Business Financials
Profitability Analysis
An Economic Profit Calculator is a powerful financial tool used by business owners and investors to determine the true profitability of a venture. While standard accounting only looks at the cash moving in and out of a business, economic profit factors in "what could have been," ensuring that your capital and time are being used in the most lucrative way possible.
How Economic Profit is Calculated
To calculate economic profit, you must subtract both your explicit costs and your implicit (opportunity) costs from your total revenue.
Accounting Profit = Total Revenue - Explicit Costs
Economic Profit = Accounting Profit - Implicit Costs
Explicit Costs are traditional out-of-pocket business expenses like payroll, rent, inventory, and utilities. Implicit Costs represent the opportunity cost of resources already owned by the firm or the entrepreneur. For example, if you quit a 100,000 dollar per year job to start a business, and invest 50,000 dollars that was previously earning 5 percent interest, your implicit costs are 102,500 dollars (your forgone salary plus the forgone interest).
How to Use This Tool
- Enter your Total Revenue generated over the specific time period (usually a year).
- Input your Explicit Costs. This is essentially your total expenses listed on a standard income statement.
- Calculate and input your Implicit Costs. Think about the wages you gave up, the interest your capital could have earned elsewhere, or the rent you could have collected on a building you own but are using for the business.
- Review your Accounting Profit (what the IRS cares about) versus your Economic Profit (what your true wealth creation looks like).
Frequently Asked Questions
Can my economic profit be negative if my accounting profit is positive?
Yes. This is a very common scenario and exactly why economic profit is so important. A business might show an accounting profit of 50,000 dollars at the end of the year. However, if the owner quit a 100,000 dollar job to run the business, the venture actually has an economic loss of -50,000 dollars. The owner would have been wealthier working their old job.
What does "Normal Profit" mean?
Normal profit occurs when your Economic Profit is exactly zero. This sounds bad, but it actually means the business is earning exactly enough to cover both its explicit expenses and its implicit opportunity costs. At zero economic profit, the business owner is perfectly compensated for their time and capital risk, meaning there is no incentive to close the business or move resources elsewhere.
Why do investors care about economic profit?
Investors use economic profit (sometimes referred to as Economic Value Added or EVA) to see if a management team is actually generating surplus value above the required return of the capital markets. If a company generates an economic profit, it is a true "Value Creator."