Profit calculation: accounting and economic profit

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Analysis of the activity of any business entity is carried out using two approaches, which are conditionally called economic and accounting. The second is based on the analysis of costs that are included in the financial statements. For economic analysis, not only a set of real indicators of reports is used, but also opportunity costs, that is, a benefit that is recognized as lost.

Features of terminology

Accounting costs are actually payments made that are entered into the documentation. If accounting costs are deducted from the income received, then this will already be the calculation of accounting profit. Next, taxes and other mandatory payments must be deducted from it, which results in a net profit, and it serves as a reserve source of financing and is taken into account by the tax authorities.

If calculatedaccounting and economic profits, it is worth knowing that economic costs, in addition to accounting, include implicit or internal costs, that is, the opportunity cost of the resources available to the entrepreneur. These internal costs are estimated according to alternative uses.

For example, an entrepreneur can use his car for production purposes. Economists are convinced of the need to account for such costs, but the accounting department cannot do this, since there is no fact of payment from someone to someone. This is not reflected in the accounting in any way. On the part of economists, there may be an opinion that the car could be used differently, for example, the entrepreneur has the opportunity to rent it, for which he will receive rent. Therefore, economists recognize the shortfall in rent as an internal cost.

Features

So, if accounting and economic profits are considered, it is worth noting that the latter personifies the difference between income and economic costs. To reduce the difference between economic and accounting costs, it is necessary to record costs in accounting as accurately as possible, although usually this difference cannot be reduced to zero. But even when economic profit is less than accounting profit, and even tends to zero, the entrepreneur will still continue to operate, receiving accounting profit.

Historical Development

Back in the 19th century,different types of profit: accounting and economic, and then quite a strong difference between them was already obvious. It was then that Alfred Marshall developed the first indicator of economic profit. It was defined as the difference between the net income and the cost of the owner's capital, and all this was called residual income. Although the calculations seem simple, in practice it turns out that it is necessary to find a whole array of information necessary for this.

The main emphasis of Alfred Marshall was that when determining the value formed by the company at a particular point in time, it is necessary to take into account not only the costs that are reflected in the accounting records, but also the opportunity costs associated with raising capital.

For a long time, Marshal's developments were unclaimed, and the value of economic profit was not so great. However, in the 80s of the last century, with the beginning of globalization and the outflow of capital to developing countries, different types of profit began to be considered: accounting and economic. They are used to demonstrate alternative indicators of the company's performance in order to attract more and more investors.

Economic profit

It was she who acted as one of these indicators, through which new partners are attracted to the business. It assumes that the additional value of the invested capital will be created only when the amount of real income exceeds the opportunity cost of using this capital. You can simplify the definition like this:economic profit exists only if the resulting financial result actually exceeds all alternative uses of the capital in question.

How to use the technique?

So far, the formation of the company's profit is reflected only in the accounting documentation. Economic profit has not taken root in the domestic practice of calculations, and there are several reasons for this. First of all, we are talking about ignorance of how to use this concept in decision-making by management personnel. Everyone is used to analyzing accounting profit, so the activity of the enterprise is considered only through the prism of this factor. And those companies that choose to use this method face the challenge of adapting economic profits to tax and accounting standards.

Calculation standards

Currently, the calculation uses a profit formula that complies with international accounting and reporting standards, as well as American standards. They are fully compatible with each other, the same accounting and reporting principles are used for them, and on certain issues the methodology is spelled out more clearly in American standards.

The requirements of international standards are aimed at bringing the legislation of the current system of financial reporting and accounting standards into some kind of harmonious state. It is generally accepted that it is useful to use it to characterize the results of entrepreneurial activity of enterprises in morerealistic form. However, the American methodology relies on more developments, so there is a tendency in American companies to regulate operations quite clearly with less flexibility on an individual basis.

At the moment, economic profit is not reflected in the balance sheet at all, and its calculations are of a scientific or closed nature. The development of its widespread use is hampered by the standardization of financial reporting and certain conservatism in accounting.

Elements of economic profit

When using Marshall's measure of residual income, companies have problems matching the input data: the cost of capital will take into account the return received by the enterprise on the basis of market value, while net income serves as an accounting term, calculated based on book value. Naturally, the development of the world economy and market relations has become the reason for the aggravation of disagreements between the market and book value of the enterprise, which is why the use of the indicator of residual income has become simply impossible.

Types of profits

Different accounting, economic and normal profit. Typically, economic profit is the difference between total revenue and costs: external and internal. At the same time, the number of internal costs includes the normal profit, which represents the minimum payment for retaining entrepreneurial talent. The profit thatcalculated on the basis of accounting information, is the difference between income from different types of activities and external costs. Real profit is the income that remains on the entrepreneur's accounts.

Currently, accounting involves the use of five types of profit: gross, profit from sales, profit before tax, profit from ordinary activities, net profit. Gross is the difference between the proceeds from the sale of goods, works, products, services and the cost of goods, works, services, products sold. The proceeds received from the sale of goods, works, services and products are commonly referred to as income from ordinary activities. The profit formula in this case is as follows:

P (shaft)=BP - C, where BP is the proceeds received from the sale; C - cost of goods sold.

Features of each type of profit

Sales profit is gross profit minus selling and administrative expenses.

Profit before tax is the profit from sales, taking into account other expenses and income, which may be operating and non-operating. Operating income includes receipts that are associated with the provision of the organization's assets for a fee for temporary use. Fines, pen alties, forfeits for violation of contractual terms, assets received free of charge, profits of previous years identified in the reporting period are recognized as non-operating income.

Profit from ordinary activities is obtainedby subtracting mandatory payments and the amount of taxes from profit before tax.

Net income represents the profit from ordinary activities, which includes extraordinary income and expenses. Extraordinary income refers to receipts that arise as a result of extraordinary circumstances of economic activity. Exceptional expenses refer to expenses related to similar situations.

We dance from expenses

If we consider accounting, economic and normal profit, then it is worth noting that in general, profit is defined as the difference between total revenue and total costs. This is the simplest and most common calculation option that can be used at all.

Now you need to pay attention to the costs. Accounting and economic profit involves different approaches to their definition. The costs themselves can be external and internal. The first includes payments to external providers. When they are subtracted from total revenue, accounting profit can be obtained. But it will not take into account internal costs, which are usually referred to:

• costs associated with resources owned by the enterprise itself;
• normal profit, which depends on the most important resource - entrepreneurial ability.

Economic profit is obtained after internal costs are removed from accounting.

The most obvious differences

It turns out that accounting profit is intended only to take into account external costs, while economic profit is determined by subtracting internal costs as well. In sum, external and internal costs form economic, they are also called alternative. This means that in order to determine the amount of real profit, it is necessary to proceed from such a resource price that would be received by the owner with its best use. The formation of the profit of the enterprise in this case occurs regardless of the method of its calculation. But it is important to understand that the best option would be to increase economic profit.