ADWAITH PRAMOD

22AA02

2. Differentiate Economic Profit versus Accounting Profit with

three applied mathematical examples.

Economic Profit:

 Economic profit is the difference between total revenue and total

economic

 Total economic cost measures the opportunity costs of all the

resources used by the business (refer below image)

 Which includes both market-supplied and owner-supplied resources,

and thus:

Economic profit = Total Revenues – Total Economic cost

Economic profit = Total Revenues - Explicit costs - Opportunity costs

 Economic profit, when it arises, belongs to the owners of the firm,

and will increase the wealth of the owners
Examples of Economic Profit
1) Explicit costs amount to $5,000 and implicit costs to produce them
total $2,000. Using the formula above, we can determine that the
economic profit of producing these toys is

Economic Profit = $10,000 - $5,000 - $2,000 = $3,000

2) An individual starts a business and incurs start-up costs of $100,000.

During the first year of operation, the business earns revenue of
$120,000. This results in an accounting profit of $20,000. However, if
the individual had stayed at her previous job, she would have made
$45,000. In this example, the individual’s economic profit is equal to:

Economic Profit = $120,000 - $100,000 - $45,000 = -$25,000

3) If a company generates $10 per unit from selling t-shirts with a $5

cost per unit, then its gross profit per unit for t-shirts is $5. However,
if they could have potentially produced shorts with revenue of $10
and costs of $2 then there could be an opportunity cost of $8 as well:

Economic Profit = $10 - $5 - $8 = -$3

Accounting Profit:

 Accounting profit is the difference between total revenue and explicit

costs

 Accounting profit does not subtract from total revenue the implicit
costs of using resources

 Depending on the type of financial statement and where it appears in

a statement, accounting profit goes by a variety of names such as
net income, operating income, net profit, or net earnings

Accounting Profit = Total Revenue – Explicit Costs

Examples of Accounting Profit
1) For example, if a person invested $100,000 to start a business and
earned $120,000 in profit, their accounting profit would be $20,000.

2) Let’s assume you own a T-shirt business. You made a revenue of

$150,000 from sales. And your explicit costs include:

$70,000 for raw material costs

$10,000 in payroll
$8,000 for factory rent per year

Accounting Profit = $150,000 – ($70,000 + $10,000 + $8,000) = $62,000

3) 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:

Accounting Profit = $1,500,000 - $1,000,000 = $500,000