Accounting profit is a term for the money a business earns after all costs incurred in the process of doing business are subtracted from revenue. The accounting profit equation is thus very simple: revenue minus costs equals accounting profit. All businesses must calculate accounting profit periodically to comply with generally accepted accounting principles and to determine the amount of income taxes they must pay. Managers, investors, lenders and other stakeholders track accounting profit closely because it is, in a sense, the ultimate measure of business performance.
Overview of Accounting Profit
Accounting profit is defined as the net earnings of a business for a year or other accounting period after all expenses are subtracted from total revenue for the period. Expenses include the cost of goods sold. Costs also include operating expenses like sales costs, general expenses and administrative costs.
In addition, a company also incurs non-operating costs, including interest payments, depreciation, amortization and taxes. You can find examples of the calculation of accounting profit on a firm's income statement. This financial statement is generally available on a company's investor relations website in its annual report. On the income statement, the accounting profit is the bottom line and is referred to as net income or net profit. Accounting profit is also referred to as bookkeeping profit.
Accounting profit is a particularly important metric. Because it is the net profit a business earns, it is a key measure of a company's performance. In addition, making a profit is the main reason why businesses exist. A firm can operate at a loss for a limited time, and many startups do. However, in the long run, a business that does not make money will not survive.
Explicit Costs and Implicit Costs
The amounts subtracted from revenues to calculate accounting profit are explicit costs. Economists also recognize costs that are not part of the accounting profit formula called implicit costs. Typically, an implicit cost is an opportunity cost. Suppose Jane decides to quit her job and go into business for herself by opening a bakeshop. Her financial records will include all of the explicit costs required to run her business. However, Jane gives up the salary she made from her job. She can calculate her "economic profit" by subtracting this opportunity cost from her accounting profit.
For the most part, implicit cost and economic profit are theoretical abstractions. These concepts are useful in that they help managers to estimate the potential of alternative investment of capital so they can make better decisions.
Calculating Accounting Profit
Begin calculating accounting profit by determining the firm's net revenue. Net revenue equals sales minus discounts, returns and similar adjustments. Next, subtract the direct cost of acquiring goods for sale. For retailers, this is the cost of goods sold. Manufacturers subtract the direct costs of production such as direct labor and raw materials. What remains is the gross income or gross profit. Suppose the Deluxe Widgets Company has $6 million in net revenues and the direct costs of manufacturing come to $2 million. The gross income equals $4 million.
Operating expenses are then subtracted from gross profit, meaning costs related to sales, administration and general activities. These costs include rent, utilities, insurance, office expenses and salaries for administrative employees. The resulting figure is the operating income. Deluxe Widgets recorded $2.4 million in operating expenses for the year. Subtracting this amount from $4 million gross profit leaves an operating income of $1.6 million.
Businesses also have non-operating expenses. These include allowances for depreciation and amortization. In addition, firms must pay financing costs like interest on outstanding loans and bonds. The last items to be subtracted are income taxes. The remainder is the accounting profit. Interest, depreciation, taxes and other non-operating expenses for Deluxe Widgets come to a total of $1.2 million. When these costs are subtracted from the $1.6 million operating profit, the company earned an accounting profit of $400,000.
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