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Economic profit vs accounting profit

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Accounting profit is what many people tend to think of when they think profit, but an economist would say that you leave something very important out when you do so: opportunity costs. In this video, explore the difference between a firm's accounting and economic profit. Created by Sal Khan.

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  • leaf green style avatar for user Soren.Debois
    Is the economic profit always less than or equal to the accounting profit?
    (8 votes)
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  • blobby green style avatar for user jwarded
    Where in the economic curriculum does the concept of RISK enter? I find that students and teachers have a poor grasp of this. This includes market and non-market factors. Example: the risk of putting $$ into an insured savings account with a guarantee of .50% return vs the risk of investing the same amount into a software start up with no guarantee, high risk, but a huge potential return.
    (4 votes)
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  • leaf green style avatar for user tigre 200
    Isn't labour written with a u?
    (1 vote)
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    • spunky sam blue style avatar for user morris.pj
      It depends where you live. American English dropped most (all?) of the "u"s in the "-our" word endings whereas British and International English retained the earlier spelling. Hence American spelling is color rather than colour and labor rather than labour.
      (7 votes)
  • leaf green style avatar for user hlinee
    So if I'm understanding this correctly, then it would be impossible to increase economic profit more if it's already zero or positive, because you can't do anything else to improve your situation, otherwise the economic profit would reflect that and thus be negative? What am I missing here?
    (3 votes)
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    • blobby green style avatar for user mrfootball29
      Profit is simply all the money you make minus all the expenses you've paid in order to make that money. The only difference between accounting profit and economic profit is that economic profit also evaluates what you would have made and uses it as an instrument of comparison when deciding how profitable a person actually is relative to their next best alternative. In the example his economic profit was negative, indicating that his old job was the better choice monetarily. However if his econ. profit had been positive, that would indicate that his current engagements proved to be the most profitable and therefore he was relatively better off. But like accounting profit, you can always improve - by cutting costs (i.e. expenses) and finding cheaper ways to make the same if not more revenue. Profit can ALWAYS be increased due to factors like improvements in productive efficiency (lower expenses), increase in demand (higher revenue), etc. Hope that helps.
      (3 votes)
  • blobby green style avatar for user Sandra Nwogu
    what about my money i incorporate into the business as capital, would that be taken into consideration as an explicit cost, and would it also be counted as an expense when calculating accounting profit ?
    (1 vote)
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    • blobby green style avatar for user mrfootball29
      If you simply mean money that you personally set aside for your business and have sitting somewhere in an account until you need it, then no it isn't an expense - it's a cash asset. However when you spend that money on things to benefit your business like Plant and Equipment and other expenses, then that money does get factored in as such - money used to finance your expenses.
      (3 votes)
  • blobby green style avatar for user chloeduxin
    I don't understand why wages as a implicit cost should be deducted in the economic view? I think wages should be also deducted when calculating accounting profit?.I am a little confused about that.
    (2 votes)
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    • leaf green style avatar for user Jeffrey Sugar
      The explicit costs are outlays (actual cash) paid for those goods. The implicit cost of wages forgone (given up) is not an outlay (no real cash transaction). As Sal says, suppose you were a doctor making $150K and gave that up to run the restaurant business. That salary given up is not counted in determining the accounting profit but is included in the economic profit calculation.
      (1 vote)
  • blobby green style avatar for user tradingkunskap
    But is economic profit fictive cost?

    i mean if i am working as doctor and making 100' usd per year. and suddenly i hear that my friend is opening a pizza place and making 400' usd per year. Than my opportunity cost is the "the profit i could make being a pizza maker instead of a doctor".

    but what if making pizza is more harder than being a doctor:)
    the not opening a pizza place will be an indirect benefit for me, How does indirect benefit affect economic profit?

    what i am trying to say is that this types of cost does not really affect us in the real life, i mean it could but most of the times they affects us in theory.
    (2 votes)
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  • blobby green style avatar for user Mij Florungco
    Why is it that Implicit cost is not included on the list for Accounting Profit?
    (1 vote)
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    • starky ultimate style avatar for user Geoff Ball
      Accountants don't count implicit costs. They are concerned with the literal financials. Economists do, as we are worried about not just monetary costs, but also intangibles like benefit, utility, etc.

      Both have their contexts in which they're better, but it's crucial not to mix up the two.
      (3 votes)
  • blobby green style avatar for user ieltstaker98
    Due to coronavirus pandemic auto sales decreased significantly. One of the automakers decided to sell cars cheaper or even at a loss than to shut down. When it is said selling cars at a loss, is it referring to accounting profit or economic profit?
    (2 votes)
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    • starky ultimate style avatar for user Evan Li
      Selling the cars at a loss is an explicit cost, so it is referring to the accounting profits. However, it is important to remember that accounting profits are a complete subset of economic profit, so this change will actually affect both
      (1 vote)
  • leaf red style avatar for user Doctorholy
    What is exactly the difference between explicit and implicit costs?
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      Explicit costs are costs for which you actually see money leaving the door. They are things like interest on a loan, labor, rent, equipment costs, material costs, etc. Implicit costs are costs in which there is no money leaving, but instead either money could have been entering instead or the value of your assets is decreasing. For instance, if you own a building, it undergoes depreciation, so it's value is going down. That is an implicit cost.

      If you make an investment, there are costs associated with it. If you took out a loan to make that investment, then the interest you are paying on that loan is an explicit cost. If you had the money already, then the interest that you could have gotten on loaning that money out instead is an implicit cost.
      (2 votes)

Video transcript

Background voice: Let's say this past year I started a restaurant and I want to think about what type of a profit I've been making at that restaurant. We're going to think about it in 2 different ways. We're going to think about it in terms of an accounting profit, which is really the type of profit that most of us associate with a business or a firm. We're also going to think about it in terms of economic profit, which we'll see is a little bit different. Instead of telling us whether a business is producing income, it tells us whether it makes sense to even run the business in the way that we're actually running it. First, let's focus on the traditional way of calculating profit. Let's say my firm, my restaurant, (my firm in a restaurant) in year 1 it brings in, in revenue, it brings in $500,000. Revenue literally is the amount of money the customers pay me to eat at the restaurant. They are paying for their dinners. This is literally the money that's coming in the door. Sometimes people call it the top line, because it's literally the top line of our income statement. I just wrote it. It's the top line. Now we have to think about our expenses. Expenses. Now, when you're running a restaurant one of the obvious expenses is going to be the cost of food. Food, we're going to say cost us $100,000. $100,000. Then, you have the cost of labor. I have the wait staff. I have the chefs and the bus boy. On all of those people, in this past year, I spent $100,000. Then, I have, and I am going to assume that I don't own the building, that I rent the building. So, building rent. I'm assuming this is on the building, let's say that that was $200,000. Then finally, I really just rented everything. I also rented the equipment, all of the stoves, the fridges, all of that stuff. None of this is stuff that I own, so the equipment rent. Equipment rent, I spent another $50,000. How much profit do I have here? Those are all of my expenses. I didn't borrow any money, so I didn't have any interest expense or anything like that. How much profit do I have before paying tax, or essentially my pretax profit? The reason why we think of it in those terms is because the amount you pay in tax is usually derived from your pretax profit. That depends on where this business is, what country, what state, what type of business it is. The easy way to calculate pretax profit, pretax profit. This is pretax and we're thinking in terms of accounting profit right over here. We take how much money comes through the door and then we just have to subtract out all of the payments we essentially have to make to other people. What we have left is out pretax profit. 500,000 minus 450,000 gives us a pretax profit (I'll do it in that same bright yellow) of $50,000. I'm assuming that I'm the only owner of this business, so I can essentially take it all out for myself. Maybe help pay my own personal rent or whatever else, or I could take some of this or all of this and reinvest it back into the business. Maybe I start buying my equipment or I expand in some way. Who knows what I might do with that money. This is just traditional accounting profit. This is how profit is calculated. Although, this is a super simple example. In the future I would like to do more nuanced examples in the accounting world. This, you would refer to as just accounting profit. Accounting profit. When people in the everyday world talk about profit, this is normally what they're talking about. Now, when economist talk about profit, they're talking about something slightly different. The best way to realize that is to just calculate economic profit for this exact same business, or this firm, as a economist would call it. A firm really is a general idea for an organization that is trying to maximize profit. Once again, it's year 1. Actually let me just copy and paste it. It's year 1, that's our revenue. I'm going to copy and I'm going to paste it. This right over here. So far, so good. Looks pretty similar. Now, we're going to think about things in a slightly different way. Economist view cost in terms of opportunity cost. As we'll see, some of the opportunity cost you can measure in terms of dollars. Some are less explicit. I'm going to write here, just so we can get in the economist frame of mind, opportunity cost. Within opportunity cost there are going to be explicit opportunity cost and implicit opportunity cost. First, let's do the explicit. Explicit opportunity cost. Actually, all of these are explicit opportunity cost. Let me just copy and paste that. I will copy and paste. All of these are explicit opportunity cost. The reason why they are explicit is I'm actually making up ... I'm paying money for all of these things. Even the equipment and the rent of the apartment, I don't own it. I'm actually paying whoever does own it. These are direct outlays out of the business. I'm explicitly making these payments. The reason why we can think of them as opportunity cost, even though they're given in dollar terms, is that if I was spending $100,000 on food, that's $100,000 that I couldn't spend on something else. If I'm spending $100,000 on labor, that's $100,000 that I couldn't spend on something else. I'm just measuring the opportunity cost in terms of dollars, but dollars that I could have spent on other things. So far, it looks pretty much identical. I'm just viewing it with a slightly different lens. You're like, "Well, what's the big deal here?" We're going to see a little bit of divergence when we start thinking about the implicit cost that really weren't taken into account here, the implicit opportunity cost especially. Implicit cost. If I am running this business and let's say, in order to run it I actually had to focus on it full time. I couldn't have actually quit my job. Then, there's an implicit cost of … An implicit opportunity cost of the job that I gave up, or my wages foregone. Let me write this down, wages foregone. Let's say, and this will depend on who we're talking about. Let's say I was a doctor and I was making a nice steady, risk free $150,000 a year. I was giving up $150,000 a year. Now, we've listed all of the explicit and the implicit opportunity cost. Now we're ready to calculate our economic profit. Let me draw a line over here. Our economic profit is going to be our revenue that we're taking in, minus all of these expenses. That gives us a positive $50,000. Now, we have to subtract the wages foregone. Then, I get to negative $150,000. This is interesting. This is kind of a big discrepancy here. In accounting terms, I'm profitable. In economic terms, I'm not profitable. The important thing to realize is economic profit, when it's negative, isn't saying, or you say that you have $100,000 economic loss, or an economic profit of negative $100,000. This isn't saying that the business or the firm isn't spinning out money. What it is saying, is it probably doesn't make sense to run this business or at least to run this business in this way. If this was 0, that means, hey, it's probably making money, but you're kind of neutral whether it makes sense to run it this way or not. If it's positive, that means it definitely does make sense to run the firm in this way and that it is definitely doing better than all of the alternatives. This right over here is saying, look, you're making $50,000 a year, that's the 50,000 that you have to spend, if you're the owner, or reinvest in the firm. This is saying, essentially, look, you could have been making more money than that $150,000. Instead of making $50,000 doing this, you could have been making $100,000 more doing something else. You are essentially giving up, you are giving up $100,000 to do this restaurant. If you are a rational decision maker and you're really are about maximizing your profit, this actually might not make so much sense for you.