RCMA 4: ACCOUNTING VS. ECONOMIC PROFIT

Accounting Profit vs. Economic Profit

Key Definitions

Accounting profit - is the gross income of a company, which is calculated as revenues minus explicit costs. These are the costs for which the company has to make a payment to another party.
Economic profit - is the amount by which total revenue exceeds the total economic costs of the company, which include all of the firm’s explicit costs plus the relevant implicit (opportunity) costs.
Implicit costs - any cost that has already occurred but is not necessarily shown or reported as a separate expense

Accounting Profit vs. Economic Profit

Accounting profit and economic profit are both used to evaluate a company’s performance.
Accounting profit uses accrual accounting based on Generally Accepted Accounting Principles (GAAP). Accounting expenses are also called explicit costs.

ACCOUNTING PROFIT = Accounting Revenue - Explicit Costs

Elements of the Formula:

Total revenue refers to the total amount of money gained from selling products and services, computed by multiplying the quantity sold by the price per unit. For instance, if a business sells 100 pens at P5 each, the total revenue would be 100 pens x P5, equaling P500.
Explicit costs are the expenses incurred in operating a business, which are clearly recorded in the business's financial records and directly impact its profit. Common examples include equipment, rent, cost of goods sold, and insurance.

Illustration for Accounting Profit

Let's say you own a lemonade stand. Last month, you sold 500 cups of lemonade for $3 each. Your expenses for the month were $200 for ingredients (lemons, sugar, cups) and $50 for renting the stand. Calculate the accounting profit for the month.

Economic profit also includes opportunity costs, which are called implicit costs. These costs are defined as the benefits given up by choosing one alternative instead of another.

ECONOMIC PROFIT = Accounting Revenue - Explicit Costs - Implicit Costs

Elements of the formula

The calculations for revenue and explicit costs remain consistent for both accounting and economic profit, but economic profit considers implicit costs.
Implicit or opportunity costs represent the potential revenue foregone from alternative choices when selecting one option over another. These costs are not recorded on financial statements because they are theoretical estimates utilized for comparing different alternatives. For instance, an implicit cost might involve the potential earnings your business could have generated if it invested in stocks instead of allocating those funds toward purchasing equipment for business operations.

Illustration for Economic Profit:

Imagine you have the opportunity to invest $10,000 in two different ventures: Venture A and Venture B.

It is possible to have a positive accounting profit and a positive economic profit, or a negative meaning an economic loss.
- A positive economic profit means the better alternative was chosen.
- When there is economic loss it could mean that a different alternative should have been chosen.
- By definition, economic profit will be lower than accounting profit and is a better reflection of the true profit of a business.

Summary: This topic aims to understand the difference between accounting profit and economic profit, how they're calculated, and what they mean for business decisions.

Practice Questions

Part 1: Theories (5)

1. Which of the following statements is not correct?

A. Economic profit includes more items than accounting profit.

B. Economic profit is less objective than accounting profit.

C. Economic profit can be higher or lower than accounting profit.

D. Economic profit is a more comprehensive measure of performance than accounting profit.

2. All of the following statements about accounting profit and economic profit are true except:

A. Accounting profit is the difference between accounting revenues and accounting expenses.

B. Accounting profit is the difference between accounting revenues and explicit costs.

C. Economic profit is the difference between accounting revenues and explicit costs.

D. Economic profit is the difference between accounting profit and opportunity costs.

3. When economic profit is negative,

A. total economic cost exceeds total revenue.

B. the firm's owners experience the principal-agent problem.

C. the firm's owners experience a decrease in wealth.

D. both a and b

E. both a and c

4. Blossom owns an organic vegetable company. Her accountant most likely includes which of the following costs on his financial statements?

A. Forgone dividends that Blossom's money was earning in the stock market before Blossom sold her stock to purchase land to grow vegetables.

B. Wages Blossom could earn managing a supermarket.

C. Interest that Blossom's money was earning before she spent her savings on a delivery truck.

D. Cost of vegetable seeds.

5. Explicit costs:

A. are considered by economists and accountants when measuring a firm's profit.

B. do not enter into an accountant's measure of a firm's profit.

C. do not require an outlay of money by the firm.

D. are not an opportunity cost.

Part 2: Problem-Solving (5)

1. 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?

A. Accounting profit: $30,000; Economic profit: $5,000

B. Accounting profit: $55,000; Economic profit: $5,000

C. Accounting profit: $30,000; Economic profit: $55,000

D. Accounting profit: $80,000; Economic profit: $5,000

2. Suppose Buttercup, the owner-manager of Buttercup’s Golf Academy, earned $200,000 in revenue last year. Buttercup's explicit costs of operation totaled $130,000. Buttercup has a Bachelor of Science degree in civil engineering and could be earning $60,000 annually as a civil engineer.

A. Buttercup's implicit cost of using owner-supplied resources is $130,000.

B. Buttercup's economic profit is $70,000.

C. Buttercup's implicit cost of using owner-supplied resources is $60,000.

D. Buttercup's economic profit is $10,000.

E. both c and d.

3. Bubbles makes $52,500 a year as an accounting clerk. She decides to quit his job to enter an MBA program full-time. Assume Bubbles doesn’t work in the summer or hold any part-time jobs. Her tuition, books, living expenses, and fees total $37,500 a year. Given this information, the annual total economic cost of Bubbles’ MBA studies is:

A. $90,000

B. $15,000

C. $37,500

D. $52,500

4. Mojo Jojo owns a T-shirt business. Mojo Jojo's explicit costs include $70,000 for raw material costs, $10,000 in payroll, and $8,000 for factory rent per year. Assuming, for the year, Mojo Jojo sold 5,000 units of T-shirts for $30 each. Calculate the accounting profit.

A. $62,000

B. $150,000

C. $88,000

D. $30,000

5. Professor Utonium spends $20,000 per year on painting supplies and storage space. He recently received two job offers from a famous marketing firm: one offer was for $100,000 per year, and the other was for $90,000. However, he turned both jobs down to continue a painting career. If Professor Utonium sells 20 paintings per year at a price of $10,000 each. Compute the accounting profit and economic profit.

A. Accounting profit: $20,000; Economic profit: -$10,000

B. Accounting profit: $180,000; Economic profit: -$10,000

C. Accounting profit: $180,000; Economic profit: $80,000

D. Accounting profit: $200,000; Economic profit: $10,000

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Answer Key

Theories

1. C. Economic profit can be higher or lower than accounting profit.

Explanation: Economic profit includes the opportunity costs associated with production and is, therefore, should be equal to or lower than accounting profit.

2. C. Economic profit is the difference between accounting revenues and explicit costs.

Explanation: This is the formula to calculate the accounting profit. As accounting profit focuses only on explicit costs, economic profit provides a more comprehensive measure of profitability by considering both explicit and implicit costs. It reflects not only the financial costs recorded in accounting statements but also the opportunity costs associated with the use of resources.

3. A. total economic cost exceeds total revenue.

Explanation: Negative economic profit indicates that the firm's total costs, including both explicit and implicit costs, are higher than its total revenue. This implies that the firm is not generating enough income to cover all its costs, including the opportunity costs of using its resources.

4. D. Cost of vegetable seeds

Explanation: The cost of vegetable seeds is a direct expense incurred in the operation of Blossom's organic vegetable company, and it would be categorized as an explicit cost. This type of cost is typically recorded in financial statements as part of the business's operating expenses. The other options - forgone dividends, wages Blossom could earn managing a supermarket, and interest - represent opportunity costs or implicit costs, which are not typically recorded as expenses on financial statements. These costs are relevant in economic analysis but may not be explicitly included in financial statements prepared by accountants.

5. A. are considered by economists and accountants when measuring a firm's profit

Explanation: Explicit costs are costs that require an outlay of money by the firm. Both economists and accountants consider explicit costs when measuring a firm's profit. Furthermore, explicit costs are the direct, tangible expenses that a firm incurs in its operations, such as the cost of materials, labor, rent, utilities, and other resources that require an outlay of money by the firm. These costs are typically recorded in financial statements prepared by accountants and are considered in both economic and accounting analyses of a firm's profitability.

Problem-Solving

1. A. Accounting profit: $30,000; Economic profit: $5,000

Solution:

Given:

Total revenue = $80,000

Explicit costs = $50,000

Implicit costs = $25,000

Accounting Profit:

Accounting profit = Accounting Revenue - Explicit Costs

Accounting profit = $80,000 - $50,000

Accounting profit = $30,000

Economic Profit:

Economic profit = Accounting Revenue - Explicit Costs - Implicit Costs

Economic profit = $80,000 - $50,000 - $25,000

Economic profit = $5,000

Therefore, the firm's accounting profit is $30,000, and the economic profit is $5,000.

2. D. Buttercup's economic profit is $10,000.

Solution:

Total revenue = $200,000

Explicit costs = $130,000

Implicit cost = Opportunity cost of Buttercup's earnings as a civil engineer = $60,000

Using the economic profit formula:

Economic profit = Accounting Revenue - Explicit Costs - Implicit Costs

Economic profit = $200,000 - $130,000 - $60,000

Economic profit = $10,000

Therefore, Buttercup's economic profit is $10,000.

3. A. $90,000

Solution:

Explicit costs: Tuition, books, living expenses, and fees = $37,500

Implicit costs: Salary forgone by quitting her job = $52,500

Total economic cost = Explicit costs + Implicit costs

Total economic cost = $37,500 + $52,500

Total economic cost = $90,000

Therefore, the annual total economic cost of Bubble’s MBA studies is $90,000. So, the correct answer is option a. $90,000.

4. A. 62,000

Solution:

Total revenue = Number of units sold * Price per unit

Total revenue = 5,000 units * $30/unit

Total revenue = $150,000

Explicit costs = Raw material costs + Payroll costs + Factory rent

Explicit costs = $70,000 + $10,000 + $8,000

Explicit costs = $88,000

Accounting profit = Accounting Revenue - Explicit Costs

Accounting profit = $150,000 - $88,000

Accounting profit = $62,000

Therefore, Mojo Jojo’s accounting profit is $62,000.

5. B. Accounting profit: $180,000; Economic profit: -$10,000

Solution:

Explicit Cost = $20,000
Total Painting sold per year = 20

Print of each painting sold per year = $10,000

Total Revenue= Selling price of each painting x Total painting sold per year

Total Revenue= $10,000 x 20 = $ 200,000

Accounting profit

Accounting Profit = Accounting Revenue - Explicit Costs

Accounting Profit= $200,000 - $20,000 = $180,000

Implicit costs - Professor Utonium's potential earnings from the job offers he turned down:

Job offer 1: $100,000 per year
Job offer 2: $90,000 per year

Total implicit costs: $100,000 + $90,000 = $190,000

Economic profit

Economic profit = Accounting Revenue - Explicit Costs - Implicit Costs

Economic Profit = $200,000 - $20,000 - $190,000 = -$10,000

Therefore, the accounting profit is $180,000, and the economic profit is -$10,000.

References:

Becker. (2022). Becker Professional Education CMA Review - Part 2: Strategic Financial Management

Kenton, W. (2020, October 25). Implicit Cost Explained: How They Work, With Examples. Investopedia. Retrieved May 4, 2024, from https://www.investopedia.com/terms/i/implicitcost.asp

Thomas, C. R., & Maurice, S. C. (n.d.). Managerial Economics: Chapter One. Studocu. Retrieved May 4, 2024, from https://www.studocu.com/row/document/jadara-university/advanced-strategic-management/chapters-1234-lecture-notes-1/10414110

The Upwork Team. (2022, March 24). Accounting Profit vs. Economic Profit: Formulas & Differences. Upwork. Retrieved May 4, 2024, from https://www.upwork.com/resources/accounting-profit-vs-economic-profit

Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 2: Strategic Financial Management Set (1-year access). Wiley.