Economic Profit

Economic profit equals a firm's total revenues less its total economic costs. Economic costs are the sum of cash outflows and opportunity costs. Economic profit is estimated as the product of net operating profit after taxes (NOPAT) and (1 - cost of capital).

Economic profit measures the economic value added because it is calculated by subtracting both the explicit and implicit costs from revenues. The explicit costs are the accounting costs and expenses such as cost of goods sold, general and administration expenses, taxes, etc. while the implicit costs represent the the opportunity costs, i.e. the economic profit that could be earned by employing the resources elsewhere.

Economic Profit vs Accounting Profit

There are two main differences between economic profit and accounting profit: (a) economic profit is a cash flow measure while the accounting profit is based on the accrual concept, and (b) economic profit takes into account the opportunity costs while accounting profit doesn't.

Accounting profit must be adjusted for accrued items such as deferred taxes, bad debts expense, amortization of goodwill, etc. to arrive at the economic profit. The actual adjustments depend on the accounting policies used in arriving at the accounting profit. For example, interest expense on operating leases must be added back, etc. Further, a charge for use of capital should be subtracted from accounting profit to arrive at the economic profit.

Formula

Based on the definition of economic profit, the general equation for its calculation is as follows:

$$ Economic\ Profit\ =\ Revenues\ -\ Expenses\ -\ Opportunity\ Costs $$

In practice, analysts have to work with information available in the company's financial statements. The accounting income is adjusted to arrive at the net operating profit after taxes (NOPAT) and then subtract the charge for capital.

$$ Economic\ Profit\ =\ NOPAT\ \times\ (1\ -\ Cost\ of\ Capital) $$

Alternatively, economic profit can be calculated directly from return on total capital and cost of capital:

$$ Economic\ Profit\ =\ (Return\ on\ Capital\ -\ Cost\ of\ Capital)\times Capital $$

Example

Stark Industries' accounting profit for the year ended 31 December 2012 amounted to $3,130 million. CEO Tony Stark could have earned an amount of $230 million by signing up for different movies instead of running the stark industries. Instead of developing the Iron Man outfit, the resources could have been used to develop robots for medical use. The project could have earned a profit of $1,500 million. Find Stark Industries' economic profit.

Economic profits equals total revenues minus the sum of explicit costs and implicit costs. Since explicit costs are already subtracted when arriving at the accounting profit, we can find economic profit by subtracting the implicit costs from the accounting profit.

Implicit costs in this situation are the opportunity cost of CEO Tony Stark's time which amounts to $230 million plus the economic profit of $1,500 million from the alternate use of the company assets. Total implicit costs amount to $1,730 million. Economic profit of Stark Industries is hence $1,400 million ($3,130 million minus $1,730 million).

Written by Obaidullah Jan, ACA, CFA and last modified on