How to Calculate Economic Profits

To learn how to calculate economic profits, it is necessary to understand the relationship between opportunity costs and calculable revenues documented in accounting profits. The calculation itself is a simple three-step process, but involves a serious consideration of estimated money lost potential investments not made (i.e. opportunity cost losses).

Three Basic Steps

Economic profit can be calculated in three basic steps (though the components of these steps themselves require some detailed analysis prior to calculation to ensure accuracy). First, it is necessary to calculate revenue, expenses, and opportunity cost, individually. Next, expenses should be subtracted from revenue to determined net income. Finally, the opportunity cost must be subtracted from the net income, in order to arrive at the final economic profit.

Calculating Opportunity Cost

Opportunity costs, one of the components that requires additional calculation in and of itself, can amount to a number of things, such as a salary from a job that was turned down or interest from declined investments. For instance, consider an individual who decides to invest \$100,000 in a company one year that earns \$150,000 in revenue. While the accounting profit would be \$50,000, if that individual turned down employment that year that could have earned him or her \$50,000, that lost salary must be subtracted from the accounting profit, and would result in zero economic profit.

Specific Example

Imagine a situation in which a company faces two investment options, A or B, and both cost \$50,000. The company chooses to invest in option A, which earns a \$100,000, and therefore generates a nice profit of \$50,000. The firm in question also notes that option B, which they had turned down, only made \$75,000. While this would seem to make option A the better choice in terms of accounting profits, in order calculate economic profits the firm must subtract the \$25,000 they did not make (the opportunity cost) by turning down option B.