How much money did your business make this year? And how much could you have made if you had gotten that equipment financing? To evaluate your profit numbers most beneficially, you will need to understand the various types of profit that measure success.
Knowing the differences when bookkeeping will allow you to determine your company’s actual profit, find possible ways you can increase profit, and make educated business decisions. In this article, we will introduce you to two forms of profit, profit calculations, and explain the differences between accounting vs economic profit.
What is Accounting Profit?
Being a business owner, you’ll want to know the accounting profit of your business, also known as your earned profit or bottom line. Your accounting profit means how much net income your company makes. It can be used to measure the financial health of your company.
Accounting profit is found at the bottom of your income statement. According to generally accepted accounting principles (GAAP), accounting profit is calculated by subtracting total expenses from your company’s total revenue.
Finding total revenue and total expenses
Not sure what makes up your total revenue and total expenses? Here are the typical things that will go into both of these categories. You must keep accurate records of these to establish the true profit of your company.Total revenue is made up of things like:
- Total sales of goods and services
- Rental income
To calculate your accounting profit expenses, you will need to focus on the explicit costs of your company. Explicit costs are tangible expenses that appear in a company’s general ledger that were made as a direct payment to others in the course of running a business.
Total expenses are made of things like:
- Cost of goods sold (COGS), which includes expenses like the cost of raw materials and parts, production costs, direct labor costs, supplies used, overhead costs, shipping or freight costs
- Marketing expenses
- Labor (wages and salaries)
- Employee benefits
- Business travel
- Transportation/storage costs
- Sales commissions
- Any other operating expenses
What is accounting profit used for?
Of all the numbers found on your balance sheet, accounting profit may be one of the most important. There are several uses for it:
- To check performance: Accounting profit is calculated quarterly or annually on your income statement. You can use the figure to help you assess the financial performance of your company. This allows those in charge to see how well the company is doing compared to other years. If it is greater than in previous years, it indicates the company is doing better. On the other hand, if the accounting profit is lower than in previous years, it may mean there is some trouble earning revenues or expenses are too high. Company decision-makers can then use this information to update the business strategy.
- To check competition: If you are in an industry that is saturated with competition, it might be helpful to compare your accounting profit with those of competing companies. This may give you some insight as to where your company is succeeding/failing and how you stack up against other companies financially. You can then make the necessary adjustments to promote more successful strategies.
- To report to the IRS: Accounting profit is reported to the Internal Revenue Service (IRS). This helps the IRS determine how much tax liability you owe them. According to the IRS, you must use a consistent accounting method when reporting your income and expenses to them. Most taxpayers use either a cash method or an accrual accounting method. Keep this in mind when doing the books for your business. If you are unable to keep a consistent accounting method, be sure to hire a professional accountant to do the work for you.
Accounting profit example
We will use an example to help get you familiar with calculating your accounting profit. Let’s say you own a hair salon. First, you’ll want to calculate your explicit costs for the year:
- Costs of goods sold: $100,000
- Employee costs: $80,000
- Selling and administrative expenses: $15,000
- Depreciation: $5,000
- Interest: $2,500
- Taxes: $12,500
- Total costs: $215,000
Your revenue for the same year totaled: $250,000. To calculate your accounting profit or net income, you’d use the equation:
Total revenue – Total costs = Accounting Profit
Therefore, $250,000 – $215,000 = $35,000
The accounting profit for the year was $35,000. Now, if you wanted to change the amount of money we’ve calculated to include opportunity costs, added expenses, one-time payments, or simply focus on cash flow, you might want to examine other forms of profit instead.
What accounting profit is not used for
Some business owners may confuse accounting profit with several other forms of profit, including pro forma income and cash flow. Instead of focusing on accounting profit, many companies prefer to instead pay attention to underlying profit, or pro forma income.
This underlying profit refers to accounting profit that has added expenses or subtracted one-time payments. These companies, like Warren Buffett’s Berkshire Hathaway, believe that accounting profit understates what the business’ true income actually is.
For example, a quickly growing company might include growth-oriented costs such as stock compensation expenses. Or an insurance company may add back catastrophic losses. While this may be a more accurate representation of the company’s financial position, it can easily be abused.
A company that is constantly reporting large differences in profits from year to year should be considered suspect, as pro forma earnings are not reviewed, and there is no regulatory guidance or standard definitions. Accounting profit is also not the same as cash flow.
Some investors will include cash flow numbers when valuing a business. This is because they show how a business is actually doing day-to-day since cash is a good indicator of what the company’s financial position actually is. The accounting profit itself can be manipulated by companies to a point, which leads investors to look for more obvious signs of financial stability.
Accounting profit is typically confused with economic profit. Let’s explore economic profit next so we can identify the differences between the two.
What is Economic Profit?
Economic profit is a type of profit that considers the implicit costs from all inputs in addition to the explicit costs. Implicit costs are the alternative costs of a company’s resources, including total opportunity costs. Opportunity cost represents what assets invested in the business could have earned in a different investment.
If the opportunity cost is more than the accounting profit, this indicates that the invested money could have been put to better use. These costs represent what you could have sold a product or service for. Therefore, economic profit is founded on assumptions and estimates, rather than concrete numbers.
What is economic profit used for?
Financial analysts use the economic profit for several reasons including:
- Project budgeting: Economic profit can be used for project budgeting to help you forecast expected costs. This enables you to find the best path for your company to take based on economic expectations.
- Assess the market position: Having a rough estimate of other market positions you can take in the current market will help you assess whether or not you are in the optimal position. Knowing these things will help you decide whether to stay in your current position or take a better opportunity that will grow your company.
- Update business strategy: When you know the best alternative market position your company can take, you can start to plan your strategy to get you to that new position.
- Maximize revenue: Economic profit allows you to make informed business decisions for asset and budget allocation. In the long run, this helps you maximize your revenue.
Finding your economic profit
When calculating economic profit, we ignore net income and instead consider the actual amount of cash made by the company or free cash flow. This is found through accrual accounting principles. Once the free cash flow is determined, we use theoretical principles rather than GAAP to find the opportunity costs of comparable alternatives.
You will want to know the total revenue of your company, as well as the total explicit and implicit costs. To calculate economic profit, you’ll want to use the economic profit formula:
Economic Profit = Total Revenue – (Total Explicit Costs + Total Implicit Costs)
So let’s look at an example.
Economic profit example
Let’s say you’ve just given up your job to start up a new beauty salon. You would have made $60,000 if you had kept working at your job. But in your first year of opening your new hair salon, your company made a total revenue of $500,000.
- The explicit costs were:
- Raw material: $285,000
- Rental: $30,000
- Labor cost: $100,000
- Advertising: $20,000
Total explicit costs were: $435,000
The implicit costs would be the salary that she gave up from her old job, which was $60,000. To find the economic profit, we will plug our values into the formula given above.
$500,000-($435,000 + $60,000) = $5,000
$5,000 is positive economic profit, meaning the decision was a good one. However, if it had been a negative economic profit or there is an economic loss, you may have made the wrong decision for that year if your goal was to make more money. And when the total costs are equal to the total revenues, this is known as zero economic profit.
Accounting Profit vs Economic Profit
Now that you have an idea of what both accounting and economic profits are, let’s delve into the key differences between these two metrics.
Type of costs
Accounting profit is determined only using explicit costs. These are actual costs of the business that were paid directly to others, such as costs of goods sold, wages, and rent. In contrast, economic profit uses both explicit and implicit costs of the company. This includes the opportunity costs of if you would do something, rather than what you actually did. Economic profit is accounting profit minus opportunity cost.
Companies use accounting profit to figure out how much profit the business actually made in a specified period. It is calculated by taking a look at what actually happened and examining the measurable results that took place. The Securities and Exchange Commission (SEC) requires that companies report their accounting profit.
This figure will be printed on the financial statements you receive from your accountant. Your accounting profit is then plugged into any IRS tax information collected for the company and helps them assess how much taxes will be collected from you in that year.
Economic profit is limited to the use of internal company projections, and not used for any official IRS liability. It is used solely as a way to determine opportunity costs in various theoretical scenarios and alternative actions. It will help your business make decisions on how to invest and allocate its resources to increase the total profitability and know when to enter or exit a market.
You could say that it represents the efficiency of the company, while accounting profit represents the actual profitability.
Accounting profits are determined using GAAP, looking at your actual revenue and explicit costs. Economic profits are determined separately without your accounting books or software. This is because you cannot bookkeep implicit costs since no actual transactions were made.
Measuring Profitability vs Efficiency
You now know when to utilize accounting vs economic profit. Accounting profit is found on your balance sheet while economic profit is found in your projections. Accounting profit includes explicit costs while economic profit includes explicit and implicit costs (the opportunity costs).
Use your accounting profit when you want to look at the profitability of your company in that year. But what if you want to figure out if you have made good business decisions, or want to explore other possible business pathways? Then you’ll want to figure out your economic profit to increase the efficiency of your business.
Next, determine your net working capital to find out your company’s liquidity and ability to handle financial obligations.If You Like Please Share It: