Economic Costs and Accounting Costs

Below are definitions of economic costs and accounting costs.

 Economic costs = implicit costs + explicit costs Accounting costs = explicit costs

Economic Profit and Accounting Profit

Below are definitions of economic profit and accounting profit.

 Economic profit = total revenue – economic costs. Accounting profit = total revenue – explicit costs.

Examples of Economic and Accounting Profit Calculations

Example 1
Problem: Let’s say that a firm’s total revenue is \$180,000. Using the explicit and implicit costs from the business example at the bottom of section 1, what are the firm’s accounting and economic profits?

Solution: Economic profits equal total revenue minus economic costs. Total revenue is \$180,000. Economic costs are \$172,000. Thus, economic profits equal \$180,000 – \$172,000 = \$8,000.

Accounting profits equal total revenue minus explicit costs. Thus, accounting profits equal \$180,000 – \$120,000 = \$60,000.

Example 2

Problem: Let’s say that a firm’s total revenue is \$80,000 and its explicit costs and implicit costs are \$50,000 and \$25,000, respectively. What are the firm’s economic and accounting profits?

Solution: Economic Profits are: \$80,000 – \$75,000 = \$5,000. Accounting Profits are: \$80,000 – \$50,000 = \$30,000

Example 3

Problem: Let’s say that a firm’s total revenue is \$80,000 and its explicit costs and implicit costs are \$70,000 and \$25,000, respectively. What are the firm’s economic and accounting profits?

Solution: Economic Profits are: \$80,000 – \$95,000 = -\$15,000 (a loss of \$15,000). Accounting Profits are: \$80,000 – \$70,000 = \$10,000

From a financial point of view, assuming no changes in costs and revenue, should the firm in the last example continue to operate? The firm reaps a positive accounting profit of \$10,000. Thus, the firm has a positive cash flow. However, the negative economic profit indicates that if the owner had put her/his time and capital in the alternative activity, (s)he would have earned \$15,000 more. Therefore, from a financial point of view, assuming no change in the future costs and revenue, it is better for the owner to discontinue the business and pursue the alternate activity.

Video Explanation
For a video explanation of economic and accounting profit calculations, please watch: