Difference Between Economic Profit And Accounting Profit
The underlying difference between economic and accounting profit is in the fact that accounting income statement does not account for the concept of opportunity cost and the resultant forgone alternative.
Put differently, it does not account for implicit costs – unstated costs. The example below illustrates this fact;
Pacific Woodworks, Inc. has an inventory of a very unique wood that was purchased for $10,000 five years ago. Currently the market value of this wood is $23,000.
The production department has proposed to use this wood for making 1,000 statuettes and sell them for $20 each.
All other expenses for making one statuette is $6 per statuette not including the cost of wood.
Question: Is the proposal economically viable? Please explain your answer.
Less: Cost of goods sold 10,000
Gross profit: $10,000
Less: Explicit costs: $6,000
(Utilities, Property tax,
And other miscellaneous
Total: $6,000 6,000
Accounting profit: $4,000
Less implicit costs:
Value of wood: $23,000 23,000
Net economic profit: $-19,000
From the above Accounting and Economic profit chart, it is obvious that the proposal of the production department is not an economically viable one, since the net economic profit resulted in a loss of $19,000 after the implicit cost of $23,000 was added.
Apparently the forgone alternative to the proposal of producing 1000 statuettes and selling them $20 each, resulting in the net accounting profit of $4,000 is the option of selling the wood at its current market price of $23,000.
The profit that would have been earned with the economic profit module is $23,000 less $10,000 original cost of the wood, which is $13,000. This is an overwhelming profit relative to the net Accounting profit of $4,000.