A business’s financial statements might show a healthy profit, but that doesn’t always mean the business is generating revenue most efficiently. To find out, many businesses turn to the economic profit formula, which helps determine true profitability. This approach accounts for all the business’s costs, including less obvious ones (e.g., the owner’s time or potential interest earned on capital), providing a more complete picture of performance.
Understanding economic profit is more than just an exercise; it’s a valuable tool that helps with effective business management and strategic planning. A positive economic profit signals a company’s resources—capital, labor, and raw materials—are being used cost-effectively. A negative economic profit is a warning those resources could be generating more value elsewhere.
Learn more about how to calculate economic profit and how to analyze the results to gain insight into your company’s profitability.
What is economic profit?
Economic profit is the difference between a company’s total revenue and its total costs, including both implicit and explicit costs. It may be positive, zero, or negative, depending on how a company’s returns compare to its opportunity cost. The opportunity cost represents the earnings a firm could have generated by putting its resources to another use.
Economic profit differs from accounting profit, which only considers explicit costs such as wages, rent, and materials. While financial statements report a company’s accounting profit (or net income), economic profit provides a more complete measure of profitability and efficiency.
Accountants focus only on explicit costs because these can be tracked, measured, and reported under established financial rules. Economists, however, include implicit costs to capture opportunity cost. This is why accounting profit is most useful for financial reporting and compliance. Meanwhile, economic profit is better suited for evaluating business strategy and making long-term business decisions.
The economic profit formula
The economic profit formula is straightforward:
Economic profit = Total revenue - (Explicit costs + Implicit costs)
This formula can also be expressed more simply as:
Economic profit = Total revenue - Total cost
In this case, total cost is the sum of all explicit and implicit costs.
How to calculate economic profit
- Calculate total revenue
- Calculate total cost
- Subtract total cost from total revenue
- Analyze the results
Calculating economic profit involves a few steps that go beyond simply pulling data from a company’s financial statements.
1. Calculate total revenue
To begin, determine the total revenue for the period—the amount a company earns from selling its goods or services. To calculate it, multiply the price of the goods or services by the total quantity sold to determine gross revenue. Then subtract any refunds, allowances, discounts, and promotional deductions to get net total revenue. This is a more accurate representation of the actual income generated from sales, as it accounts for money the business didn’t keep.
2. Calculate total cost
Next, calculate the total cost, which includes both implicit and explicit costs.
- Explicit costs. The direct payments a company makes for factors of production, such as wages for employees, rent for a building, and raw materials, are explicit costs. Companies generally report these costs on their financial statements.
- Implicit costs. These are the opportunity costs of using the company’s own resources. Examples include the salary the business owner could have earned working for someone else or the interest they could have earned on money used to finance the business.
3. Subtract total cost from total revenue
After you determine total revenue and total cost, you’ll apply the economic profit formula by subtracting the cost from the revenue. The result will show the company’s economic profit for the period.
4. Analyze the results
After completing the calculation, you can analyze the results to gain insight into your company’s profitability.
- Positive economic profit. This means your company is earning a return greater than its opportunity cost. Your business decisions are leading to the most profitable use of resources.
- Zero economic profit. This means your company is covering all its costs, both explicit and implicit, and earning a return equal to its opportunity cost—no better, no worse.
- Negative economic profit. Also known as an economic loss, this means the company is not earning enough to cover its total costs, suggesting it could use its resources more profitably elsewhere.
Calculating economic profit example
To understand the difference between economic profit and accounting profit, let’s go through a hypothetical example.
1. Calculate total revenue
Splendid T-shirts generated $155,000 in gross sales during the year. However, some of that money didn’t stay with the business:
- Customer refunds for returned orders: $2,000
- Gift card redemptions and promotional discounts: $3,000
After subtracting these adjustments, the apparel company’s net revenue is $150,000.
In practice, total revenue in the economic profit formula is understood as net revenue—the actual income retained after refunds, discounts, and other deductions.
2. Calculate total costs
Explicit costs (recorded expenses):
- Employee wages: $30,000
- Rent: $24,000
- Materials and production: $40,000
- Utilities and other costs: $6,000
Total explicit costs = $100,000
Implicit costs (opportunity costs):
- Foregone salary: $60,000 (the owner’s former management job)
- Foregone interest: $2,000 (a 4% return on $50,000 in savings used to fund the business’s startup costs)
Total implicit costs = $62,000
3. Subtract total cost from total revenue
Economic profit = Total revenue - (Explicit costs + Implicit costs)
Economic profit = $150,000 - ($100,000 + $62,000) = -$12,000
At this stage, it’s useful to compare the result with accounting profit. Based only on explicit costs, the company showed a $50,000 accounting profit, which is the figure reported on the company’s financial statements. But once you include implicit costs, the business actually produced a $12,000 economic loss.
4. Analyze the results
Your results can show a positive, negative, or zero economic profit.
In this example, even though the accounting profit is positive, the economic profit is negative. This comparison highlights why economic profit is such a valuable measure.
While accounting profit suggests the venture is successful, economic profit reveals the business is actually losing value compared to its next best alternative. The business may need to reduce operating costs, avoid product returns, or increase prices, in order to increase the economic profit, and gain value.
Zero economic vs. zero accounting profit
When analyzing results, it’s important to distinguish between zero economic profit and zero accounting profit. Zero economic profit means the business is sustainable—it covers all explicit and implicit costs, and owners receive a fair return equal to what they could earn elsewhere. Economists call this normal profit.
Zero accounting profit, on the other hand, means revenue only covers explicit costs, with nothing left to compensate owners for their time or capital—a situation that may be unsustainable.
Economic profit formula FAQ
What is accounting profit vs. economic profit?
Accounting profit is the net income a business reports on its financial statements, calculated by subtracting explicit costs like salaries and raw materials from total revenue. Economic profit also subtracts implicit costs (opportunity costs) from total revenue. Therefore, accounting profit is often larger than economic profit.
How do you calculate economic profit?
To calculate economic profit, you first determine the total revenue of the business. Then, you calculate the total cost by adding up all the explicit costs (e.g., wages, rent) and all implicit costs (e.g., foregone salary, interest on invested money). You then subtract this total cost from the total revenue using the following formula:
Economic profit = Total revenue - (Explicit costs + Implicit costs)
Is zero economic profit good?
Yes, zero economic profit is considered good. It means that the business is covering all its costs, including the opportunity cost of the resources used. In other words, the company is earning a return equal to what its resources could have earned in their next best alternative use. A firm earning zero economic profit is sustainable in the long run.
