The expenses include the direct and indirect costs of running the business, such as depreciation, interest, taxes, labor wages, cost of goods sold, raw materials, sales and marketing costs, overheads, and advertisements.
Accounting profit is the profit or net income of the business reported in the financial statements.
It includes all revenues and expenses calculated using GAAP.
Accounting profit is a metric used by management to assess the current performance of the business, as well as compare its current financial position relative to competitors across the industry.
How to Calculate Accounting Profit
The calculation of accounting profit is as follows:
Net Income = Revenue – COGS – Operating Costs – Non-Operating Costs – Corporate Taxes
For example, Gordon owns a candy shop, and he analyzes his monthly financial statements. His monthly revenue is $5,000, where 500 packs of candy were sold for $10 each. In order to run the candy store, Gordon pays:
$500 in operating costs
$300 in sales and marketing
$200 in advertisements
Total of $1,000 in operating costs
The interest that must be paid is $50, and his candy machines depreciated $10 during that month. The cost of each bag of candy is $3 each.
Subtracting $5,000 – $1,500 ($3 * 500) = $3,500 would be the candy shop’s gross profit. Then, we subtract the operating costs, which is $3,500 – $1,000 = $2,500, to calculate the company’s EBITDA.
Then, we subtract the non-operating expenses, which are depreciation and interest to get Earnings before Tax of $2,440 ($2,500 – $60), and then multiply the amount by 35%, which is the corporate tax rate. Subtracting earnings before taxes by the taxed amount ($2,440 – 854 = $1,586) leaves you with the accounting profit.
Another example would be the following:
Joseph owns Silky-Smooth Corporation, which manufactures pants. The company’s annual revenues are $2,000,000. The COGS are:
Direct materials: $200,000
Manufacturing overhead: $100,000
The operating expense is $200,000, and the interest expense is $15,000. The depreciation cost of Silky-Smooth’s property, plant, and equipment is $10,000. The corporate tax incurred is $25,000.
In total, the accounting profit is $2,000,000 – $350,000 – $200,000 – $15,000 – $10,000 – $25,000 = $1,400,000.
Accounting Profit vs. Economic Profit
Although the two types of profit both consider explicit costs when generating their bottom line, economic profit includes opportunity costs – the potential benefits foregone when an option is not chosen.
For example, Gordon could have purchased a new candy machine for $1,000, which would’ve generated a forecasted value of $1,500 in revenues in the future. However, he did not take the deal due to the uncertainty of the current market conditions.
Aware of the fact, he would’ve subtracted $500 from his pre-tax income, as the opportunity cost of not purchasing the machine is foregoing $500 in future revenues.
To calculate economic profits, one must account for the alternative actions that could’ve taken place when making a decision. On the other hand, accounting profits do not consider opportunity costs but is instead calculated based on measurable book values. Thus, economic profits are often used to best assist management with decision-making.
Accounting Profit vs. Underlying Profit
Unlike accounting profit, underlying profit can be subjective and is based on one’s own opinion about what the true earnings should be for a company. Particularly, underlying profit may be calculated by eliminating unusual one-time charges, due to their infrequency.
Thus, underlying profit eliminates irregular or uncommon events that may affect earnings, such as natural disasters. Such a methodology generally included only every day, consistent costs that the business would incur when running operations. On the other hand, accounting profit considers all values recorded in the financial statements regardless of their frequency or normalcy.
Accounting Profit vs. Taxable Profit
Taxable profit is the value used for tax declaration after adjusting accounting profit. To calculate the value, the company needs to alter accounting profits that are allowed under accounting standards and tax law.
The composition of taxable profits varies by regional tax authorities. Therefore, when making adjustments, the company needs to identify which income items can and cannot be recognized under that area’s tax law. It also applies to expenses.
Taxable profit includes the following:
Capital gains on the sale of long-term assets
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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