Economic Profit Formula

Economic Profit Formula (Table of Contents)

• Formula
• Examples
• Calculator

What is Economic Profit Formula?

The term “economic profit” refers to the profit that is earned by a business after adjusting for the opportunity cost that the business has foregone. In other words, it is the difference between the accounting profit and the opportunity cost. The formula for economic profit can be derived by deducting the explicit costs (pertaining to the business expenses) and the implicit costs (opportunity cost) from the total revenue earned by the business. Mathematically, Economic Profit is represented as,

Examples of Economic Profit Formula (With Excel Template)

Let’s take an example to understand the calculation of Economic Profit in a better manner.

Economic Profit Formula – Example #1

Let us take the example of a company with total revenue of $200,000 and explicit costs of $150,000. Calculate the economic profit of the company if the implicit costs are $30,000.

Solution:

Economic Profit is calculated using the formula given below

Economic Profit = Total Revenue – Explicit Costs – Implicit Costs

• Economic Profit = $200,000 – $150,000 – $30,000
• Economic Profit = $20,000

Therefore, the company earned economic profit of $20,000.

Economic Profit Formula – Example #2

Let us take the example of John who has started his own company named XYZ Ltd. He has invested $50,000 as the capital for the business which he could have otherwise invested in a corporate bond with 4% annual coupon. In the first year of operation, the company booked total revenue of $120,000, while the total explicit costs stood at $110,000. Calculate economic profit earned by John during his first year of operation.

Solution:

Implicit Cost is calculated using the formula given below

Implicit Costs = Coupon Rate * Capital

• Implicit Cost = 4% * $50,000
• Implicit Cost = $2,000

Economic Profit is calculated using the formula given below

Economic Profit = Total Revenue – Explicit Costs – Implicit Costs

• Economic Profit = $120,000 – $110,000 – $2,000
• Economic Profit = $8,000

Therefore, the economic profit earned by John in his first year of operations is $8,000.

Economic Profit Formula – Example #3

Let us take the example of Stella who has recently given up her job as a business analyst to start up her dream company of organic food farming. Now her last drawn annual salary was $60,000. During the first year of operation, the company earned total revenue of $500,000, while the raw material cost, rental, labor cost, and advertising expense came to be $285,000, $30,000, $100,000 and $20,000 respectively. Calculate economic profit earned by Stella.

Solution:

Explicit Cost is calculated using the formula given below

Explicit Costs = Raw Material Costs + Rental + Labor Charges + Advertising Costs

• Explicit Cost = $285,000 + $30,000 + $100,000 + $20,000
• Explicit Cost = $435,000

Economic Profit is calculated using the formula given below

Economic Profit = Total Revenue – Explicit Costs – Implicit Costs

• Economic Profit = $500,000 – $435,000 – $60,000
• Economic Profit = $5,000

Therefore, the Stella earned economic profit of $5,000 during the year.

Explanation

The formula for economic profit can be derived by using the following steps:

Step 1: Firstly, figure out the total revenue of the company and it is the top line item in the income statement. Also, the total revenue can be calculated by multiplying the average price per unit and the number the units sold during a specific time period, usually a year, as shown below.

Total Revenue = Average Price Per Unit * Number of Units Sold

Step 2: Next, determine the explicit costs of the business that includes the usual expenses that every business has to bear out of their own pocket in order to sustain the business. Examples of explicit costs are raw material costs, wages, rent, electricity bills, telephone bills, advertising expenses, etc.

Step 3: Next, determine the implicit costs that represent the value of the opportunity that the business has foregone in order to pursue the current business operation. For instance, the salary can be the implicit cost if a person gives up his/her job to pursue his dream to run a business of his/ her own.

Step 4: Finally, the formula for economic profit can be derived by deducting the explicit costs (step 2) and the implicit costs (step 3) from the total revenue (step 1) as shown below.

Economic Profit = Total Revenue – Explicit Costs – Implicit Costs

Relevance and Uses of Economic Profit Formula

It is very important to understand that economic profit and accounting profit are two completely different things and one can’t be used as an alternative for the other in any case. Economic profit basically differs from accounting profit in the fact that the former also includes the effect of opportunity costs, which is the value that a business or individual has given up to do something else.

Now, it is possible for a business to have a positive accounting profit while the economic profit is negative, and it indicates that the individual could be financially better off by halting the current business operation and engage in a different opportunity. On the other hand, if a business is able to achieve a positive economic profit then it indicates the individual should pursue the current business operation as it is yielding better returns than other opportunities.

Economic Profit Formula Calculator

You can use the following Economic Profit Calculator

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This is a guide to Economic Profit Formula. Here we discuss How to Calculate Economic Profit along with practical examples. We also provide an Economic Profit Calculator with downloadable excel template. You may also look at the following articles to learn more –

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