Definition of Accounting Profit (Gross Profit):
The term Profit equals total revenue – explicit costs.
This is the profit used by accountants to determine a firm’s taxable income. Explicit costs are the actual cash payments for resources purchased in resource markets. These are the rent paid on land and plant and equipment, wages to labor, interest on capital, cost of raw material, transport charges etc. When all these explicit costs are subtracted from the firm’s total revenue, we get accounting profit.
There is no satisfactory definition of the term profit. Generally, profit of a firm is defined as:
“The access of revenue over its current costs”.
The word cost carries different meanings with economists and accountants.
Formula for Accounting Profit:
Accounting Profit = Total Revenue – Explicit Costs
Example of Accounting Profit:
Accounting profit is explained by taking a simple example. Let us suppose, the total revenue of a firm from the sale of goods in 2021 is $90000. Its costs on the purchase of raw material, payment of wages and other utilities i.e., explicit costs are $35000. The firms accounting profit will be $55000.
Total sales revenue…………. $90000
Cost of raw material = $15000
Wages to labor and other utilities = $20000
Accounting profit = $90000 – ($15000 + $20000) = $55000
(Total Revenue – Explicit Cost)
When depreciation charges of capital equipment used by the firm and the amount of money paid to the government as taxes is deducted from gross profit or accounting profit, we get net profit of accountants.
Definition of Economic Profit (Pure Profit):
Economic profit is different from accounting profit. Accounting profit ignores the opportunity cost of the firm’s own resources used in the production of goods. The economist include these costs named as implicit costs while determining the total cost of production.
“If a firm’s total revenue exceeds all its economic costs both explicit and Implicit, the residual which goes to the entrepreneur is called an economic or pure profit”.
Thus economic profit equals total revenue less all costs both explicit and implicit.
A firm’s implicit costs are the opportunity costs of using its self owned, self employed resources. Implicit cost include use of firm’s own building, use of its own capital, and the business owners time given for the production of goods. While determining the total costs, the money payments which these self employed resources could have earned in their best alternative uses should be worked at and added in cost. The implicit costs are in a way opportunity costs. Economic profit takes into account the opportunity costs of all resources used in production. Implicit costs also include normal profit earned by a firm.
Normal profit is the minimum amount required to keep on entrepreneur engaged in the present line of production.
Formula for Economic Profit:
Economic Profit = Total revenue – (Explicit Cost + Implicit Cost)
Example of Economic Profit:
Suppose a person uses, his own resources, land, capital, his own time in the production of goods. The opportunity costs of these resources is included below in finding out economic profit of the firm.
Accounting Profit = $55000
Entrepreneur’s own forgone salary = $40000
Foregone interest on capital = $1000
Foregone rent = $2000
Economic Profit = $12000
(a) Accounting profit is the firm’s total revenue less its explicit costs (b) Economic profit to the economist is the total revenue of a firm less explicit and implicit cost.
Implicit cost includes normal profit to attract and retain an entrepreneur engaged in the present line of production.