Economic profit consists of revenue minus implicit (opportunity) and explicit (monetary) costs; accounting profit consists of revenue minus explicit costs.
The term “profit” may bring images of money to mind, but to economists, profit encompasses more than just cash. In general, profit is the difference between costs and revenue, but there is a difference between accounting profit and economic profit. The biggest difference between accounting and economic profit is that economic profit reflects explicit and implicit costs, while accounting profit considers only explicit costs.
Explicit and Implicit Costs
Explicit costs are costs that involve direct monetary payment. Wages paid to workers, rent paid to a landowner, and material costs paid to a supplier are all examples of explicit costs.
In contrast, implicit costs are the opportunity costs of factors of production that a producer already owns. The implicit cost is what the firm must give up in order to use its resources; in other words, an implicit cost is any cost that results from using an asset instead of renting, selling, or lending it. For example, a paper production firm may own a grove of trees. The implicit cost of that natural resource is the potential market price the firm could receive if it sold it as lumber instead of using it for paper production.
Accounting profit is the difference between total monetary revenue and total monetary costs, and is computed by using generally accepted accounting principles (GAAP). Put another way, accounting profit is the same as bookkeeping costs and consists of credits and debits on a firm’s balance sheet. These consist of the explicit costs a firm has to maintain production (for example, wages, rent, and material costs). The monetary revenue is what a firm receives after selling its product in the market.
Accounting profit is also limited in its time scope; generally, accounting profit only considers the costs and revenue of a single period of time, such as a fiscal quarter or year.
Economic profit is the difference between total monetary revenue and total costs, but total costs include both explicit and implicit costs. Economic profit includes the opportunity costs associated with production and is therefore lower than accounting profit. Economic profit also accounts for a longer span of time than accounting profit. Economists often consider long-term economic profit to decide if a firm should enter or exit a market.