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Friday, August 10, 2012

Economic Profit vs Accounting Profit

The situation

Sofie is making $10 an hour tending bar.  After weeks of phone conversations and interviews with the other bars around town, she ekes our two job offers for herself, at two different establishments - Bar A and Bar B.

Let’s say that the two bars offering to hire Sofie are functionally identical.  Both are equally as easy for her to get to and equidistance from her house.  The crowds at the two places are always the same size, the bosses equally as pleasant and the hours are identical.

There is, just one difference – the pay.  Bar A is offering Sofie $11 an hour.  Bar B pays $12.

For whatever reason, Sofie takes the offer at A (the $11 an hour one) and passes on the $12 an hour job at B.

Here’s my question: do you think she’s making money or losing money?

We’ve hit a bit of a paradox.  Yes, she’s making $1/hour more by making the move to A.  But it’s still $1 less than what she have earned if she made different choices and gone to work for B.

By leaving a $10/hour job to work at a $11/hour one, while simultaneously passing on the option to work a $12/hour job, Sofie made a $1/hour accounting profit, and a $1/hour economic loss.

The analysis

I pulled the following definitions from the tome of all human knowledge – Wikipedia.

Accounting profit = “In accounting, profit is the difference between price and the costs of bringing to market whatever it is that is accounted as an enterprise.*

In this "accounting profit" framework, Sofie “brings to market” an “enterprise” called her labor, and sells her labor to Bar A for $11/hour. 

But that enterprise has a cost.  The “cost of bringing to market” her labor is $10 – she “paid for” the new job by sacrificing old $10/hour one.

So her accounting profit is $11 - $10 = $1 an hour!  This job change makes a $1 an hour accounting profit for Sofie!

Economic profit – “economic profit is the difference between a firm's total revenue and all costs* (the ‘all costs’ bit includes "opportunity costs"  

So in the "economic profit" framework, we say:

Sofie sells her labor to Bar A for $11/hour.  BUT in “bringing her labor to market” she incurs a cost - the opportunity to earn $12 (as opposed to "the loss of a $10/hour position," which was the cost she incurred in the ‘accounting profit’ framework).  $12 - $11 = -$1 (negative $1), aka a $1/hour loss!

An accountant would say Sofie made a dollar.  An economist would say she lost one.  Semantics, semantics, semantics…

Applying the concept

The distinction between these two types of profit matters in the real world, more often than you’d think:

“Non-profit” organizations Non-profit organizations (NPOs) maintain buildings and equipment, pay their employees competitive salaries, and often charge fees for their services.  Is there a contradiction, then, in the title “non-profit”?

NPOs earn accounting profits.  They pull in enough money to pay their staff, keep the office’s lights on and provide their services.  But they don’t make economic profit.  Meaning they should just be making enough to sustain the operation – which will require them to make more money than they spend (ie make an accounting profit) – without trying to multiply that revenue stream.

The money society sinks into NPOs could be used to invest in businesses, companies, inventions, products, commerce – activities that make more money.  So an “opportunity cost” is being paid to have NPOs (that is, society sacrifices the opportunity to grow its money by creating and maintaining NPOs).

Bail outs – Everyone’s getting a bail out now a days!  Banks, car makers, entire countries…I’m still waiting on mine, but I’m hopeful.

The media criticized a lot of the banks for “turning a profit” from these bailouts.  But of course, creating an accounting profit is exactly the point of a bailout.  Banks were in danger of failing, and out of concern that it might lead to a broader economic disaster, they were gifted their accounting profits for the year by Uncle Sam. 

They were kept afloat, however, they didn’t grow.  They would have grown more (ie multiplied their assets, ie secured economic profits) if they hadn’t have done so many silly things and imploded their own industry. 

They sacrificed the opportunity to have some real growth to chase down CDOs and MBSs and a variety of other houses of cards.  So they lost out on their economic profits but still had accounting profits thanks to Uncle Sam.


To say that a bailed out entity “made money” from being bailed out is a little like saying someone who got bit by a bus and subsequently received a check from their health insurance “made money.” 

Yeah, technically, there’s some cash coming in, so there’s an accounting profit there. 

But the guy paid much more in opportunity costs when he sacrificed all his time and energy to recovering his health – and just getting back to where he was before he got smucked. 

Just ask our hapless pedestrian in traction if he feels that bus running him down was a windfall.  And keep in mind, if banks and business truly earned economic profits from bail outs, there would be an industry failure every year in every sector.  Corporations would be falling over themselves to lose every dollar they make, every step of the way.

1 comment:

  1. Thanks for sharing your info about Economic Profit vs Accounting Profit.I really appreciate your efforts. thanks once again....