What is Economic Profit?

//What is Economic Profit?
What is Economic Profit? 2017-10-04T06:44:37+00:00

Definition: Economic profit is the profitability measurement that calculates the amount that revenues received from selling a product exceeds opportunity costs incurred from using resources to make and sell these products. In other words, it’s the excess money a company earned from one course of action over another had they chosen differently.

What Does Economic Profit Mean?

What is the definition of economic profit? Economic profit is a theoretical measurement of opportunity costs in conjunction with actual revenues. Economists and business owners look at these implicit costs to analyze past decisions and see if a better course of action could have been taken in the past.

You can think of opportunity costs like values of alternative actions that could have been made using the company’s resources had management not redirected them to a certain project. For example, if management uses all of its resources to pursue project A, it cannot pursue project B.

Economists and business owners use the economic profit formula to calculate if they made the right choice between project A and project B after the fact.

It’s important to note the difference between economic profit and accounting profit. They are not the same, as EP is a theoretical calculation based on what if scenarios; whereas, AP is based on what actually happened.

Let’s look at an example.

Example

Jennifer, a young entrepreneur, starts her own business and incurs around $50,000 in startup costs. During her first year in business, her company earned revenues of $75,000. She left her previous job as a bar tender to pursue this new venture, but if she had stayed at her job, she would have made $30,000 in the same time frame.

According to these values, her accounting profit is $25,000 ($75,000 – $50,000). Her EP is different, however, because it factors in her lost potential earnings from her previous job. She had to forego her salary of $30,000 in order to pursue this new business.

Thus, her EP profit would $45,000 ($75,000 – $30,000). This calculation shows Jen made the right choice leaving her job.

Summary Definition

Define Economic Profits: Economic profit means the amount actual revenue earned exceeds implicit costs used to earn that revenue.