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Use in economics

Economic profit vs. accounting profit

Opportunity costs are typically associated with ‘economic profit’ as opposed to 'accounting profit', which it is seldom considered. Although being quite similar, both types of profit have different principles and objectives in mind, the key difference being the opportunity cost.

Accounting profits are the ‘real costs’ (in terms of real monetary value) of businesses which are included on balance sheets, cash flow statements, and income statements but do not include implicit costs which opportunity costs take into account . The main objective of accounting profits is to give an account of a company’s fiscal performance, typically reported on in quarters and annually. As such, accounting principles focus on tangible and measurable factors associated with operating a business such as wages and rent, and thus, do not “…infer anything about relative economic profitability.” Opportunity costs are not considered in accounting profits as they have no purpose in this regard.

The purpose of calculating economic profits (and thus, opportunity costs) is to aid in better business decision-making through the inclusion of opportunity costs. However, economic profits are not used to explicitly report real monetary gain. As such, it is more aligned with cost-benefit analysis and its applications in determining business decisions and weighing potential investments (e.g. Why a firm would choose to invest in Project A over Project B).

Simplified example of comparing economic profit vs accounting profit

The calculation behind both economic and accounting profits can be distinguished in a highly simplified fashion as follows:

Opportunity cost = Explicit Cost + Implicit Cost

Economic profit = Income - Opportunity Cost

Accounting profit = Income - Explicit Costs

It is important to note that economic profit does not indicate whether or not a business decision will make money. It signifies if it is prudent to undertake a specific decision against the opportunity of undertaking a different decision. As shown in the simplified example in the image, choosing to start a business would provide $10,000 in terms of accounting profits. However, the decision to start a business would provide -$30,000 in terms of economic profits, indicating that the decision to start a business may not be prudent as the opportunity costs outweigh the profit from starting a business.

Several performance measures of economic profit have been derived to further improve business decision-making such as risk-adjusted return on capital (RAROC) and economic value added (EVA) , which directly include a quantified opportunity cost to aid businesses in risk management and optimal allocation of resources . Opportunity cost, as such, is an economic concept in economic theory which is used to maximise value through better decision-making.