Economic profit
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In Economics, a firm is said to be making an economic profit when its average total cost is less than the price of the product or service at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
Economic profit differs from standard profit in that it is considered the actual profit over and above the profit which is purely attributed to the investor's money being tied up in the venture. It is accepted that any investment requires some profit to make a venture worthwhile, and economists refer to this as accounting profit which covers the opportunity costs of a venture. Economic profit then looks at the equity investors have used and the level of risk of the investment to come up with a required return. Economic profit, then, is any earnings above this required level. It is seen as beneficial as it focuses management on giving priority to projects where the return is high relative to the risk taken and capital consumed. This contrasts with accounting profit which looks at earnings with no reference to equity use or risk. Theoretically a state of perfect competition would see no economic profit, for if any exists in an industry it will attract new investors and start-ups until all economic profit disappears.
Long-lasting economic profit is thus viewed as an inefficiency caused by monopolies or some other form of market failure.
Economic profit is sometimes referred to as supernormal profit.
In accounting, economic profit, or EP, is a single-period metric to determine the value created by a company in one period - usually a year.
- EP = Net Earnings - Equity Charge
- = (ROE - COE) * Equity
where
- ROE = Return on Equity
- COE = Cost of Equity
- = Risk-free Rate + (β · Equity Risk Premium)
Economic profit versus accounting profit
- Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.
- Accountants measure the accounting profit.
- When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
- Economic profit is smaller than accounting profit.
There are commentators who see benefit in making adjustments to economic profit such as eliminating the effect of amortised goodwill or capitalising expenditure on brand advertising to show it's value over multiple accounting periods. The originators of this concept of adjusted economic profit are Stern Stewart & Co. who have trade-marked their adjusted economic profit as EVA or Economic Value Added.Template:Econ-stub