Question

What is the difference between accounting profit and economic profit? I was asked about how to interpret the notion of normal rate of return and the term opportunity cost? I have a pretty good idea about both but wanted to see and experts thought or interpretation.

Answer 1

Let us assume we have earned a revenue of $ 1,000,000 and the expenses which incurred are raw material expenses $ 250,000, Labour $ 300,000, all other expenses $ 300,000.

Thus by subtracting all the cost from revenue we can determine the accounting profit

Accounting profit = Revenue - Explicit cost

Accounting profit = $ 1,000,000 - (250,000+300,000+300,000)

Accounting profit = $ 150,000

In case of economic profit it can be calculated as follows

Economic profit = Total revenue - implicit cost - explicit cost

Here implicit cost is the opportunity cost foregone. For example before starting the business I was earning $ 200,000 per year. And started the business by sacrificing my job.

Consider the same organization

Economic Profit = $ 1,000,000 -(250,000+300,000+300,000) -200,000

Economic Profit = - $ 50,000

As we can see under accounting profit the profit was $ 150,000 while in case of Economic Profit the profit is -$ 50,000.

The use of economic profit tells us that before you were earning $ 200,000 per annum and after starting your business your income has declined and it is -$ 50,000.

Although the firm is earning an accounting profit of $ 150,000 but economicst point of view says you are losing $ 50,000.

Economic cost includes a normal rate of return. A normal rate of return is the rate that is just sufficient to keep the current investors interested in the industry.

Opportunity cost is the cost of what you have to give up to get something.

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