Economic profit is a key calculation for businesses, as it can help determine the true profitability of a company. Unlike accounting profit, which simply accounts for revenue minus explicit costs, economic profit also considers opportunity costs. This article will guide you through the process of calculating economic profit with easy-to-follow steps.

Step 1: Identify Total Revenue

To begin, gather all sources of the company’s revenue during a specific period. This includes sales income, interests and dividends from investments, and any other potential or actual revenues.

Step 2: Calculate Explicit Costs

Explicit costs are the monetary costs associated with producing goods or services. These costs include wages, raw materials, equipment, rent, utilities, advertising expenses, and other tangible outlays. Add up all explicit costs to get the total explicit cost.

Step 3: Calculate Implicit (Opportunity) Costs

Next, identify your implicit or opportunity costs. These are the forgone benefits from using resources in their next-best alternative use. For instance, if you chose to invest in a business instead of pursuing higher education or working elsewhere. Evaluate what those alternative uses could have brought in terms of earnings or other benefits.

Step 4: Combine Explicit and Implicit Costs

Now that you’ve identified both your explicit and implicit costs, add them together to arrive at your total cost.

Step 5: Calculate Accounting Profit

Subtracting total explicit cost from total revenue will give you accounting profit. This figure reflects the financial profitability of the business but does not factor in opportunity costs.

Step 6: Calculate Economic Profit

Finally, calculate economic profit by subtracting total cost (the sum of explicit and implicit costs) from total revenue. If economic profit is positive, it suggests that the business is generating returns greater than its opportunity costs and is a wise investment. On the other hand, if economic profit is negative, it may be worth evaluating alternative uses of resources.

Conclusion:

Understanding how to calculate economic profit is crucial for making informed business decisions. By factoring in both explicit and implicit costs, you can gain a true picture of your company’s profitability and make better choices regarding resource allocation. Be sure to follow these steps when considering your next venture or analyzing current business performance.