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.
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.
Economic Value Added
Another name for the process of determining economic profit is “economic value added” (EVA). While this calculation also generates an estimate of economic profit, it is determined by considering economic capital and financial performance. That is, this process involves calculating the net profit after interest and taxes (NOPAT), determining the net working capital (assets-liabilities), and then calculating the total capital invested in a firm (net working capital + fixed assets). After this, total capital (EVA) is calculated by multiplying risk percentages by the invested capital.
A specific formula may better demonstrate how to calculate economic profit according to the language of EVA. In this formula, r is the return on capital, c is the cost of capital, and K is the capital used. The mathematical equation corresponding to EVA might look like this: EVA=(r-c) K=NOPAT-c K. In short, EVA is the net profit after taxes minus a capital cost, but each of these components requires a series of calculations (demonstrated by this formula).
Unlike the calculations for accounting profits, there is much more at stake involved in determining how to calculate economic profits. This process involves a precise understanding of the capital involved in the financial choices made, and an awareness of the business opportunities lost during a particular period.