into account and is used to evaluate a firm's financial performance as recorded in its financial statements. Economic profit includes both explicit and implicit costs, providing a more comprehensive view of a firm's performance by considering opportunity costs. Economic profit is more focused on the firm's potential and whether it's using resources in the most efficient way, while accounting profit is concerned with the firm's current financial situation.