Accounting profit is the total earnings of a company after reducing costs, calculated according to the requirements of the generally accepted accounting principles or GAAP. It factors in all the explicit costs of business operations including operating expenses, interest, taxes and depreciation. Accounting profit is also known as financial profit or book-keeping profit.
Accounting profit does not necessarily have to be the same as profit normally calculated in the general course of business. Read on to find out what it is and how it is calculated.
What is accounting profit?
Profit is a metric that is normally used all over the world to determine the financial health of a company. Organizations, the world over, publish various types of profits in the financial statements they prepare on a periodic basis. These profits are generated after considering all income and expense items as mentioned in their income statements.
Accounting profit is the net income that remains after all dollar costs are subtracted from the total revenue a company earns in a period. It denotes the amount of money remaining with a company after it has deducted all the explicit costs of its business operations.
The costs that are normally included in calculating accounting profit are as follows:
- Labor costs such as wages
- Raw material costs
- Inventory and stock required for production
- Transport costs
- Production and overhead costs
- Marketing and sales costs
Accounting profit versus other types of profit
Let’s look at how accounting profit stacks up against other types of profit:
Accounting profit and underlying profit
Underlying profit is one of the metrics that companies sometimes choose to go with rather than accounting profit. This metric is popular since it does not include infrequent transactions or one-time charges. The main goal of the underlying profit concept is to leave out the impact of one-time or random events such as natural disasters on earnings and profits.
Losses and gains that usually do not occur as part of regular business operations are not taken into account while calculating the profit for a particular period as they are not considered to affect the regular functioning of the business. This includes items such as buying and selling of property, organizational restructuring, losses from a fire accident, etc.
The senior management of companies often uses the underlying profit to attract the attention of potential investors since it depicts the financial status under normal circumstances.
Accounting profit versus economic profit
Similar to accounting profit, economic profit also calculates profit by reducing explicit costs from revenue. The main difference between these two metrics is that economic profit also considers implicit costs. This includes opportunity costs. Opportunity cost is the benefit foregone when allocating the company’s resources to another need. Some examples of implicit costs are:
- Plant and equipment
- Buildings that the company owns
- Resources allocated for self-employment
Accounting profit is calculated based on what actually happens and materializes for a particular period. Economic profit, on the other hand, is based on a theoretical calculation of what can or may happen if an alternative course of action is pursued. This metric is used mainly to help the management make certain decisions. Accounting profit is a mandate for preparing financial statements and also for tax declarations.
Let’s look at an example to understand the difference between these two profit metrics better. If you start a business by investing $200,000 and your revenue for the period is $250,000, then you would have made a profit of $50,000. This is the accounting profit. Now, if you have left your salaried job which would have paid you $70,000 for the same period, then you have foregone that salary to run your business. This is called opportunity cost according to economics and hence, your economic profit would, in fact, be a loss of $20,000 ($50,000 – $70,000).
Example of accounting profit
Let’s now try and understand accounting profit in detail with the help of an example.
A company manufactures and sells a product for $10 each. It starts off the year by selling 20,000 units in January. Therefore, its total revenue for January is $200,000 and this is the first number that gets added to the company’s income statement.
The first item of cost to be deducted from revenue is the cost of goods sold (COGS). This includes all the costs incurred to manufacture the product. If each unit costs $2 to make, then the total COGS is $40,000 (20,000 x $2). So, the gross revenue would be $160,000 ($200,000 – $40,000).
After this, the rest of the costs are to be considered. These costs include salaries and wages, operating expenses, etc. Interest expenses, taxes, depreciation, and amortization should not be considered at this stage. The resulting amount is the operating profit of the company. if the operating profits add up to $80,000 for the period, the operating profits would be $80,000 ($160,000 – $80,000).
After the operating profits are determined, interest expenses, taxes, depreciation, and amortization should be deducted from it. Assuming that depreciation and interest expense are a total of $20,000 for the period, the company’s earnings before taxes (EBT) will be $60,000 ($80,000 – $20,000). Ideally, depreciation is first deducted to get earnings before interest and taxes (EBIT). From this, interest expense is deducted to get EBT.
Corporate taxes at 35% are applied on EBT. This comes up to $21,000 ($60,000 x 35%). Deducting taxes from EBT gives earnings after tax (EAT) which is $39,000. This EAT is also known as accounting profit.
