Find out How to Calculate Profit

Looking at Profit
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Calculating Profit

Profit
Courtesy of Jodi Beggs

Once revenues and the costs of production are defined, calculating profit is pretty straightforward.

Simply put, profit is equal to total revenue minus total cost. Since total revenue and total cost are written as functions of quantity, profit is also typically written as a function of quantity. In addition, profit is generally represented by the Greek letter pi, as indicated above.

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Economic Profit Versus Accounting Profit

Accounting Profit
Courtesy of Jodi Beggs

As stated earlier, economic costs include both explicit and implicit costs to form all-inclusive opportunity costs. Therefore, it's important to also distinguish between accounting profit and economic profit.

Accounting profit is what most people probably envision what they think about profit. Accounting profit is simply dollars in minus dollars out, or total revenue minus total explicit cost. Economic profit, on the other hand, is equal to total revenue minus total economic cost, which is the sum of explicit and implicit costs.

Because economic costs are at least as big as explicit costs (strictly larger, in fact, unless implicit costs are zero), economic profits are less than or equal to accounting profits and are strictly less than accounting profits as long as implicit costs are greater than zero.

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A Profit Example

Accounting Profit
Courtesy of Jodi Beggs

To further illustrate the concept of accounting profit versus economic profit, let's consider a simple example. Let's say you have a business that brings in $100,000 in revenue and costs $40,000 to run. Furthermore, let's assume that you gave up a $50,000 per year job to run this business.

Your accounting profit would be $60,000 in this case since that is the difference between your operating revenue and operating cost. Your economic profit, on the other hand, is $10,000 because it factors in the opportunity cost of the $50,000 per year job that you had to give up.

Economic profit has an interesting interpretation in that it represents the "extra" profit compared to the next best alternative. In this example, you are $10,000 better off by running the business because you get to make $60,000 in accounting profit rather than make $50,000 at a job.

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A Profit Example

Accounting Profit
Courtesy of Jodi Beggs

On the other hand, economic profit can be negative even when accounting profit is positive. Consider the same setup as before, but this time let's assume that you had to give up a $70,000 per year job rather than a $50,000 per year job in order to run the business. Your accounting profit is still $60,000, but now your economic profit is -$10,000.

A negative economic profit implies that you could be doing better by pursuing an alternative opportunity. In this case, the -$10,000 represents that you are $10,000 worse off by running the business and making $60,000 than you would be by taking the $70,000 per year job.

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Economic Profit Is Useful in Decision Making

Economic Profit

The interpretation of economic profit as "extra" profit (or "economic rents" in economic terms) compared to the next best opportunity makes the concept of economic profit very useful for decision-making purposes.

For example, let's say that all your were told about a potential business opportunity was that it would bring in $80,000 per year in accounting profit. This is not enough information in order to decide whether it's a good opportunity since you don't know what your alternative opportunities are. On the other hand, if you were told that a business opportunity would yield an economic profit of $20,000, you would know that this is a good opportunity since it provides $20,000 more than alternative options.

In general, an opportunity is profitable in an economic sense (or, equivalently, worth pursuing) if it provides an economic profit of zero or greater, and opportunities that provide economic profits of less than zero should be foregone in favor of better opportunities elsewhere.