Economic Profit vs Accounting Profit

9 Key excerpts on "Economic Profit vs Accounting Profit"

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  eBook - PDF

  A Moderate Compromise

  Economic Policy Choice in an Era of Globalization

  • S. Suranovic(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Finally, understanding and using the distinction between these two variants of profit seeking provides a heuristic mechanism, a step- ping stone, to guide policy choices in this complex globalizing world. What Do We Mean by Profit? In business accounting, profit is defined as the difference between a firm’s total revenue and the total cost of its inputs. It is the money left over after all the normal expenses of the company have been paid. Accounting profit represents the return to the owners of the firm since they have the right to retain any surplus for themselves. In a private firm, the owners may also be employees, in which case profit will be a surplus above what they pay themselves in wages. If the firm is a corpo- ration with shares of stock issued, then profit will often be distributed in the form of dividends to the shareholders. Economic profit is defined slightly differently as total revenue minus full economic cost, which, in addition to the cost of productive inputs, includes normal profit to the owners of firms for the risks they incur in running the business. In competitive markets, economic profit is The Pursuit of Profit 115 driven to zero, however because under this definition an average profit rate is allowed for, accounting profit would remain positive despite achieving “zero” economic profit. Essentially then, profit is the income received by an individual who has contributed entrepreneurial services, taken risks, and pro- vided direction and guidance for the company. Viewed as a production service that generates income, profit is similar to payments for other income-generating services in the marketplace (wages, rents, and inter- est). Economists and accountants sometimes classify income acquisi- tion into these four fundamental categories: wages, rents, interest, and profit. The sum of these four items in an entire economy is one way to measure the nation’s gross domestic product (GDP).

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  Managerial Economics

  The Analysis of Business Decisions

  • Stephen Hill(Author)
  • 2016(Publication Date)
  • Red Globe Press

    (Publisher)

  In particular, economic profit needs to be careful-ly distinguished from the concept of accounting profit. The differ-ence is largely due to a difference in purpose. It is the purpose of the accountant to present a 'true and accurate' record of the firm's activities. Given this criteria, it is inevitable that the accountant will be concerned with the precise recording of previous activities, dealing wholly in payments and receipts actually occurring. The measurement of profits for decision-making purposes is a rather different objective, involving especially the notion of opportunity cost, i.e. the conceptualisation of what might have happened but did not. 'In business problems the message of opportunity cost is that it is dangerous to confine cost knowledge to what the firm is doing. What the firm is not doing but could do is frequently the critical cost consideration which it is perilous but easy to ignore.' 2 The measurement of profit The notion of profit has developed a variety of meanings, some technical and some emotive. Defining profit as the surplus over opportunity cost is conceptually ideal from a decision-making point of view, but notoriously difficult to measure in any consistent and objective sense. It is time to take a closer look at the details of profit measurement, and to attempt to arrive at a working definition of profit that has operational value. In a sense the firm can be considered as an organisation that transforms inputs into output. Any input-output mechanism can be evaluated in terms of the ratio of the output to input. For example, Profits and objectives 45 the efficiency of a motor car can be measured in terms of the ratio of output (miles) to input (petrol). Thus a car returning 40 miles per gallon is more fuel efficient than a car which gives 30 miles per gallon. Problems arise, however, when the inputs and outputs have more than one dimension. Continuing the motor car example, inputs include oil , servicing time , tyres etc.

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  eBook - PDF

  Agricultural Production Economics in 2 Vols.

  • Kumar, K Nirmal Ravi(Authors)
  • 2021(Publication Date)
  • Daya Publishing House

    (Publisher)

  8.2. Different Types of Profits The term ‘profit’ is used in different senses and they are discussed here This ebook is exclusively for this university only. Cannot be resold/distributed. under. 1. Economic Profit and Accounting Profit Economic profit refers to the difference between TR and total expenditure. In economic sense, the total expenditure includes both explicit costs and implicit costs. Thus, Economic profit = TR – Total expenditure = TR – (Total explicit cost + Total implicit costs) But, in accounting sense, profits refer to the difference between TR and total explicit costs. So, while computing accounting profits, implicit costs are not considered. Thus, Accounting profit = TR – Total explicit costs. 2. Gross Profit and Net Profit Gross Profit The term ‘profit’ generally refer to ‘gross profit’. That means the excess of income earned by the entrepreneur over the total expenses incurred in the production programme refers to gross profit. But, this ‘gross profit’ will include several items, which are not profits in the strict sense and they are discussed here under. a. Remuneration for the Factors of Production Contributed by the Entrepreneur Himself During the course of production programme, the entrepreneur himself contributes his owned land, owned labour and owned capital. So, the implicit returns like implicit rent, implicit wages and implicit interest earned by the entrepreneur will get included in the gross profit. These implicit earnings should be deducted from the gross profits to compute net profits. b. Depreciation and Maintenance Charges During the process of production, the machinery will get depreciated and thereby, the entrepreneur has to pay repairs and maintenance charges on the depreciated machinery. So, these costs should be deducted from gross profits to arrive at net profits.

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  Customer Value, Shareholder Wealth, Community Wellbeing

  A Roadmap for Companies and Investors

  • Denis Kilroy, Marvin Schneider(Authors)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The second is economic profit, or profit less a charge for capital employed. Both include income statement (or P&L) and balance sheet components. The reason both components are required is that to be economically meaningful, financial performance metrics need to take into account the amount and the cost of the capital required in order to deliver a particular financial performance outcome. Once a board accepts that it is necessary to take full account of the capital required to deliver a particular financial performance outcome, then earnings and EPS fall by the wayside as standalone performance metrics and the question shifts to whether cash flow or economic profit is the better measure. As we have already indicated, there are a number of reasons why economic profit is the better measure. 42 2 Some Important Truths Summarising the Truths The material covered in this chapter contains 12 fundamental truths, which are summarised below. 1. True commercial success for every listed company involves succeeding in two markets – the market for its products and services and the market for shareholder capital. 2. Success in the first leads to success in the second, but this truth can only be observed through the lens provided by economic performance measures. 3. The combination of P/E ratio and EPS is not the primary determinant of share price and market capitalisation of a listed company. The P/E ratio is an outcome, not a determinant. For the same reason, the combination of P/E ratio and EPS growth is not the primary determinant of any change in share price and market capitalisation. 4. Economically meaningful performance measures must include both income statement and balance sheet components. There are only two that do this: cash flow, or profit less change in capital employed; and economic profit, or profit less charge for capital employed.

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  An Entrepreneurial Approach to Stewardship Accountability

  Corporate Residual and Global Poverty

  • Raymond W Y Kao, Kenneth R Kao;Rowland R Kao;;(Authors)
  • 2004(Publication Date)
  • WSPC

    (Publisher)

  From Cost to Profit 91 accounting such as: Operations for the period of January 1, 2005 to December 31, 2005. Therefore, the possibility of determining a firm’s profit is at the time when the business effectively terminates its operation. Our current accounting practice for profit determination would be illogical and contrary to economic reality. No wonder, in today’s accounting practice, the word “profit” has not been used in the presentation of a corporation’s Profit or Loss statement, rather it is renamed as: “Accounting Income” or “Financial Income.” Consequently, though it is still in use, the commonly used term “profit” no longer reflects economic reality, and is confined within the limitations defined by generally accepted accounting standards. 6.1.2. Profit and its varied source and identity It is seldom noticed that the meaning of “profit” has a rather varied origin. The late Professor Kierstead believed profit has no singular form. 2 We have taken the liberty to expand his version of profit into the categories in table 6.1. 3 To westerners Dr. Sun Yat-Sen (Sun Wen), the founder of the Republic of China and his work may be just as strange as finding a Bible on the sur-face of Moon. But people in Taiwan, and to a lesser extent in China still regard him as being as important as George Washington in the United States, or any other revolutionists who founded their countries and deter-mined not just the right of governing, but how to govern as well. Dr. Sun Yat-Sen left his work to people in Taiwan, and to some extent mainland China as well, in his 200 page book on how to re-build China Table 6.1. Categories of profit 1. Operating profit Residuals generated from business activities during the normal course of operations 2. Visional profit Gains from working on the entrepreneurial vision, a reward through the pursuit of opportunities beyond the normal business conduct 3. Windfall gains Gains from changes of nature, not controlled by human beings 4.

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  eBook - ePub

  The Value Sphere

  The Corporate Executives' Handbook for Creating and Retaining Shareholder Wealth

  • John Boquist, Todd Milbourn, Anjan Thakor(Authors)
  • 2009(Publication Date)
  • WSPC

    (Publisher)

  Reaching for the article he'd just put down, Jerry said, “No, I haven't changed my mind, so I'll sign it. And you're not wiggling your way out of this job quite that easily. But if we're done, I want to talk about Economic Profit.”

  “Sure,” said Bob. This was one of his favorite topics. “I know how it's defined and all that. It's laid out quite clearly in our manual,” said Jerry. “What I want is a concise summary of why a company like ours should consider using it.” Bob walked over to the white board in Jerry's office to explain. He began with an overview.

  “Jerry, I believe there are five important reasons why Economic Profit is a good performance measure to include in our Value Sphere. First, as an internal operating performance measure, it seems conceptually well aligned with the way stock market analysts look at firms for valuation purposes. Second, it is an excellent tool for strategic resource allocation. Third, it can be used effectively in capital budgeting because it never conflicts with net present value (NPV). Fourth, it lends itself nicely to value-driver analysis of components of shareholder value. Finally, it fosters an ownership mindset when tied to compensation and performance assessment. This last advantage is the most important. Economic profit is first and foremost a behavioral tool.”

  Bob then proceeded to explain each advantage in detail. A summary of his conversation with Jerry is provided in the following sections.

  2. Economic Profit and Shareholder Wealth Creation

  There are many different ways to measure shareholder wealth creation. One is total shareholder return, which measures the return earned by the shareholders in price appreciation and dividends over any chosen time period.

  The other is market value added (MVA), measured as the difference between market value and adjusted book value. This could be a measure we could define over any time period we choose.

  Let us consider the first way to measure shareholder wealth creation. To deliver to the shareholders the total return they expect based on the risk they are exposed to, internal decisions must strive to deliver consistently positive and growing economic profit. This link between capital market expectations and managerial decision making within the firm is shown in Fig. 10.1

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  eBook - PDF

  Finance for Strategic Decision-Making

  What Non-Financial Managers Need to Know

  • M. P. Narayanan, Vikram K. Nanda(Authors)
  • 2004(Publication Date)
  • Jossey-Bass

    (Publisher)

  Some of them claimed that the introduction of EP has cleaned up many of the past ineffi-ciencies in capital allocation, though there has not been enough data to evaluate the long-term effects on stock price. You want to learn about EP and compare it to the current metrics that Flurox uses. Since it already uses NPV and IRR for re-source allocation decisions, you also want to understand how EP is related to these measures to ensure consistency between resource allocation and performance evaluation. You also want to get a bet-ter understanding of the link between the performance evaluation metrics Flurox uses (EPS and ROCE) and shareholder value. Starting with a simplified concept, this chapter builds a useful definition of economic profit, shows how it is superior to earnings or return-based measures for evaluating performance, and demonstrates how it is in line with our theme of shareholder value creation. ■ An Introduction to Economic Profit As the workshop speaker warned, resource allocation method-ologies and performance evaluation metrics must be consistent with each other and with shareholder value. Therefore, to start Performance Evaluation 249 it is important to understand how EP works as a resource allo-cation tool, and its relation to other resource allocation tools such as NPV and IRR, discussed in Chapter Two. We begin with a basic concept of EP, and gradually make it more sophisticated throughout the chapter. The Basic Concept The concept of economic profit is simple. Fundamentally, it is value added. As Chapter Three points out, a company needs to maintain a minimum rate of return on capital—referred to as the Weighted Average Cost of Capital, or WACC—that would sat-isfy the capital providers (both lenders and stockholders) just to stay even. To make an economic profit (as opposed to account-ing profit), the company must earn a return greater than this cost of capital.

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  An Accounting Thesaurus

  500 years of accounting

  • Richard L. Chambers(Author)
  • 2014(Publication Date)
  • Pergamon

    (Publisher)

  He describes the conduct of this imaginary individual in an imaginary market situation. The older economists were content to discuss broad qualitative type-differences almost exclusively. The accountants have always dealt in classified individual differences of a quantitative character . . . . The economist looks upon social benefit, the accountant upon individual profit, upon that which can be acquired and appropriated by certain individuals. Canning, 1929b, 2 Economics and accounting treat of similar subject matter. Both are concerned with property and with human activities relating to . . . this property . . . . Economics 96 The Economic Background of Accounting treats of society as a whole, of wealth in general .... Accounting sets up individual units, the property of each unit . . . . Economics is general; accounting is specific. McKinsey & Noble, 1935, 9 in the past few years . . . . The economist, supported by a growing body of account-ing opinion, was contending that conventional accounting based upon historical costs failed to represent the economic profit or loss, that when costs, incurred at various price levels, were brought together as though they were homogeneous units the results were deceptive . . . . accounting must make up its mind in the near future whether it is primarily concerned with historical monetary arithmetic or with con-structive business economics, [attributed] Alban, 1949a, 3 the underlying conceptual conflict between economists and accountants concerns futurity. Economic ideas of income, assets and net worth all look to the future for their meaning, while the corresponding financial accounts are all histories of past transactions. Dean, 1951, 26 The urge to change the valuation basis . . . . appears to have been generated by a group of economists whose interest has been not in balance sheets but in the advance-ment of techniques yielding components of national income.

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  Available until 8 Dec |Learn more

  The Meaning of Company Accounts

  • Walter Reid(Author)
  • 2018(Publication Date)
  • Routledge

    (Publisher)

  Section 5 Measuring profit or loss Profit measurement 93 Accrual accounting 95 Measuring sales revenue (turnover) 103 Treatment of expenditures 105 Measuring ‘revenue investments’ 105 More complex aspects of measuring profit 107 Summary 108 Problems 109 PROFIT MEASUREMENT Estimating profit or loss for an accounting period involves two stages. Business people first ‘recognize’ the sales revenues earned in the period, then determine what expenses to set against those revenues. The difference is the profit for the period (or loss, if expenses exceed revenues). In practice there are many accounting rules (‘standards’), to help deal with the problems that can make measurement difficult. Even so, those preparing accounts often have to make judgements or estimates. As a result, for most businesses, a given period’s reported profit is bound to be subject to a wide margin of uncertainty. In looking at measurement of profit or loss, we want to get a clear idea of what the figures in company accounts mean, how they have been estimated, and what is the margin of error. We shall see that published accounts can never be entirely accurate. The larger the number of incomplete transactions, the longer their timespan, and the greater their size, the wider will be the range of possible figures for profit or loss. Many of the problems in accounting stem from the ‘chopping up’ of a business’s whole life into a series of much shorter (usually one-year) accounting periods. Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Ongoing life of business Companies are normally ‘going’ concerns. To calculate their profit requires ‘freezing’ their financial position at regular intervals in order to measure the constituent parts. But this is an artificial ‘snapshot’. We cannot expect to get ‘accurate’ valuations for half-used assets or for half-finished products at year-ends, since in most cases there is no available ‘market’ to provide them.

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