What are Accounting and Economic Profits?
One comes across the concept of Profits in the context of business and in analyzing the results of business activity. Profits of a business can be accounting profits, and they can also be economic profits. So how does one understand the concept of accounting versus economic profits?
Basis of Economic Profits and Accounting Profits
Economic profits are based on the principle that whoever works in the business must get paid for it. Accounting profits are based on the principle that whatever expenses are incurred in the business must be properly recorded and accounted for.
Economic profit is obtained after deducting economic costs from the revenues. It is measured by taking into account the implicit costs of running the business. Economists define four factors of production, viz. land, labor, capital, and entrepreneurship. These four resources used in the production of goods and services should be rewarded for being applied in the business. The reward for land is rent; for labor, it is salary/wage; for capital, it is interesting; and for entrepreneurship, it is profit. Each of these rewards to the factors of production is a reward to them but is a cost to the business. In other words, the economic cost of employing land as a factor of production in the business is the rent that is paid. Similarly, the economic cost of employing labor is the wages paid, the economic cost of employing a capital is the interest that is paid, and the economic cost of entrepreneurship employed in a particular business is the profits that the business has to pay the entrepreneur.
The numbers in terms of revenues, costs, and net income in the Profit & Loss Account are shown in the financial statement of a company. The Cash Flow Statement recalculates cash flows from the profits as mentioned in the Profit & Loss Account. In addition, a Balance Sheet of the company showing all the assets and liabilities and the capital it holds. These financial statements are prepared to account for revenues earned and all expenses incurred to earn the said revenue. The net profits or the net income figures in a Profit and Loss Account depict the Accounting Profits of the business. Accounting profits are arrived at after considering the explicit costs actually incurred in running the business and earning the revenues as reported every year.
Measuring Economic Profits and Accounting Profits
How does one calculate these economic costs? If the land is not owned by the entrepreneur, they will pay rent to the landowner, and this would get accounted for as an explicit cost in both – economic costs and accounting costs. But if the land was owned by the entrepreneur and she/he uses it to run their own business, she/he should consider the amount of rent she/he had to forego to employ the said land in their own business and use that number as an implicit cost of using the resource to earn economic profits. Such implicit costs are the opportunity costs of the use of the four factors of production. Economic profits are earned by subtracting from revenues the economic costs of use of land, labor, and capital. “PLUS” the reasonable reward to the entrepreneur for taking the risk and running the enterprise. If there is a positive economic profit or “ZERO” economic profit after considering all economic costs of the factors of production used in the business, then the business is considered economically viable. If there is a negative economic profit, then the business is considered economically unviable and should be discontinued.
For example, Kookooland is a wellness resort owned by Mr. Birdie. It was built on 500 sq. miles of land, of which 300 sq. miles of land is owned by Mr. Birdie, and 200 sq. miles is taken by him on annual rent of $10,000. It employs ten resort staff and pays a total annual salary of $20,000 to them. Capital employed in the business is $100,000 is borrowed at an annual interest rate of 5%. If Mr. Birdie were to be employed in a similar resort as CEO, he would have earned an annual salary of $40,000.
In the year 2019, Kookooland earned a revenue of $75,000.
|Accounting Profit||Economic Profit|
|Salary to staff||20,000||20,000|
|Foregone Salary of Mr. Birdie||40,000|
|Economic Profit (Loss)||(15,000)|
As it can be seen that the accounting profit of $40,000 makes the business look very lucrative, but it is not economically viable. The difference arises because one needs to consider the proportionate rent for his land used by Mr. Birdie for the business. If Mr. Birdie would have rented the same land out instead of using it for Kookooland, then he would have earned $15,000 for his 300 sq. miles at the same rate as he is paying rent for the 200 sq. miles he took on rent. Also, the residual surplus from the business after paying for the other three factors of production should be at least equal to the salary he has foregone. In other words, he has to pay himself for the efforts he puts in to run Kookooland. Suppose the revenues were $ 80,000, Mr. Birdie would have just been able to make enough to pay himself, and the business would have been economically viable.
Another factor to consider the viability, in this case is the objective of running the business in the long run. In the short run of saying a year or two, the economic profits may be negative, but if there is a potential to grow the business and thereby earn a positive economic profit, only then it makes sense to ignore the economic loss in the short run and focus on growing the business with future profits in mind.
Application of accounting and economic profits
The concept of accounting profit and economic profit is applied based on the objective of the analysis. Accounting of revenues, costs and profits is made to ensure all explicit costs are recorded properly and reported in an appropriate format, as per regulatory requirements, to all the stakeholders. This would enable them to calculate, on a historical basis, the Net Revenues, Cost of Goods Sold (COGS), Earning Before Interest & Tax, and Net Income as well as surplus available for distribution as a dividend to shareholders.
Economic profit analysis is done before making a commercial or economic decision about starting, continuing, or discontinuing a business in the future and is used for internal managerial decision-making. It is done to calculate if the surplus remaining after paying for the economic costs of using all factors of production is positive and stays so in the long-run projections of the business. It is not a regulatory requirement to calculate or report economic profit to external stakeholders of a business.
Relationship between Risk and Reward
Applying the concept of economic profits further, we can arrive at the relationship between “Risk and Reward.” Among the four factors of production, it is only the Entrepreneur who takes the maximum “Risk” by starting the enterprise and running it. Hence, it would be observed that salaries, rent, and interest on borrowed capital do not reduce if the business is not doing well, but it is only the entrepreneur’s profits that reduce during an economic downturn. On the other hand, if there is an economic boom and the business earns more than average revenues, the salaries, rent, and interest on borrowed capital do not increase, but the resultant extra profits are all earned by the entrepreneur as a “Reward” to themselves for taking all the risk to start and run the business. It would be observed the application of this principle in rewards for Debt vs. Equity Capital in the business.
There is a directly proportional relationship between Risk and Reward; the higher the risk, the higher the Reward.
People make when analyzing the viability of a business is that they do not consider implicit costs as discussed above. When they fail to apply the principle of rewarding all the four factors of production, they sometimes ignore the implicit costs like the founder’s salary, notional rent for own land or building used in the business, and cost of own capital used in the business.
Context and Applications
The concepts of accounting profits and economic profits are required to succeed in CFA, CPA, MBA and all major business courses focused on finance and/or economics. All businesses apply these concepts to comply with applicable regulatory requirements and/or to make managerial and business decisions.
Opportunity costs, risk-reward analysis, factors of production, cost of capital.
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