Economic profit (or loss) refers to the difference between the total revenues, less costs, and the opportunity cost associated with the revenue generated. Opportunity cost is the cost of an opportunity foregone, i.e., given up in order to pursue another one.
For example, assume a company needs to make significant changes in their business model in order to survive in the market and beat the competition. After a review of their business model, the manager suggests that the company can survive if it adopts either of two feasible options: cost-cutting or the introduction of new product lines.
Management decides to go forward with cost-cutting. In such a case, the potential earnings that could be generated by introducing a new product are given up in exchange for the increased profits realized by cutting costs. Choosing not to pursue developing new product lines represents a lost opportunity. Hopefully, the company’s done a careful cost-benefit analysis and discovered that the largest potential profit increase would be derived from reducing operating costs.
Advantages of Economic Profit
1. Helps rank all opportunities
Economic profit is an excellent way to compare various opportunities for a business and to select the best and the most profitable option. It helps rank each and every opportunity in order to make an informed decision.
2. Measures success
Economic profit, along with accounting profit, is an excellent way to measure a company’s success. If all potential opportunities were carefully assessed and an informed decision was made, economic profit is an excellent way of showing how the company is doing better than it would’ve had it gone forward with any other option.
3. Measures efficiency
While accounting profit measures the profitability of a business, economic profit is an excellent way to measure the business’ efficiency, specifically its efficiency in resource allocation.
Disadvantages of Economic Profit
1. Does not account for several important financial aspects
While economic profit is an excellent way to measure a company’s success, it is not an accurate and complete measure of a company’s profitability. It does not include all important financial aspects and transactions that may occur during a given time frame.
2. Difficult to estimate
The opportunity cost of a business activity not pursued is difficult to estimate accurately. Therefore, it is difficult to accurately estimate economic profit.