Profit - the difference between economic and

accounting costs, economic profit, economic losses,

and zero economic profit
The Difference between Economic and Accounting Costs
Accounting costs the costs most often associated with the costs of producing. These costs
include direct payments to labor and capital to produce output. Accounting costs are the costs
that appear on the income statement. Historic cost is an accounting cost measure. The historic
cost of an activity is the sum of the costs the firm actually attributes to providing that activity in a
given accounting period.
Accounting costs can be represented by the following equation:
Accounting costs = direct costs + indirect costs
Accounting costs include all explicit costs plus some of the implicit costs. For example,
depreciation expenses (which are not explicit because they are not out-of-pocket expenses) are
counted as part of the accounting costs.
Economic costs the costs of production include not only the accounting costs but also the
opportunities forgone by producing a given product. By choosing to produce one good,
producers give up the opportunity for producing some other good. Sunk cost is an economic
cost concept. Sunk costs are historic costs that are irreversibly spent and independent of the
future quantity of service supplied.
Economic costs can be represented by the following equation:
Economic costs = explicit costs + implicit costs
As you can see, the major difference between accounting and economic costs is the inclusion
of opportunity costs as a part of economic costs.
The following is an example to illustrate the difference between accounting and economic costs:
Total Revenue $1,500
Economic Costs
Explicit $600
Implicit 400
Economic Profit $500
Total Revenue $1,500
Accounting Costs
Direct $700
Indirect $100
Accounting Profit $700
As you can see, in this case the firm is earning an economic profit of $500 while from the
accounting standpoint; the firm is earning an accounting profit of $700.
Economic Profit
Economic profit the difference between the total revenue received by the firm from its sales
and the opportunity costs of all the resources used by the firm. A positive economic profit
indicates that book value is increasing which over time will yield a positive shareholder value. It
is one of the most dynamic performance measurements to account properly for all ways in
which value can be added or lost.
An example of economic profit: Say you invest $200,000 to start a business and in that year you

earn $250,000 in profits. Your accounting profits would be $50,000. However, in that year you
could have earned $30,000 had you been employed somewhere else. Therefore, your
economic profit would only be $20,000 (250,000 - 200,000 - 30,000).
Economic Losses
Economic losses doesnt necessarily mean the firm has negative accounting profits, it does
mean that the firms accounting profits are smaller than the owners opportunity
costs. Therefore, an economic loss means the firms accounting profits are not covering the
firms opportunity costs. An economic loss indicates that the capital of the organization is being
eroded, that is, operations are not profitable enough to support the cost of capital, or the
organization has too much capital for its operations.
Economic losses encourage a firm to close in the long run. The managers of a firm must look at
whether losses are greater if the firm stays open than if it closes. The losses can be greater
when the firm closes because of the possibility of having to still pay the fix costs associated with
the firm. If economic losses are less than fixed costs, then the firm is better off staying open,
and hoping that they earn a profit in the future. If economic losses are greater than its fixed
costs, then the firm is better off closing.
An example of economic losses: Say you invest $200,000 to start a business and in that year
you earn $250,000 in profits. Your accounting profits would be $50,000. However, in that year
you could have earned $60,000 had you been employed somewhere else. Therefore, you have
an economic loss of $10,000. (250,000 - 200,000 - 60,000). You have positive accounting
profits while still having an economic loss.
Zero Economic Profit
Zero economic profit is when a firm is just covering their opportunity costs, or when
opportunity costs = the average total cost of production. While zero accounting profit would be
undesirable, zero economic profit is not. Zero economic profit is a characteristic of the long run
equilibrium state in a model of pure competition or perfect competition. By including opportunity
cost, economic profit accounts for things like the value of ones time in producing a good or
service.

Multiple Choice Questions

1. Which of the following make up accounting costs?
a. All explicit and implicit costs
b. Direct costs and implicit costs
c. Direct costs and indirect costs
d. Explicit costs and indirect costs
Answer: C accounting costs are made up of the direct and indirect costs of a firm.
2. If a firm has an economic loss of ($25,000) and its fixed costs total ($20,000) what should the
firm do?
a. Stay open and hope to earn an economic profit in the future
b. Close because the economic loss is greater than fixed costs
c. Close because they have an economic loss
d. Compare to accounting profits/losses and then decided whether to stay open or close
Answer: B when the economic loss is greater then the fixed costs, the firm is better off closing.
3. Firm A has total revenue of $1000, explicit costs of $400, implicit costs of $300, direct costs
of $300, and indirect costs of $200. What is the firms economic profit?
a. $300
b. $200
c. $500

d. $400
Answer: A- economic profit is measured by total revenue (explicit costs + implicit costs). So
1000 (400 + 300) = 300.
4. How is zero economic profit measured?
a. opportunity costs = marginal cost
b. opportunity costs = accounting costs
c. economic costs = accounting costs
d. opportunity costs = average total cost
Answer: D- There is zero economic profit when opportunity costs = average total cost of
production.
5. Suppose a company has total revenue of $200, expenses of $125. This same company could
have rented out the building it currently uses for business for $100. Which of the following does
the company have?
a. Zero economic profit
b. Economic profit
c. Economic loss
Answer: C 200 total revenue 125 expenses 100 opportunity costs = (25) economic loss.