What Is Accounting Profit?
Accounting profit is a company’s net profits as determined by GAAP. Explicit costs can be directly attributed to running a firm and include operational costs, depreciation, interest, and taxes.
How Accounting Profit Works
The company’s profit margin is a popular financial indicator to assess its health.
Companies’ financial filings often include many variants of the profit figure. Some of these totals include all line items from the income statement, including revenues and expenditures. Some are just management and its accountants coming up with fanciful explanations.
After deducting all dollar expenditures from total revenue, the remaining amount is the accounting profit, also known as bookkeeping or financial profit. A company’s net profit is the amount of money remaining after all operating expenses have been paid.
The costs that need to be considered include the following:
- Labor, such as wages
- Inventory needed for production
- Raw materials
- Transportation costs
- Sales and marketing costs
- Production costs and overhead
Accounting Profit vs. Economic Profit
Economic profit, like accounting profit, is calculated by subtracting direct expenses from income. The key distinction is that economic profit also considers implicit costs, such as the opportunity costs, when allocating resources.
Examples of implicit costs include:
- Company-owned buildings
- Plant and equipment
- Self-employment resources
If an entrepreneur spends $100,000 to start a company and generates $120,000 in revenue, the entrepreneur’s “accounting profit” is $20,000. However, the opportunity cost of $50,000 (what they would have made had they retained their day job) would reduce their economic profit. Therefore, the company would incur a $30,000 economic loss ($120,000 minus $100,000 minus $50,000).
While accounting profit considers what happened and can be quantified, economic profit is a theoretical estimate based on what might have been done. Among these applications is the reporting of taxable income. However, economic profit is primarily computed to aid management in choosing.
Accounting Profit vs. Underlying Profit
Businesses often use their subjective assessment of profit to enhance accounting profit. Underlying profit is an example of such a thing. This standard, widely applied measure often eliminates unusual expenses or events and is routinely highlighted by management as an important indicator for investors.
The underlying profit aims to shield profits from calamitous occurrences like natural disasters. Restructuring charges and the purchase and sale of real estate are two examples of unusual losses and profits that are often disregarded since they are not considered representative of the typical expenses of a company.
Example of Accounting Profit
A manufacturing firm, Company A, sells its widgets for $5 each. It sold 2,000 widgets in January, bringing in $10,000 for the month. This is the first line item in the company’s income statement.
Gross revenue is calculated by totaling sales and then deducting the cost of goods sold (COGS). If it costs $1 to make a widget, then a corporation would have $2,000 in cost of goods sold (COGS) and $10,000 in revenue before taxes and other expenses.
All operating expenses must be reduced from total revenue to determine operational profit or profits before interest, taxes, depreciation, and amortization (EBITDA). If the business only had to pay $5,000 monthly in salaries and benefits, the operating profit would be $3,000 ($8,000 minus $5,000).
After computing operational profit, a business must account for any costs that aren’t directly related to making a profit. In this scenario, the business has no debt but loses $1,000 every month due to the depreciation of its assets, which are written off in a straight line. The tax rate for corporations is 35%.
Before taxes, the business has earned $1,000, or ($2,000 – $1,000), after deducting the depreciation expense. After deducting $350 in business taxes, the net gain for the period is $650 ($1,000 minus $1,000 times 0.35).
Summary
- Profit in the books is the amount that remains after all direct expenses have been subtracted.
- Labor, raw materials, and inventory, as well as transportation, manufacturing, and advertising expenses, are all considered explicit costs.
- Accounting profit is distinct from economic profit since it reflects the monetary outflow and cash inflow into and solely out of business.
- Another distinction is between accounting profit and underlying profit, which attempts to discount for one-off expenses.
