Accounting Profit vs. Economic Profit

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Business firms utilize two kinds of inputs or resources, i.e. market-supplied resources and owner-supplied resources, Market-supplied resources are those resources which are owned by outsiders (or others) except producer and hired, rented, or leased by the producer (or – firm). These resources include raw materials purchased in resource markets from commercial suppliers, capital equipment and land rented or leased from equipment suppliers and land owners, labour services of skilled and unskilled workers etc. The opportunity cost of using market-supplied resources is the out-of-pocket monetary payments made to the owners of resources. These costs are also known as explicit costs. They are recorded in the debit items of the accounting book under Generally Accepted Accounting Principles (GAAP). Hence, they are also known as accounting costs.

Explicit costs are indeed opportunity costs, specifically, it’s the amount of money sacrificed by firm owners to get market supplied resources.

Owner-supplied resources are those resources which are owned and used by the producer (or owner of a firm) himself. These resources include money invested in the business by its owners, land, buildings and capital equipment owned and used by the firm and time, talent and labour services provided by the firm’s owners. All the costs incurred on owner-supplied resources are known as implicit costs because the firm makes no monetary payments to use its own resources. These costs are evaluated on the basis of opportunity costs.

The opportunity cost of using an owner-supplied resource is the best return the owners of the firm could have received had they taken their own resource to market instead of using it themselves. They include: (i) the opportunity cost of using land or capital owned by the firm; (ii) the opportunity cost of the owner’s time spent and talents used to manage the firm or work for the firm in some other capacity; and (iii) the opportunity cost of cash invested to a firm by its Owners.

Business firms incur opportunity costs for both categories of resources used and apply to examine their real performance. Thus, total economic costs are the sum of the opportunity costs of market-supplied resources and the opportunity costs of owner supplied resources.

Accounting profit is the difference between the firm’s total revenue and total explicit costs. But economic profit is the total revenue, less total economic costs- Therefore, when an economist says that a firm is able to cover its costs (i.e. recover both explicit and implicit costs), the entrepreneur is receiving a return just large enough to retain his talents in the present line of production. If an entrepreneur receives a residual surplus between the total revenue and the total economic costs, it is economic profit or pure profit. Economic profits are not part of the cost of production.

In short,
Accounting Profit (Profit A) = Total sales receipt — Accounting costs
Economic profit (Profit E) = Total sales receipt — Economic costs.
or Profit E = TR — (Accounting cost + Implicit costs)

or Profit E = TR — [Accounting cost + (Imputed costs + Normal return to the entrepreneur)]
Where
Imputed costs = Implicit rent + Implicit wages + Implicit interest

Normal rate Of return to the entrepreneur = Opportunity cost of an entrepreneur (or normal profit)

For example, an entrepreneur operates a poultry farm as the sole proprietor. He owns outright his farms and buildings and supplies all his own labour and money capital. Though his farm has no explicit cost (as rent or wages), implicit rents and wages are incurred. By using his own land and building a poultry firm, he sacrifices Rs. 3000 monthly rental income which he otherwise could earn by renting it out to someone else. Similarly, by using his money capital and labour on his own farm, he sacrifices the interest and wages which he otherwise could earn by supplying these resources in their best alternative employments. Finally, by running his own farm, he forgoes the earnings which he could realize by supplying his managerial efforts in other firms. In short, the money payments that the self-employed or self-owned resources could have earned in their best alternative employments are called implicit costs. These costs are evaluated on the basis of opportunity cost. Implicit costs can be classified into two groups:

a. Imputed Costs: Imputed costs refer to the imputed value of the inputs (i.e. land, labour and capital) owned by the firm and used by it in its production unit.

b. Normal Profit: It is defined as the minimum payment which must accrue to an entrepreneur in order to induce him to undertake the risk of business. If this minimum return is not realized, the entrepreneur will withdraw his efforts from one line of production and reallocate them to some alternative line of production, or he may cease being an entrepreneur in favour of becoming a salary earner. Thus, it is the minimum supply price of the managerial services and part of the cost. It is also called the normal rate of return to the entrepreneur.

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