What is Economic Profit?
Economic profit, also known as economic value added or abnormal profit, is a measure of profitability that accounts for both explicit costs (actual monetary expenses) and implicit costs (opportunity costs). Unlike accounting profit, which only considers explicit costs, economic profit reveals whether a business or investment is truly creating value above and beyond what could be earned from alternative uses of resources.
Economic profit provides a more complete picture of business performance by asking: "Is this the best use of my resources, or could I be doing better elsewhere?" This makes it an essential concept for entrepreneurs, investors, and economists when evaluating the true success of a venture.
The Economic Profit Formula
Economic profit is calculated using the following formula:
Or equivalently:
Understanding the Components
Total Revenue
Total revenue is the complete income generated from selling goods or services. This includes all sales revenue, fees, and any other income directly related to business operations.
Explicit Costs (Accounting Costs)
Explicit costs are the actual, out-of-pocket expenses that appear on financial statements. These are tangible payments made for resources:
- Wages and Salaries: Payments to employees
- Materials and Supplies: Raw materials, inventory, supplies
- Rent and Utilities: Facility costs, electricity, water, internet
- Interest Payments: Cost of borrowed capital
- Insurance: Business insurance premiums
- Marketing: Advertising and promotional expenses
- Equipment: Machinery, vehicles, technology
Implicit Costs (Opportunity Costs)
Implicit costs represent the value of resources used in a business that could have been employed elsewhere. These are "hidden" costs that don't involve direct payments but represent forgone alternatives:
Common Implicit Costs
- Forgone Salary: What the owner could earn working for someone else
- Forgone Interest: Return that invested capital could earn elsewhere (stocks, bonds, savings)
- Forgone Rent: Rental income from property used for business instead of leasing
- Owner's Time: Value of owner's labor and expertise
- Depreciation of Owner's Assets: Wear on personal assets used for business
Accounting Profit vs Economic Profit
The key difference between accounting profit and economic profit lies in how costs are measured:
Because economic profit includes implicit costs, it is always less than or equal to accounting profit. This difference is crucial for understanding true business performance.
Example: Restaurant Owner
Sarah owns a restaurant with the following financials:
- Annual Revenue: $400,000
- Explicit Costs (food, wages, rent, utilities): $300,000
- Accounting Profit: $400,000 - $300,000 = $100,000
However, Sarah has implicit costs:
- She could earn $70,000/year as a manager elsewhere
- Her $200,000 investment could earn 5% ($10,000) in stocks
- Total Implicit Costs: $80,000
Economic Profit: $100,000 - $80,000 = $20,000
While the restaurant shows a healthy $100,000 accounting profit, Sarah is only earning $20,000 more than her next best alternative. She should consider whether this premium justifies the additional risk and effort of running a business.
Interpreting Economic Profit
Positive Economic Profit
When economic profit is positive, the business is creating genuine economic value. Resources are being used more productively than in their next best alternative. This indicates:
- The venture is a worthwhile endeavor
- Resources are well-allocated
- The business has competitive advantages
- Continued operation is economically justified
Zero Economic Profit (Normal Profit)
Zero economic profit doesn't mean the business is failing—it means the business is earning exactly enough to cover all costs, including opportunity costs. This is called "normal profit" and indicates:
- The business is performing as well as alternatives
- Resources are being used efficiently
- The owner is indifferent between continuing and alternatives
Important Note
Zero economic profit still means positive accounting profit! A business with zero economic profit is covering all explicit costs plus earning returns equivalent to what could be earned elsewhere.
Negative Economic Profit
Negative economic profit (economic loss) means resources would be better employed elsewhere. While the business might show positive accounting profit, the owner could earn more through alternative uses of their time and capital.
Why Economic Profit Matters
For Business Owners
- True Performance Measure: Reveals if your business truly outperforms alternatives
- Resource Allocation: Helps decide whether to continue, expand, or exit
- Opportunity Assessment: Quantifies what you're giving up to run the business
For Investors
- Value Creation: Shows if a company creates value above required returns
- Capital Allocation: Identifies which investments truly outperform
- Comparative Analysis: Enables fair comparison across different investments
For Economists
- Market Entry/Exit: Positive economic profits attract competition; negative profits cause exit
- Long-Run Equilibrium: In competitive markets, economic profit tends toward zero
- Resource Efficiency: Measures how well an economy allocates resources
Economic Profit in Competitive Markets
In perfectly competitive markets, economic profit serves as a signal for resource allocation:
- Positive Economic Profit: Attracts new firms to enter the market, increasing supply and reducing prices until economic profit falls to zero
- Negative Economic Profit: Causes firms to exit, reducing supply and raising prices until economic profit rises to zero
- Zero Economic Profit (Long-Run Equilibrium): Resources are optimally allocated with no incentive for entry or exit
How to Calculate Implicit Costs
Calculating implicit costs requires estimating what you could earn from alternative uses of your resources:
Forgone Salary
Research comparable salaries for positions matching your skills and experience. Consider what companies in your industry would pay for someone with your qualifications.
Forgone Investment Returns
Consider what return your invested capital could earn elsewhere. Common benchmarks include:
- Risk-free rate (Treasury bonds): ~4-5%
- Stock market average return: ~7-10%
- Real estate returns: ~8-12%
Match the risk profile of your alternative investment to the risk of your business.
Forgone Rent
If you use personal property for business, research rental rates for similar properties in your area.
Frequently Asked Questions
Can economic profit be higher than accounting profit?
No. Since economic profit equals accounting profit minus implicit costs, and implicit costs are always zero or positive, economic profit can never exceed accounting profit.
What's the relationship between economic profit and EVA?
Economic Value Added (EVA) is a specific calculation of economic profit used by corporations. While the concepts are related, EVA uses more specific definitions for capital costs and adjusted operating profits.
Why do accountants ignore implicit costs?
Accountants focus on explicit costs because they are verifiable, objective, and consistent for financial reporting and tax purposes. Implicit costs are subjective and vary based on individual circumstances.
Should I close my business if economic profit is negative?
Not necessarily. Consider factors like growth potential, personal satisfaction, non-monetary benefits, and whether losses are temporary. However, persistent negative economic profit suggests resources might be better employed elsewhere.