Are you a busy fool with your business?
I used to be at times.
However, I’ve discovered how to make better managerial decisions which means I’m training myself not to be. I’m so excited to share with you the secret to improving your business profitability by learning how to calculate economic profit.
When you run your own small business or organisation, you know how hard it is to make money. Sometimes you feel like you need to jump at every opportunity to make at least some money, no matter how little. But, this may not be a good use of your time.
Moreover, multiple opportunities may pop up together, or you may need to decide which project you’re going to focus on. How do you choose?
And occasionally, jobs that appear to be profitable at the outset may take so long, and involve so much of your time, that you find yourself passing up more profitable work to complete them.
Learning how to calculate economic profit can help you decide which opportunity to take up and which project to focus on. As scary as it sounds, it can also help you to measure your business performance which is so important if you want to succeed.
This is why I’m so excited to tell you all about it and to show you how to work it out!
But first, it’s important to be able to understand why economic profit is different from the accounting profit we normally use when talking about profit in a business.
So, let’s start with the more usual concept of profit, accounting profit.
When an accountant calculates the profit or loss of a business at the end of a year, they add up all the money coming into the business over that year and then take away all the money that went out.
In other words, they add up the money made from sales (revenues) and take away from this all the money we spend on buying stuff for the business (expenses, or explicit costs).
The difference between the revenues and expenses is the accounting profit. This is the figure you’ll see on financial statements put together by your accountant or when you work out the money you’ll make from selling your goods and services.
In economics jargon, Total Revenue – Explicit Costs = Accounting Profit
If you’ve money left over after taking away your costs from your sales, then you make an accounting profit. If you spend more money than you brought in, you make an accounting loss (or a negative accounting profit!)
However, economics is a way of thinking about managing scarce resources. This means it recognises your time and effort as resources and gives us a different way to view profit. And this is where economic profit differs from accounting profit.
What is economic profit?
In economics, your time is very valuable. Economic thinking takes into account the time, effort, and any other resources you put into your business or a particular project. Economics refers to these costs as implicit costs.
This is helpful because accounting profit only recognises money – money in and money out – in its explicit costs.
However, economic profit takes into account what you’ve given up to make your profit happen. For example, if a lot of your time is taken to complete a project, the implicit costs of your time are high. If you don’t spend much time on something, then the implicit costs are low.
Learning how to calculate your economic profit can give you an indication of which opportunities will be a profitable use of your time and which won’t be. Sometimes, we are offered what appears to be a lot of money at the outset of a task, but when the length of time or other resources needed are taken into account, the task may be paying you a bare minimum.
Calculating your economic profit will highlight the best opportunity open to you before you agree to anything.
So, in economics speak, Economic Profit is Total Revenues – Total Costs.
But total costs here are more than only the explicit costs (money). They include the implicit costs too.
You might now be thinking that this is all very simple in theory. But, how do you work out what the implicit costs are?
This is where the concept of opportunity cost is useful.
An opportunity cost is the cost of your choice in terms of what you’ve given up to make it.
If I’m working on my blog (definitely a labour of love and not money!) I can’t be writing a blog post for someone else at the same time. If I’m paid £30 to write a blog post and it takes me 4 hours to write, then the opportunity cost of me working on my blog instead, for those 4 hours, is £30
This is the implicit cost to me.
Other implicit costs are calculated in the same way. You work out the money you’d make if you made the other choice – the opportunity cost – or the cost of the resources needed for the other work.
How to Calculate economic profit
Once you understand the difference between explicit (money) and implicit (other resources) costs, you can calculate economic profit. This is easily done in three steps.
1. Calculate the total revenue.
This is the total amount of money you make from selling your products.
If I own a wedding dress shop, I may sell 1 dress in a week for £1200.
So, the Total Revenue = number of units sold x price per unit = 1 x £1200 = £1200.
2. Calculate the total costs of selling the dress.
This is the sum of the explicit costs and implicit costs.
i) Explicit costs: The dress cost me £750 to buy from the wholesalers.
This gives an accounting profit of £1200 – £750 = £450.
ii) Implicit costs. However, if I’d decide to sell bridesmaids dresses instead, I could probably sell 10 per week at £100 each. If each dress costs me £65 to buy, I’d make an accounting profit of £350:
Total Revenue = £100 x 10 = £1000.
Explicit costs = £65 x 10 = £650.
Accounting Profit = Total revenue – explicit costs = £1000 – £650 = £350.
So, the opportunity cost, or implicit cost, of only selling bridal gowns is £350. This is the potential profit I’m giving up by not selling bridesmaids dresses.
Therefore, the total costs of selling my one bridal gown are the explicit costs added to the implicit costs.
Total costs = explicit costs + implicit costs = £750 + £350 = £1100.
3. Calculate the economic profit.
Economic profit = total revenue – total costs = £1200 – £1100 = £100
However, if I only sell bridesmaids dresses (and not bridal gowns) and work this out the other way, the economic profit is:
Total revenue = £1,000 Total costs = £650 + £450 = £1,100
Economic profit = £1,000 – £1,100 = – £100 It’s a loss!
Selling one bridal dress as opposed to ten bridesmaids dresses over one week is the way to go for me.
This example is fairly straightforward and you may have seen instantly that selling the one bridal gown would be a better use of your time.
However, sometimes when circumstances are different, it’s not so clear. If, over a month I could sell on average 3 bridal gowns or 40 bridesmaids dresses, I’d have to sell the bridesmaids dresses to make an economic profit. However, both scenarios would show a positive accounting profit. (Try it!)
Meet Jenny – another economic profit example
Jenny works for a well-known coffee shop chain as a barista for £15,000 per year.
However, she thinks she can run a better coffee shop, so she decides to set up her own business instead.
The start-up costs for her coffee shop are £25,000. During her first year in business, she takes in £38,000 in revenues, or sales. This is far more than her £15,000 per year salary.
However, now she has business costs to pay.
So her accounting profit is:
Total revenue – explicit costs = £38,000 – £25,000 = £13,000.
But, she gave up her £15,000 per year job to make this profit. So, her economic profit is:
Total revenue – total costs = £38,000 – (£25,000 + 15,000) = – £2,000.
She makes an economic loss. And she likely works a lot more too.
Unless Jenny can earn more or reduce her costs in the next year, starting her own business was not a good move for her if her aim is to make more money in one year.
When you’re making decisions about a project or opportunity to pursue, understanding your economic profit, helps you make the best decision for you and your situation.
Advantages and Disadvantages of Economic Profit
Calculating economic profit allows you to weigh up different opportunities to choose the best and most profitable option for your business.
You can make informed decisions and can measure your choices against each other. Rather than just guessing if you should be selling 40 bridesmaids dresses or 3 bridal gowns over a month, you can work it out.
In a nutshell, learning how to calculate economic profit means you can see how efficient your business is, and can help you decide how to use your resources.
However, opportunity cost can be difficult to estimate, meaning that your calculations may not be completely accurate. It does give you a good indication though which can help sometimes when you’re not sure.
As you’ve seen, the important thing about calculating economic profit is to work out your opportunity costs – the cost of your next best alternative, or another option.
So, a really good opportunity or course of action is one where your opportunity costs are low. This means your economic profit will be greater than zero. If it’s less than zero, the option may not be worth taking.
Where your economic profit is zero, economists call this earning a normal profit. Jenny, the barista, earns a normal profit if she was paid £13,000 per year in her previous salaried job.
However, if it takes more of her time to do this, she will again make an economic loss. If this loss happens in her second year of business, she may consider whether running her coffee shop is worth her time and effort. This is because she could make better money, and more easily, working for the larger coffee shop brand.
On the other hand, if Jenny reduces her business costs, or makes more money, she’ll earn an economic profit – a ‘supernormal profit’ in economist speak. And this makes running her business worth her time and effort.
The downside, of course, is if she’s making an economic profit (or supernormal profit), others may see her doing well and open coffee shops themselves. This will make extra competition for Jenny, keeping her on her toes and working her hard to earn her supernormal profit.
If she doesn’t do this, she may find herself going out of business and working for someone else again!
Running a successful business is really hard work. You need to continually be making an economic profit for it to be worth your time and effort.
Don’t be a busy fool. I’ve made this mistake plenty of times. Knowing how to calculate economic profit is so important. It will help you to make better and more profitable decisions with your business, or even with life in general.
Did you know about economic profit? Have you used the concept before? Do you find it useful?