How can accounting make you profitable despite incurring economic losses?

Profit is one of the most widely watched financial metrics in evaluating the financial health of a business or investment. It is the financial gain or revenue generated from any business or investment activity in excess of any expenses, taxes, and any other costs. Simply, earnings are revenue minus expenses.

There are two types of profit, namely economic profit and accounting profit.

Economic Profit

Economic profit is a form of profit that is derived from producing goods and services while factoring in the alternative uses of a company's resources.

It deducts explicit costs from revenue and includes the opportunity costs incurred during that period of time. Implicit costs, which are typically the costs of a company's resources, are also part of the equation.

The implicit costs could be the market price a company could sell a natural resource for versus using that resource. A paper company owns a forest of trees. They cut down trees and create paper products. Their implicit costs are the timber, which they could sell for market prices.

Accounting Profit

Accounting profit is also known as a company's earned profit, net income, or bottom line. It's the profit earned after various costs and expenses are subtracted from total revenue or total sales, as stipulated by generally accepted accounting principles (GAAP). Those costs include labor costs, such as wages and salaries; any inventory needed for production, raw materials, transportation and storage costs; production costs and overhead sales and marketing costs

Key Differences

Economic profit is more of a theoretical calculation based on alternative actions that could have been taken. Accounting profit, on the other hand, calculates what actually occurred and the measurable results for the period.

Here's another way to think about it. Accounting profit is the profit after subtracting explicit costs (such as wages and rents).

Economic profit includes explicit costs as well as implicit costs (what the company gives up to pursue a certain path). Businesses can use it to determine whether to enter or stay in a particular market.

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