How to Calculate Economic Profit?

How to Calculate Economic Profit

If you have several excellent projects at hand where you can invest your money but want to know which investment will be more profitable, understanding how to calculate economic profit can help you in this regard. And if you are interested in learning this, then you are in the right place.

Economic profit lets you compare different business options and gives you an idea about what you would’ve gained (or lost) from choosing one over another. And this can be very helpful for individuals who are starting their own business by finding out whether they are making the best possible investment or not.

This article will provide you with the definition of economic profit and explain to you what it actually means. The article will also show you the economic profit formula and how you can calculate it along with examples to help you understand the concept of economic profit better. 

Economic Profit Formula

The formula for calculating economic profit can be derived by subtracting the total cost of business from the total revenue earned by the business. Here, the total cost of business includes both implicit costs and explicit costs.

The mathematical expression of the formula is given below,

EP = R – C

Where, 

EP = Economic Profit

R = Total Revenue

C = Total Cost

The total cost (C) can be calculated using the following formula,

Total Cost = Implicit Costs + Explicit Costs

Definition of Economic Profit

The term “Economic Profit” refers to the difference between total financial revenue and total cost. Here, the total cost includes both implicit and explicit costs.

The term “Economic Profit” is somewhat different from “Accounting Profit”. Economic profit takes the opportunity cost into account. As a result, economic profit is smaller as opposed to accounting profit.

Again, economic profit accounts for a longer period compared to accounting profit. Not to mention accounting profit doesn’t reflect the true nature of the business. That’s because it doesn’t ensure whether the business is making an actual profit or not. This is one of the reasons why economists rely on economic profit.

What is Economic Profit?

Whenever you are about to set up your new business, the first question that is going to cross your mind would be “How much I’m going to make in profit?” To understand the concept of profit, you will need to have a clear grasp of its two core elements. They are – cost and revenue.

Assume a hypothetical situation where you are thinking of starting a coffee shop. Now, you can easily calculate your total revenue by multiplying how many cups of coffee you sold over a specific time span by the number of their prices. And profit is the adjusted revenue that you get after subtracting all the costs from it.

These costs include the cost of the coffee maker, various ingredients that you will use, and the monthly rent of your coffee shop. All these costs are known as “Explicit costs”. That’s because you can identify these costs with ease as you are going to pay them from your own pocket.

Unlike explicit costs, some costs are almost always overlooked by many people as they are less obvious. For example, the opportunity cost. Now consider you are a graphics designer and work for an animation studio. Assume your hourly wage is $50. As a result, for every hour you work as a coffee seller, you will be losing $50 in income. 

This amount that you lose for choosing one option over another is known as opportunity cost. And this type of less obvious cost is grouped as “Implicit cost”.

These implicit costs are taken into account when economic profit is calculated. If another animation studio offers you an hourly wage of $200 rather than $50, this might make you give up your coffee business dreams and work as a graphics designer for that studio instead. So, you can easily understand how this overlooked factor can change your business decisions.

Economic profit gives you an idea about whether you are going to make any actual profit or not from your business by taking both the explicit and the implicit costs into account. 

How to Calculate Economic Profit?

Use the following steps to calculate economic profit:

Step 1: First of all, find the total revenue of the business. Multiply the number of units sold during a specific time span by the average price per unit.

Total Revenue = Number of Units Sold × Average Price Per Unit

Step 2: Secondly, identify the explicit costs of the business. These are the costs that every business has to pay to sustain the business. Not to mention businesses have to pay such costs out of their own pocket. Some examples of explicit costs are – electricity bills, rents, advertising expenses, raw material costs, wages, etc.

Step 3: Next, find out the opportunity cost that the business has renounced for choosing the current business venture. 

Step 4: Now, use the values from “Step 2” and “Step 3” to find out the total cost of the business.

Step 5: Finally, put the values from “Step 1” and “Step 4” into the formula mentioned above to get the economic profit of the business.

Practical Examples

Take a look at the following examples to get a clear idea about how to calculate economic profit.

Example 1

Let’s start with something simple. Consider the example of a footwear company that made a revenue of $10,000 and the explicit costs were $5,000. If the implicit costs were $3,000, find out the economic profit of the company.

From the example, we can see that,

The explicit costs of the company were $5,000

The implicit costs of the company were $3,000

The total revenue was $10,000

Now, let us try to find out the total cost of the company first.

Total Cost = Implicit Cost + Explicit Cost

      = $3,000 + $5,000

      = $8,000

Now that we have the total cost, let’s calculate the economic profit of the company using the formula mentioned above in this article.

EP = R – C

Here, 

R or total revenue is $10,000

C or total cost is $8,000

So, EP or economic profit is going to be,

EP = $10,000 – $8,000 = $2,000

Therefore, this footwear company earned an economic profit of $2,000.

Example 2

Let’s consider a hypothetical situation where Eric has given up his job as a legal advisor for an investment company and started his very own arcade. When he was working as a legal advisor, his annual salary was $200,000. Since the launch of his arcade, he earned a total revenue of $700,000 within the first year of business. But at the same time, he had to spend $200,000, $60,000, $70,000, and $50,000 as arcade machine purchasing cost, labor cost, arcade rent, and advertisement expenses respectively. Now find out the economic profit of Eric.

Here, the total revenue is given to be $700,000. Now, let us try to find out the total cost by identifying the implicit and explicit costs of that arcade and then summing them up. 

From the example, we can see that Eric has given up his legal advisor job where he used to earn $200,000 per year. This is the implicit cost of his arcade business.

Now, arcade machine purchasing cost, labor cost, arcade rent, and advertisement expenses, all are explicit costs of the business. So, the explicit costs for Eric’s arcade business will be,

Explicit Costs = Arcade Machine Purchasing Cost + Labor Cost + Arcade Rent + Advertisement Expenses

            = $200,000 + $60,000 + $70,000 + $50,000

            = $380,000

So, the total cost is going to be, 

Total Cost = Implicit Cost + Explicit Cost

      = $200,000 + $380,000

      = $580,000

Finally, the economic profit for Eric’s arcade will be,

EP = R – C

Here, 

R or total revenue is $700,000

C or total cost is $580,000

So, EP or economic profit is going to be,

EP = $700,000 – $580,000 = $120,000

Therefore, Eric’s earned an economic profit of $120,000 in the first year of his arcade business.

Use and Importance of the Economic Profit Formula

Accounting profit and economic profit are not the same things. And you can never use one of these two as an alternative to another in any situation. The main difference between economic profit and accounting profit is that while the first one takes both explicit and implicit costs into account, the latter one only considers the explicit costs of the business while calculating profit.

The value of the economic profit can either be positive or negative. If the economic profit is positive for a business, that means the business is yielding a better return as opposed to other opportunities. 

On the other hand, if you find that the accounting profit of a business is positive but the economic profit is negative, that means you would be better off stopping your current business operation and undertake a different opportunity.

Conclusion

Economic profit is one of the concepts that companies use in deciding on their production level. Learning how to calculate economic profit will help you to find out whether you are investing in the best possible project before taking the decision. 

And by doing so, you will be able to make the correct decision to secure your financial future.

Atikur Rahman
Atik loves Economics since his student life. He has a passion for learning and sharing through the written word and has contributed to (Your Website Name) since 2021.