Economic profit vs accounting profit | Microeconomics | Khan Academy
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Economic profit vs accounting profit | Microeconomics | Khan Academy

Background voice: Let’s say this past year I started a restaurant and I want to think about what type of a profit I’ve been making at that restaurant. We’re going to think about it in 2 different ways. We’re going to think about it in terms of an accounting profit, which is really the type of profit that most of us associate with a business or a firm. We’re also going to think about it in terms of economic profit, which we’ll see is a little bit different. Instead of telling us whether a business is producing income, it tells us whether it makes sense to even run the business in the way that we’re actually running it. First, let’s focus on the traditional way of calculating profit. Let’s say my firm, my restaurant, (my firm in a restaurant) in year 1 it brings in, in revenue, it brings in $500,000. Revenue literally is the amount of money the customers pay me to
eat at the restaurant. They are paying for their dinners. This is literally the money
that’s coming in the door. Sometimes people call it the top line, because it’s literally the top line of our income statement. I just wrote it. It’s the top line. Now we have to think about our expenses. Expenses. Now, when you’re running a restaurant one of the obvious expenses is going to be the cost of food. Food, we’re going to say cost us $100,000. $100,000. Then, you have the cost of labor. I have the wait staff. I have the chefs and the bus boy. On all of those people, in this past year, I spent $100,000. Then, I have, and I am going to assume that I don’t own the building, that I rent the building. So, building rent. I’m assuming this is on the building, let’s say that that was $200,000. Then finally, I really
just rented everything. I also rented the equipment, all of the stoves, the fridges, all of that stuff. None of this is stuff that I own, so the equipment rent. Equipment rent, I spent another $50,000. How much profit do I have here? Those are all of my expenses. I didn’t borrow any money, so I didn’t have any interest expense or anything like that. How much profit do I have before paying tax, or essentially my pretax profit? The reason why we think
of it in those terms is because the amount you pay in tax is usually derived from
your pretax profit. That depends on where this business is, what country, what state, what type of business it is. The easy way to calculate pretax profit, pretax profit. This is pretax and we’re thinking in terms of accounting
profit right over here. We take how much money
comes through the door and then we just have to subtract out all of the payments we
essentially have to make to other people. What we have left is out pretax profit. 500,000 minus 450,000 gives us a pretax profit (I’ll do it in that same bright yellow) of $50,000. I’m assuming that I’m the only owner of this business, so I can essentially take it all out for myself. Maybe help pay my own personal rent or whatever else, or I could take some of this or all of this and reinvest it back into the business. Maybe I start buying my equipment or I expand in some way. Who knows what I might do with that money. This is just traditional
accounting profit. This is how profit is calculated. Although, this is a super simple example. In the future I would like to do more nuanced examples in the accounting world. This, you would refer to as just accounting profit. Accounting profit. When people in the everyday world talk about profit, this is normally what
they’re talking about. Now, when economist talk about profit, they’re talking about
something slightly different. The best way to realize that is to just calculate economic profit for this exact same business, or this firm, as a
economist would call it. A firm really is a general idea for an organization that is trying to maximize profit. Once again, it’s year 1. Actually let me just copy and paste it. It’s year 1, that’s our revenue. I’m going to copy and I’m going to paste it. This right over here. So far, so good. Looks pretty similar. Now, we’re going to think about things in a slightly different way. Economist view cost in
terms of opportunity cost. As we’ll see, some of the opportunity cost you can measure in terms of dollars. Some are less explicit. I’m going to write here, just so we can get in the
economist frame of mind, opportunity cost. Within opportunity cost there are going to be explicit opportunity cost and implicit opportunity cost. First, let’s do the explicit. Explicit opportunity cost. Actually, all of these are explicit opportunity cost. Let me just copy and paste that. I will copy and paste. All of these are explicit
opportunity cost. The reason why they are explicit is I’m actually making up … I’m paying money for all of these things. Even the equipment and
the rent of the apartment, I don’t own it. I’m actually paying whoever does own it. These are direct outlays
out of the business. I’m explicitly making these payments. The reason why we can think
of them as opportunity cost, even though they’re given in dollar terms, is that if I was spending
$100,000 on food, that’s $100,000 that I couldn’t
spend on something else. If I’m spending $100,000 on labor, that’s $100,000 that I couldn’t
spend on something else. I’m just measuring the opportunity
cost in terms of dollars, but dollars that I could
have spent on other things. So far, it looks pretty much identical. I’m just viewing it with
a slightly different lens. You’re like, “Well,
what’s the big deal here?” We’re going to see a
little bit of divergence when we start thinking
about the implicit cost that really weren’t
taken into account here, the implicit opportunity cost especially. Implicit cost. If I am running this business and let’s say, in order to run it I actually had to focus on it full time. I couldn’t have actually quit my job. Then, there’s an implicit cost of … An implicit opportunity cost of the job that I gave up, or my wages foregone. Let me write this down, wages foregone. Let’s say, and this will depend
on who we’re talking about. Let’s say I was a doctor and I was making a nice steady,
risk free $150,000 a year. I was giving up $150,000 a year. Now, we’ve listed all of the explicit and the implicit opportunity cost. Now we’re ready to calculate
our economic profit. Let me draw a line over here. Our economic profit is going to be our revenue that we’re taking in, minus all of these expenses. That gives us a positive $50,000. Now, we have to subtract
the wages foregone. Then, I get to negative $150,000. This is interesting. This is kind of a big discrepancy here. In accounting terms, I’m profitable. In economic terms, I’m not profitable. The important thing to realize is economic profit, when it’s negative, isn’t saying, or you say that you have
$100,000 economic loss, or an economic profit
of negative $100,000. This isn’t saying that
the business or the firm isn’t spinning out money. What it is saying, is it probably doesn’t make
sense to run this business or at least to run this
business in this way. If this was 0, that means, hey, it’s probably making money, but you’re kind of neutral
whether it makes sense to run it this way or not. If it’s positive, that means it definitely does make sense
to run the firm in this way and that it is definitely doing better than all of the alternatives. This right over here is saying, look, you’re making $50,000 a year, that’s the 50,000 that you have to spend, if you’re the owner, or reinvest in the firm. This is saying, essentially, look, you could have
been making more money than that $150,000. Instead of making $50,000 doing this, you could have been making $100,000 more doing something else. You are essentially giving up, you are giving up $100,000
to do this restaurant. If you are a rational decision maker and you’re really are about
maximizing your profit, this actually might not
make so much sense for you.

About James Carlton

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89 thoughts on “Economic profit vs accounting profit | Microeconomics | Khan Academy

  1. Mr. Khan what Are from your point of view independent variables that explain the profitability variance? For me they Are moral, intelektuall, social, physical, and financial capital and just in sucu order!

  2. This generally works, but only in simple cases. Imagine you had 5 business opportunities which don't consume your whole time during the day, and can't be extended to a full day. You can't just add and subtract this time. Money is just a measurement of value. Value is productivity*time. Productivity is a relatively constant value, so time is what you've got to measure. Calculating the hourly profit will get you to operational research, which is what you want in complex, real life situations.

  3. So if you have a limited resource – your time, which you have to divide across different sources of income, you need to measure the accounting profit from each hour you can provide, and then go straight to this: en wikipedia org/wiki/Operations_research

  4. Another thing that has to be considered is the long affects of both of these .. in year 4 of 5 of the restaurant, the accounting profit ur making could be something like 400000, which will most likely be greater than the salary a doctor would get, so it all depends 🙂 .. good video though

  5. he forgot to add the utilities to the expense list gas bill, electricity water and so on in that case he won't make any profit , however with that pointed out this is a good generalization in basic economics

  6. @RJForce I wasn't criticizing I was just making an observation ,I know its supposed to be just an example of sorts and if you'll recall correctly I did state that it was a good one at that so don't be so hypersensitive I wasn't trying to be insulting

  7. @mnljh711986 adding to what RJForce said, utilities are an explicit cost, which generate "receipts" and are part of your accounting profit, which only cares about the receipts, no implicit costs.

  8. What you left out is that the doctor has seen so much senseless pain and human suffering and confusion as a doctor that the only thing he wants is to leave that world, that way of thinking behind and operate a bustling yet simple restaurant in the chance he might one day forget how big and horrifying the world is and the innumerable problems it poses.

    If you're making money but your suicidal, whats the point?

  9. why making things so complicated? In one job you earned $150,000 in the other job $50,000 so of course the first job was better than the second one by $100,000 why making everything so complicated?

  10. Whoa! Watch out everybody, this guy's from a Commonwealth country and knows what's up! Far be it from us to challenge him with the fact that "labor" is the proper spelling in American English!

  11. im sorry but he didnt half 5 hours to go through everything that is related to either accounting profit or economic profit

  12. Economic Profit is just a different way of thinking about it. Accounting profit is what you use to report your payments to the government, for instance. In this case it means the business is surviving! Economic takes into account the sacrifices people made for that business to run and the Accounting focuses on the business alone. Economic is a bit more personal. Maybe the guy hated being a doctor, or his business will make more money every year.

  13. Think about living a life with no worries. Nice right? Well anyone can. Look for Easy Income Monster on Google (GOOGLE IT). My partner has has been making $3,675 a week with Easy Income Monster. Seriously search for it on Google.

  14. I was confused about the economic profits of a firm. Now I get it. Thanks again. I love education videos….love them.

  15. if your implicit costs were more than one option, say for example you could have been earning 150,000 by being a doctor but you could also have been earning 100,000 by being a runway model, would the total implicit costs be the highest valued opportunity cost only? thanks for the great videos!

  16. The explanation is so simple for me to understand! Thanks so much for this eye-opener.

  17. Are you the guy who does the voice for the video Llamas with Hats? Because you sound uncanningly like Carl

  18. Thanks so much for these video. I'm not an economist and that why this Is veeeery useful for me. thanks again.

  19. Thanks for the help! Economics is very theoretical and your examples help a lot with putting them in to a reality setting.

  20. When calculating economic profits, and there are two different employment alternatives – do you calculate two different economic profits, based on the different wages foregone for each employment alternative?

  21. It is a great video. I have a question : for the implicit opportunity costs why do you use the full amount of wages foregone instead of the difference between the wages foregone and the accounting profit of 50000$. my point being that the restaurant owner could not have been a doctor and a business owner at the same time. so what he is really missing on is not 150000$ since he is making 50K with the restaurant. Isn't he missing on 100000$ instead ?

  22. If I need a kindergarten education then I'll ask that teacher … when I need a real business idea I refer to @experts … good luck with this video as it isn't #USEFUL  at all

  23. I'm a Managerial Economics student and my Professor is Dr. Gotwalt @ Purdue University…This is an awesome video and user friendly. When I started this class, I was so nervous but Dr. Gotwalt has provided us with tools such as this video link and I feel a bit at ease and comfortable with the class…Thank you for sharing…Sir….#Nice

  24. What I'm not understanding is how his revenue is 500,000 and has those list of expenses while he is working as a doctor and making 150,000/yr instead of running the restaurant. I'll rephrase that, If he is a doctor then how does he even have that list of expenses. It wouldn't even be existent. Wouldn't that be like me saying that I have an economic profit of negative 92.5 billion dollars because I didn't create microsoft?

  25. thanks for the help man I've been struggling with economic in university because it's really new to me and my current professor is a very confusing lecturer I got a midterm coming up and this clears up a lot things for me

  26. So basically, the formula for economic profit is, Revenue – explicit cost – implicit cost? Correct me if I'm wrong 🙁 I need to report this topic and I am still confused with their formulas, thank you in advance ☺️

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