What's The Deal Dirk?

Accounting profits are the amount of revenue over and above costs; for example, if a business made $100,000 in revenue in a year, and the total costs of running that business for the same year was $96,000, then there was a $4,000 accounting profit.  Accounting profits are regularly reported in the news and, therefore are presumably important – but they are different from economic profits.

Consider how economists determine profits. Economic profits include all the accounting costs plus the opportunity costs of conducting your business elsewhere. The $4,000 profit that the accountant reports does not consider what else your business could have done. Suppose that instead running your business that year you had cashed out and placed $100,000 in the stock market and stocks that year had returned, on average, 10%. You could have made $10,000 in the stock market. The $4,000 you made running the business doesn’t look so good. In this case, the economic profit for your business was $4,000 - $10,000, or -$6,000. By considering the opportunity cost economists are really asking a much more important question, are you satisfied with the rate of return on your investment? A business that earned $4,000 on a $100,000 would show an accounting profit but the managers of the company would not be enthusiastic about that level of profits.