Hi Guys, Pls could you help me differentiate between the two? Thx!
When considering Economic Profit the idea is to incorporate OPPORTUNITY costs of the Capital Used, Forgone Interest, Entrepreneurs Time into the costs. In accounting profit we just consider the explicit costs like Selling, Administrative etc. So Accounting Profit>Economic Profit. Also, since economic profit takes into consideration opportunity costs, it means that even at zero economic profit you would stay in a business, because you are earning a return that matches the next best alternative (meaning if you used to money in another business or put it in a bank). Did I confuse you?
Thank KH! got it now. so accounting profit would be devoid of stuff such as normal profit? and if i , as an owner of a firm achieve accounting profit, I am still in business right?
andyb1 Wrote: ------------------------------------------------------- > Thank KH! got it now. > so accounting profit would be devoid of stuff such > as normal profit? and if i , as an owner of a firm > achieve accounting profit, I am still in business > right? No no. You got it mixed up. Suppose accounting profit=40 Opportunity costs=50 Economic Profit=-10 What I mean is you might think from the accounting profit that the company is profitable. But once you incorporate the Opportunity costs (the money you could have earned if you used the capital elsewhere) you find the economic profits which in this case is Negative. Conclusion: Seeing accounting profit you think company is profitable, whereas you would be better of investing somewhere else.
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If you got a little bit of the concept, reading the book should clear it for you now I think.
its crystal now! cheers
yea…accounting profit only considers explicit costs which can be measured not the implicit… now…wen we talk abt oppertunity costs…it consists of 2 things… 1. implied rental rate 2. normal profit now implied rental rate consists of foregone interest and economic depriciation(together called the oppertunity cost of investing the companies cash somewhere else ) and normal profit is the oppertunity cost of entreprenurial skills of the people who run the business…both of these things are not included in accounting profit which makes it a not so good measure of profitability.
I would relate economic profits to the NPV equation. While your accounting profit (the real profit) would be computed straight off of the financial statements, your economic profit will consider other factors that are needed to make the investment decision. You need to think about how much you could earn somewhere else with your free time and capital base at your disposal. This total opportunity cost would then be subtracted out to get to your economic profit. As long as it’s 0 or above, you are earning a rate of return worth the risk/efforts.