In business world, profits are measured by two methods. One is known as accounting profit and other is termed as economic profit.
It is the excess of business income over the business expenses. This method is mainly used to measure the amount of profit value. A business earns money after selling the goods. If the business earns more money than the money spends then it is said to be accounting profit. Accounting process doesn’t only include the money, which was spent by the business, but it also includes provision losses or depreciation that makes over an accounting period.
Hence after reducing all the spend cost from total income, if the remaining amount is positive then it is considered as accounting profit and if there remaining amount is negative then it is considered as accounting loss.
Accounting Profit = Total Income – Total Expenses is a common formula to calculate the accounting profit.
This is a slightly complicated concept. It is used to determine trade off what actually received with what could have received. Economic profit also adds the opportunity lost cost of another investment option to the cost of an investment. Hence an economic profit not only gives a profit on investment, but also gives more profit on accounting profit. This can be understood with following example.
Lets say, there is a two-investment option plan: A and B. Both the investment plans cost $500,000. Now, simultaneously track the progress of options A and B. At the end of investment option, A earns $550,000 while option B earns $520,000. The accounting profit formula will tell that by investing in option A, a person can made a tidy profit of $550,000 – $500,000 = $50,000. In case of option B, there will be an accounting profit of $520,000 – $500,000 = $20,000. A person can get $20,000 by investing in B. But the $30,000, which didn’t get is the opportunity lost cost or simply, opportunity cost of not investing in option A.
Economic Profit = Total Income – Total Expenses – Opportunity Lost Cost