If we are thinking like a business or investor, the point of both--owning a business or investing in a business--is to make a profit.
For a business, profit equals revenues or sales minus costs.
Profit = Revenues - Costs
Now, investors and firms have to make strategic decisions all the time, such as what to produce, which technology to use, whether to hire more labor, etc.
Whatever their decision, they are sacrificing something else, which is known as an opportunity cost.
EXAMPLEFor example, suppose a firm has to make a decision about producing Product A or Product B. If they decide to focus their attention on Product A, they are sacrificing the ability to produce Product B, as well as sacrificing the potential returns that Product B could have given them.
Investors also make decisions. When investing, they are looking at which company will yield a better return.
They need to evaluate whether a potential investment is safe versus risky.
Therefore, whatever their decision, investors are also sacrificing the return that could have been made on the other option.
As investors, it is important that we consider what we are sacrificing or giving up, because these opportunity costs will help us decide whether or not we made a profitable decision.
Accounting profit is rather straightforward: total revenue minus total cost.
Total revenue--abbreviated TR--is the price of the product times the quantity sold.
Total cost is the cost per unit times the quantity.
It is important to keep in mind that with accounting profit, the cost per unit represents explicit, out-of-pocket costs--exactly what it cost to produce the product.
Let's look at an example.
She tells her accountant that she sold 15,000 meals at $10 each that first year. She figures out that her overall cost per meal--after factoring in those explicit costs such as the food, labor, overhead costs, etc.--was $8 per meal.
To calculate accounting profit, the accountant takes total revenue minus total cost:
Total Revenue Total Cost P x Q Cost per Unit x Q $10 x 15,000 $8 x 15,000 $150,000 $120,000
According to this calculation, Sue's accountant says that Sue has an accounting profit of $30,000.
However, what would an economist say?
An economist would say that something is missing, that the calculation above did not account for all of Sue's true costs.
It did not account for her opportunity costs. An economist would ask Sue what she gave up the opportunity to do in order to open her diner.
Well, it turns out that she quit her previous teaching job in which she was earning $40,000 per year.
She also had invested $100,000 of her savings to open the restaurant, and before she invested it in the restaurant, she was earning a guaranteed 5% interest on it, or $5,000.
|Sue's Total Costs|
|Opportunity Cost - Teaching||$40,000|
|Opportunity Cost - Guaranteed Interest||$5,000|
Therefore, Sue's total costs, including opportunity cost, equal $165,000, also known as her economic costs.
An economic profit, then, is total revenue minus total cost, where total cost includes implicit or opportunity costs.
So, what does her economic profit look like? Well, nothing changes on the revenue side; it's still price times quantity.
However, on her total cost side, she has to account for her explicit costs plus the opportunity cost of what she gave up--her previous job and the guaranteed interest.
|Total Revenue||Total Cost|
|P x Q||(Cost per Unit x Q) + Opportunity Costs|
|$10 x 15,000||($8 x 15,000) + ($40,000 + $5,000)|
We would actually call this an economic loss of $15,000 in her first year of operations.
As a reminder, economic profit equals total revenue minus all costs, which would also include opportunity costs.
Now, it is possible for a firm to earn zero economic profit.
You may think that this is a terrible situation, but in reality, zero economic profit simply means that you have covered all of your opportunity costs.
EXAMPLEIn Sue's example, she would have made enough opening her diner that it would have covered the salary she used to make in her teaching job and the previous interest she earned.
This would be a positive accounting profit. In this case, zero economic profit would actually just be enough to keep Sue in that business.
Therefore, accounting profit minus economic profit equals opportunity cost.
Accounting Profit - Economic Profit = Opportunity Cost
The opportunity cost here represents the return an investor or business is expecting. It is the foregone return on the next best alternative available.
If a firm earns higher returns by changing investments--earning more than zero economic profit--then we can say they have made an economic profit.
Source: Adapted from Sophia instructor Kate Eskra.