Answer to Question #8596 in Microeconomics for jesschris88

Question

Using an appropriate example, explain the differences between economic profit and accounting profit.
[4 marks]

Answer 1

Simply stated Accounting Profit equals Sales Revenue minus all costs except the
cost of equity capital, while Economic Profit is Sales Revenue munus all costs
including the opportunity cost of equity capital. Thus economic profit may be
lower than the accounting profit. If accounting profit equals the opportunity
cost of equity capital, economic profit is zero. Only when accounting profit is
greater than the opportunity cost of equity capital, economic [profit is
positive. Under perfect competition, all firms in the longrun earns zero
economic profit.
Notes:
1.Profit generally is the making of gain in
business activity for the benefit of the owners of the business. The word comes
from Latin meaning "to make progress", is defined in two different ways, one for
economics and one for accounting.
Pure economic profit is the increase in
wealth that an investor has from making an investment, taking into consideration
all costs associated with that investment including the opportunity cost of
capital. Accounting profit is the difference between price and the costs of
bringing to market whatever it is that is accounted as an enterprise (whether by
harvest, extraction, manufacture, or purchase) in terms of the component costs
of delivered goods and/or services and any operating or other expenses. A key
difficulty in measuring either definition of profit is in defining costs. Pure
economic monetary profits can be zero or negative even in competitive
equilibrium when accounted monetized costs exceed monetized price.
In
economics, a firm is said to be making a normal profit when total revenues equal
total costs. These normal profits then match the rate of return that is the
minimum rate required by equity investors to maintain their present level of
investment. Economically, the "normal profit" is thus treated as a cost, and
recognized as one of the two components of the cost of capital.
An economic
profit arises when its revenue exceeds the total (opportunity) cost of its
inputs, noting that these costs include the cost of equity capital that is met
by "normal profits." A business is said to be making an accounting profit if its
revenues exceed the accounting cost the firm "pays" for those inputs.[1]
Economics treats the normal profit as a cost, so when deducted from total
accounting profit what is left is economic profit (or economic loss).
All
enterprises can be stated in financial capital of the owners of the enterprise.
The economic profit may include an element in recognition of the risks that an
investor takes. It is often uncertain, because of incomplete information,
whether an enterprise will succeed or not. This extra risk is included in the
minimum rate of return that providers of financial capital require, and so is
treated as still a cost within economics. The size of that return is
commensurate with the riskiness associated with each type of investment, as per
the risk-return spectrum.
"Normal profits" arise in circumstances of perfect
competition when economic equilibrium is reached. At equilibrium, average cost =
marginal cost at the profit-maximizing position. Since normal profit is
economically a cost, there is no economic profit at equilibrium. In a
single-goods case, a positive economic profit happens when the firm's average
cost is less than the price of the product or service at the profit-maximizing
output. The economic profit is equal to the quantity output multiplied by the
difference between the average cost and the price.
Economic profit does not
occur in perfect competition in long run equilibrium. Once risk is accounted
for, long-lasting economic profit is thus viewed as the result of constant
cost-cutting and performance improvement ahead of industry competitors, or an
inefficiency caused by monopolies or some form of market failure.
Positive
economic profit is sometimes referred to as supernormal profit or as economic
rent.
The social profit from a firm's activities is the normal profit plus or
minus any externalities that occur in its activity. A polluting oil monopoly may
report huge profits, but by doing relatively little for the economy and damaging
the environment. It would exhibit high economic profit but low social
profit.
Accounting definitions of profit
In the accounting sense of the
term, net profit (before tax) is the sales of the firm less costs such as wages,
rent, fuel, raw materials, interest on loans and depreciation. Costs such as
depreciation, amortization, and overhead are ambiguous. Revenue may also be
ambiguous when different products are sold as a package, or "bundled." Within US
business, the preferred term for profit tends to be the more ambiguous
income.
Gross profit is profit before Selling, General and Administrative
costs (SG&A), like depreciation and interest; it is the Sales less direct
Cost of Goods (or services) Sold (COGS),
Net profit after tax is after the
deduction of either corporate tax (for a company) or income tax (for an
individual).
Operating profit is a measure of a company's earning power from
ongoing operations, equal to earnings before the deduction of interest payments
and income taxes.
To accountants, economic profit, or EP, is a single-period
metric to determine the value created by a company in one period - usually a
year. It is the net profit after tax less the equity charge, a risk-weighted
cost of capital. This is almost identical to the economist's definition of
economic profit.
There are commentators who see benefit in making adjustments
to economic profit such as eliminating the effect of amortized goodwill or
capitalizing expenditure on brand advertising to show its value over multiple
accounting periods. The underlying concept was first introduced by Schmalenbach,
but the commercial application of the concept of adjusted economic profit was by
Stern Stewart & Co. which has trade-marked their adjusted economic profit as
EVA or Economic Value Added.