When a company needs to make significant changes to its business model to survive in the market and beat the competition, After multiple reviews, the managers suggest possible options for cost-cutting or the introduction of new product lines. Some strategies and decision-making processes in this setting can be aided by the functions of economic profit and opportunity cost.
Economic profit is an excellent way to compare various opportunities for a business and to select the best and most profitable option. It helps rank every opportunity to choose the best among the other alternatives listed. The opportunity cost is the current loss of potential gain as a result of choosing the current alternative over others.
Analyzing these functions beforehand can help in reducing risks in investments, making it easier for decision-making processes and increasing the probability of success.
Economic Profit Vs. Opportunity Cost
Economic profit is obtained by reducing explicit opportunity costs from the total revenue. Economic profit may be only used for internal analysis within the firm and does not often involve transparent disclosure.
Opportunity costs are the profits that are already lost when you choose a single choice among other alternatives.
Difference Between Economic Profit and Opportunity Cost in Tabular Form
Main parameters of comparison
An economic profit is the difference between the total revenue obtained and the opportunity costs of its inputs. The primary distinction between an accounting profit and an economic profit is that an economic profit accounts for both a firm's implicit and explicit costs.
The cost of a potential opportunity that was lost due to choosing the current alternative over others is referred to as opportunity cost.
Economic profit = Income - Opportunity Cost
Opportunity cost = Explicit Cost + Implicit Cost
1. Assists in ranking all opportunities and determining success.
2. Evaluates efficiency
Opportunity cost is one of the key issues prevalent throughout various decision-making processes.
Does not take financial considerations into account
Difficult to estimate
Difficult to estimate
What is Economic Profit?
An economic profit is a difference between the total revenue obtained and the opportunity cost of its inputs. The main difference between an accounting profit and an economic profit is that an economic profit accounts for both implicit and explicit costs of a firm, whereas an accounting profit considers only explicit costs of a firm. This is what usually appears on the financial statement generated by a firm. Hence, economic profit also covers implicit costs, which makes it easily distinguished from an accounting profit that includes additional implicit costs. The economic profit usually differs from the accounting profit.
What is the relation between economic profit and normal profit?
As both economic profit and opportunity costs cover a firm's implicit costs, economists may often view economic profits as normal profits. A normal profit covers the costs required for the firm, both the implicit and explicit costs. In the absence of such profits, parties frequently withdraw their funds to shift their funds to a better alternative advantage.
On the other hand, economic profit considers the added profit, which is the profit that remains even after both the implicit and explicit costs are covered.
Where can economic profits occur?
- New firms entering the market consider lowering the price of the product to an amount equal to the average cost of production. This is when perfect competition comes into play, and economic profits no longer exist.
- However, economic profit can also occur in competitive markets, but only in the short run. Once risks are calculated, long-lasting economic profit occurs as a result of constant cost-cutting and improved performance ahead of other industry competitors.
- Economic profits usually arise in markets that include monopolies and oligopolies which are usually non-competitive but with significant barriers to entering the market.
To accountants, economic profit, or EP, is a metric used to determine the value created by a firm. Typically, this value is calculated over a year. It is the surplus earnings after tax less the equity charge. This definition is almost similar to the economist’s definition of economic profit. The adjusted economic profit is also referred to as the Economic Value Added (EVA). Optimum profit, on the other hand, is a theoretical measure of the exact profit a business can achieve. This figure is usually obtained after taking into account a variety of factors, such as marketing strategy, market position, and existing competition. Accounting profits also include economic profits, called "economic rents."
What is an Opportunity Cost?
An opportunity cost is the calculated potential gain lost while choosing one alternative among the others. The difference between the returns on a potentially better alternative and the revenue of the currently chosen alternative is defined as opportunity cost. It underlines the effect on benefits caused by the economic decisions that are made in society daily. This term was first coined by John Stuart Mill.
Opportunity costs may be explained as the result of the time we give up on work. In opportunity cost, both leisure and income are valued at the same time. It can be termed as the profit of forgone alternatives over the currently chosen opportunity. Opportunity costs are closely related to "economic profit."
While accounting profits account for the total costs of a business, they do not include the implicit costs of a business, which is exactly what occurs in an opportunity cost. Accounting profit is the one that usually appears on balance sheets and financial statements but does not include the possible implicit costs. The main objective of accounting profits is to give an account of a company’s external performance, typically reported by annual audits. Opportunity costs are not considered in accounting profits as they have no purpose in this regard.
The utility received is always expected to be larger in opportunity cost. The utility is defined as the amount of satisfaction you can get from consuming different goods and products. When the utility has to be greater than the opportunity cost, it is considered the perfect choice by economists. Through the analysis of opportunity costs, a company can formulate strategies by which they can increase the rates of benefits over the opportunity cost so that maximum efficiency is ensured.
The two types of opportunity costs defined in economics are:
- Explicit costs
- Implicit costs
Explicit costs include the real business operating costs or expenses. In other words, explicit opportunity costs are the external costs of a firm. These particular costs are usually identified on a firm's income statement and balance sheet, which represent all the cash outflows of a firm.
Examples of explicit costs that can be listed are:
- Property and infrastructure costs
- Working and maintenance costs
This usually includes the expenses or cash outflow to supply wages for the employees, rent, overhead, and primary supply materials.
Some examples of actions that can result in explicit costs are given below:
- When an employee leaves work early, the explicit costs for the individual for basic facilities are wasted till the end of working hours. This causes an additional loss or explicit cost.
- When one of the printers stops working in the office section, the explicit cost for the company is equal to the money that might be paid to the repair technician to repair it.
Implicit costs refer to the costs that result from utilizing firm resources that could be used for other beneficial purposes. Often, these costs are not identified, defined, or reported like the explicit costs of a firm. As implicit costs are the result of assets, they are also not recorded for accounting purposes because they do not represent any monetary losses or gains. In terms of factors of production, implicit opportunity costs allow for the depreciation of goods, materials, and equipment that ensure the operations of a company.
Some examples of implicit costs that include sections of production that utilize firm resources are given below:
- Work labor
What are the sunk costs?
These are costs that are excluded from opportunity costs. Sunk costs may also be denoted as historical costs as they consider the already incurred costs. These costs cannot usually be recovered. They remain unchanged and do not influence any present or future actions or decisions regarding benefits and costs.
Main Difference Between Economic Profit and Opportunity Cost in Points
It helps rank all opportunities and measure success.
Economic profit enables comparing all possibilities of opportunities individually and ranking them for a business and selecting the best and most profitable option. It helps rank each opportunity to make an informed decision.
It ensures that the current alternative is more efficient than the others and allows us to decide whether to reallocate resources or stick with the same plan.
Economic profit and opportunity cost disadvantages
Does not take financial considerations into account
Difficult to estimate: The opportunity cost is difficult to estimate accurately, which makes it difficult to accurately estimate economic profit.
The difference in the calculation of both functions
The calculation difference between economic and opportunity cost profits is as follows:
Explicit Cost + Implicit Cost = Opportunity Cost
Income minus opportunity cost equals economic profit.
Role in the decision-making processes of a firm
It is important to note that economic profit does not indicate much about which decisions make more profit, unlike that of opportunity costs.
On the other hand, opportunity cost is one of the key factors prevalent throughout various decision-making processes. The cost of a potential opportunity that was lost due to choosing the current alternative over others is referred to as opportunity cost.
Profit is defined as the difference between the total revenue and total costs a firm incurs. It is said to have a maximum profit when business strategy plans work out at extremes. The main focus of economic profit is maximizing production without significantly increasing its marginal cost per good. Another significant factor for profit maximization is market fractionation.
Market fractionation is defined as operating separate outlets with individual strategies and separate client targets, with supply matching the particular demand of the client in that region only. In this way, treating each location as a separate market maximizes the profits earned. Rather than matching supply and demand for the entire company, the matching is done within each market.
The main goal of calculating economic profits is to help firms with better business decision-making processes. In this way, a business evaluates whether a decision and the allocation of its resources for it are efficient or not, or whether to change the existing strategies and work-out plans for a better advantage.
It typically aids in cost-benefit analysis, determining business decisions, and weighing the potential risk benefits of a made investment.
Some examples of its applications could be
- Why should a firm invest in Project A over Project B?
- Why is this particular decision preferable to the other option's cost?
When a company needs to make significant changes to its business model to survive in the market and beat the competition, After multiple reviews, the managers suggest possible options for cost-cutting or the introduction of new product lines. Management decides to go forward with cost-cutting. In such a case, the potential earnings that could be generated by introducing a new product are given up in exchange for the increased profits realized by cutting costs. A decision not to pursue developing new product lines represents a lost opportunity. Hopefully, the company has done a careful cost-benefit analysis and discovered that the largest potential profit increase would be derived from reducing operating costs.
Economic profit and opportunity cost are two such functions that aid a company in its business strategies and work-up. Analyzing these functions beforehand can help in reducing risks in investments, making it easier for decision-making processes and increasing the probability of success.