Economic Profit (Or Loss)

Published Mar 26, 2023

Definition of Economic Profit (or Loss)

Economic profit (or loss) is the difference between the revenue earned by a firm and the total opportunity costs of all inputs used in production. Opportunity costs refer to the cost of the best alternative forgone, such as the highest-valued alternative use of a resource. In simpler terms, economic profit (or loss) is the net profit (or loss) that a firm earns after accounting for all implicit and explicit costs.

Example

Let’s say that ABC Inc. is a company that produces and sells T-shirts. The company generated USD 100,000 in revenue in a year. Additionally, the total explicit (out-of-pocket) cost incurred by the company, such as raw materials, labor wages, and rent, amounted to USD 80,000. However, the company also incurred implicit costs, such as the opportunity cost of the owner’s time spent running the business, which amounted to USD 20,000.

To calculate the economic profit, we can subtract the total explicit and implicit costs from the revenue. In that case, the economic profit for ABC Inc. is USD 100,000 – USD 80,000 – USD 20,000 = USD 0. This means that the company did not earn any economic profit in that year.

Why Economic Profit (or Loss) Matters

Economic profit (or loss) is an essential metric for businesses as it helps them assess whether their operations are profitable or not. Unlike accounting profits, which focus only on explicit costs, economic profits take into account both implicit and explicit costs. This metric provides a more accurate picture of the company’s true profitability, and it can guide managerial decision-making.

If a company’s economic profit is positive, it indicates that the company is creating value above its total opportunity cost. This is a sign that the company is using its resources efficiently and that it could consider expanding its operations in that area. If a company’s profit is negative, it indicates that the company’s resources are not being used effectively, and it may need to reevaluate its operations to improve profitability. Therefore, understanding economic profit (or loss) is crucial for businesses seeking long-term success.