What is Economic Profit and Why is it Important for Businesses?

When we think about running a business, profit is usually at the forefront of your mind. After all, making money is the primary goal for any company, whether it’s a startup or an established corporation.

However, not all profits are created equal. In the world of business, there’s a critical distinction between different types of profit that can impact decisions at every level. One such concept is economic profit – a measure that goes beyond basic earnings to provide a deeper understanding of a company’s financial health.

In this article, we’ll break down what economic profit is, why it matters, and how it differs from other forms of profit, like accounting profit. By the end, you’ll have a clearer idea of how economic profit can influence your business strategies and long-term success.

What is economic profit?

Economic profit is a measure of profitability that takes into account not only the explicit costs of running a business (expenditure like rent, wages, and materials) but also the implicit costs, which represent the opportunity cost of the resources used.

In simple terms, economic profit tells you how much a business earns after considering both the money spent on operating expenses and the potential income that could have been made if resources were used elsewhere.

How is economic profit different from accounting profit?

This makes economic profit different from accounting profit, which is typically the number that shows up on a company’s financial statement. Accounting profit is calculated by subtracting what is known as explicit costs from the total revenue. It doesn’t factor in the opportunity costs, which is why accounting profit may give a less accurate picture of a business’s true financial performance.

In essence, while accounting profit helps businesses track their direct financial performance, economic profit provides a more comprehensive view by considering what businesses are giving up in order to generate their current revenue.

The importance of economic profit

One of the key advantages of considering economic profit is that it offers a clearer picture of long-term viability. A business might be showing a positive accounting profit, but if it’s failing to earn more than what could be achieved elsewhere with the same resources, its future growth and sustainability could be at risk. Economic profit reveals whether a business is really growing or if it’s simply treading water. In other words, it shows if the business is creating value beyond just covering its costs – something crucial for long-term success.

For example, imagine a tech startup that has been generating solid accounting profits, but after factoring in the opportunity cost of the founder’s time and the capital invested, their economic profit is minimal. This could signal that it might be worth exploring other ventures or rethinking their business model. By taking economic profit into account, the company can make smarter decisions, whether that’s re-investing in the business, diversifying their offerings, or even considering a pivot.

In short, economic profit doesn’t just help businesses stay afloat – it helps them thrive by ensuring that every resource is being used in the most profitable way possible.

How to calculate economic profit

Calculating economic profit involves a straightforward formula, but understanding the components is key to applying it effectively. Here’s the basic formula:

Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)

Let’s break down what each of these terms means:

• Total Revenue: This is the total income your business earns from selling goods or services.
• Explicit Costs: These are the direct expenses that a business incurs. Think of rent, wages, utilities, and raw materials.
• Implicit Costs: These are the opportunity costs of using your own resources, such as time, money, and expertise, rather than investing them elsewhere. For example, if you’ve chosen to run your business full-time instead of working another job, the implicit cost is the salary you could have earned elsewhere.

Now, let’s walk through a simple example to make this clearer:

Imagine a small coffee shop. The owner, Sarah, brings in a total revenue of £100,000 a year. Her explicit costs (rent, employee wages, coffee beans, etc.) total £60,000. However, Sarah’s also using £20,000 of her personal savings to run the business, which could have been invested elsewhere for a return. This represents an implicit cost of £20,000.

Now let’s plug these numbers into the formula:

Economic Profit = £100,000 (Total Revenue) – (£60,000 + £20,000) (Explicit + Implicit Costs)

Economic Profit = £100,000 – £80,000 = £20,000

In this case, Sarah’s economic profit is £20,000, which means that after accounting for both her explicit and implicit costs, her business is generating an actual return above what she could have earned by investing her time and money elsewhere. If her economic profit were zero or negative, it might suggest that the business isn’t as profitable as it could be, considering the opportunity costs.

What is a real-world application of economic profit?

Let’s explore how companies use economic profit in real-world situations.

Economic profit in business strategy

When a company is thinking about launching a new product or expanding into a new market, it needs to look beyond just the revenue it expects to generate. By calculating economic profit, businesses can assess whether the potential return justifies the opportunity cost of the resources involved. If the economic profit is positive, it suggests the venture is worth pursuing. If it’s negative or near zero, it may signal that the resources could be better used elsewhere.

For example, imagine a tech company considering a new mobile app. Before committing to the project, they calculate the expected total revenue, subtract the explicit costs (like development, marketing, and distribution), and then factor in the opportunity cost of using their team’s time and capital. If the economic profit is positive, they might decide to move forward with the app. If it’s negative, they could reconsider the investment or explore alternative projects.

Economic profit in market entry or exit

Economic profit also plays a key role in market entry and exit decisions. When entering a new market, businesses must consider not just the immediate costs but also the potential opportunity costs of their resources. A company might find that entering a new market would yield positive accounting profit but could be less profitable when accounting for the opportunity costs. If the economic profit of entering the new market is negative, the business may choose to stay out and focus on more profitable areas instead.

On the flip side, economic profit helps businesses decide when to exit a market. If a company has been operating in a particular market but finds that its economic profit is consistently negative, it may be time to cut losses and redirect its resources to more profitable opportunities.

Example case studies

Apple’s product line expansion

When Apple launched the iPhone, the company had to consider not only the direct costs of development and production but also the opportunity cost of investing time and resources into a completely new product. By calculating the expected economic profit, Apple was able to determine that the iPhone was not only a profitable product in terms of accounting profit but also a highly valuable innovation in terms of economic profit – leading them to aggressively pursue the mobile phone market.

Netflix’s international expansion

Netflix’s decision to expand internationally involved significant upfront investment in marketing, infrastructure, and content creation. However, Netflix had to weigh these costs against the potential revenue from new subscribers in international markets. By factoring in the opportunity costs of the resources being invested, Netflix was able to determine whether the long-term economic profit would justify the expansion. Their calculated economic profit ultimately helped them make a successful push into global markets.

The role of economic profit in competitive markets

In a competitive market, economic profit is typically the signal for businesses to innovate or improve their operations. When a company is earning economic profit, others will likely be drawn to the market, attracted by the potential for similar returns. This competition pushes businesses to constantly improve, whether through technological advancements, better customer service, or more efficient production methods, which ultimately benefits consumers and the market as a whole.

Tracking economic profit with Brixx

Understanding economic profit is crucial for making informed, strategic business decisions. It gives you a more comprehensive view of your company’s true profitability by factoring in both explicit and implicit costs, beyond just the basic accounting profit. Whether you’re assessing new business opportunities, deciding to enter or exit a market, or planning for long-term growth, economic profit provides the insights you need to make smarter, more effective choices.

At Brixx, we believe that financial forecasting tools like ours can help you track and calculate economic profit with ease, allowing you to apply this concept directly to your business strategy. By incorporating economic profit into your financial models, you can make more accurate predictions and ensure that your resources are being used in the most efficient way possible.

Start using Brixx for free to factor economic profit into your business planning and financial analysis. With the right tools, you’ll be able to make data-driven decisions that guide your business toward sustainable growth and success.