Economists and accountants view profits differently largely because they view costs differently. Economists and accountants apply different kinds of costs to the same production or service revenue, resulting in economic profits vs. accounting profits. The concept of economic profits is most useful in making business decisions that often consider both direct costs and indirect cost, namely opportunity costs. On the other hand, the concept of accounting profits is very beneficial in making management decisions that generally focus on direct costs only.
The Direct Costs
Direct costs are most relevant when evaluating the management of production or service operations. Direct costs, also referred to as explicit costs, include purchasing direct materials and supplies, hiring labor, obtaining administrative and marketing supports as well as making use of any other elements that are directly involved in a production or service operation. Direct costs are accounting costs that companies use to compare against sales revenue to arrive at the accounting profits.
The Indirect Costs
Indirect costs are opportunity costs, also referred to as implicit costs, that a company and its owners can actually incur even though the costs are not part of their current business activities. For example, the amount of profit a company could have made if it had invested its capital somewhere else is a cost of lost opportunity to the company. Or, the amount of money company owners could have earned, if they had worked for someone instead of starting their own business, is another implicit cost. Such implicit costs become highly relevant when making business decisions.
Accounting profits are total sales revenue minus total direct costs. Accounting profits are larger than economic profits because they do not take into account any indirect or opportunity costs. Generally, accounting profits are best suitable for evaluating the profitability of a company’s current business, independent of any potentially lost opportunities elsewhere. Thus, a company may realize accounting profits in a particular business, but it might be more profitable doing something else, which accounting profits cannot measure.
Economic profits are total sales revenue after both direct operation costs and indirect lost of opportunity costs. If a company’s total sales revenue covers just the direct costs and indirect costs, the economic profits are zero. But the company is considered to have made a normal profit in the amount of the indirect costs, which are the profit that the company could have earned doing something else. If revenue doesn’t fully cover the indirect costs, the company has incurred an economic loss. Only when revenue is greater than the sum of the direct costs and indirect costs, the company has achieved an economic, or pure, profits. Without potential economic profits, companies should not seek to pursue new business ventures.
An investment and research professional, Jay Way started writing financial articles for Web content providers in 2007. He has written for goldprice.org, shareguides.co.uk and upskilled.com.au. Way holds a Master of Business Administration in finance from Central Michigan University and a Master of Accountancy from Golden Gate University in San Francisco.