Profit is usually perceived as earnings and measured by subtracting costs from revenues. However, there are different types of costs: explicit and implicit. Explicit costs can be directly measured and expressed in monetary terms, for example, wages, rent, and utility costs (Orsag & Džidić, 2018). Implicit costs refer to the opportunity costs, that is, the cost of choosing one way to utilize the firm’s resources over another (Greenlaw & Shapiro, 2018). Based on what costs are subtracted from revenues, economists distinguish between accounting and economic profit. Accounting profit is measured by subtracting explicit costs from the revenues, while economic profit is the difference between the firm’s total revenues and both explicit and implicit costs. Thus, one way to measure economic profit is to calculate explicit and implicit costs and subtract them from the revenue.
Overall, economic profit is a concept that determines whether the business is economically successful. It serves as an important instrument for investors to assess how effectively the company uses its assets and contributes to a long-term increase in shareholders’ wealth (Dudin et al., 2018). Therefore, another way to measure a company’s economic profit is by calculating the economic value added (EVA). To determine EVA, one should multiply capital invested by the weighted average cost of capital and subtract this product from the net operating profit after tax (Onica, 2019). All the elements necessary for calculating EVA can be retrieved from the information that is usually available in companies’ financial statements. This indicator not only shows the company’s true financial performance in terms of increasing shareholders’ wealth but also allows for comparing different companies and helps shareholders decide which firms to invest in.
To sum up, economic profit reveals the company’s performance by indicating how effectively it uses the resources at its disposal. One way to measure economic profit is to subtract implicit and explicit costs from revenues. Another method is to calculate the EVA indicator that shows the company’s true financial performance and the possibility to increase shareholders’ wealth. Both ways help investors and entrepreneurs to understand how economically successful a certain enterprise is.
References
Dudin, M. N., Lyasnikov, N. V., Reshetov, K. Y., Smirnova, O. O., & Vysotskaya, N. V. (2018). Economic profit as indicator of food retailing enterprises’ performance. European Research Studies Journal, 21(1), 468-479.
Greenlaw, S. A., & Shapiro, D. (2018). Principles of economics 2e. OpenStax.
Onica, C. M. (2019). Economic value added (EVA) as an indicator for financial decisions. Annals of the University Dunarea de Jos of Galati: Fascicle: I, Economics & Applied Informatics, 25(3), 1-8.
Orsag, S., & Džidić, A. (2018). Value added as a measure of economic profit. Acta Economica, 16(29), 9-37.