What is Economic Profit? Understanding True Business Performance Beyond Accounting Numbers

Economic profit represents the difference between the revenue a business generates and the full costs of its operations—including both explicit costs that appear on financial statements and implicit opportunity costs that don’t. It measures the value a company creates beyond what would be expected given the resources employed and the risks taken.

In its simplest form, economic profit answers a fundamental question: Is this business earning more than the minimum return required to compensate for the resources committed and risks assumed?

While accounting profit tells us if a company is making money in the conventional sense, economic profit reveals whether it’s generating returns above what investors could earn elsewhere with similar risk—the true measure of value creation.

The difference between economic profit and accounting profit centers on the treatment of opportunity costs:

A company can report substantial accounting profits while actually destroying economic value if its returns don’t exceed the opportunity cost of the resources employed. Conversely, a business with modest accounting profits might create significant economic value if those profits exceed what investors require given the risks.

Opportunity cost—the value of the next-best alternative forgone—is the cornerstone of economic profit. In business contexts, the most significant opportunity cost is typically the cost of capital, representing what investors could earn elsewhere with similar risk.

This includes:

• Cost of Debt: Interest paid on borrowed funds (already reflected in accounting profit, though typically after tax adjustments)
• Cost of Equity: The expected return shareholders require (not reflected in accounting profit at all)

By incorporating opportunity costs, economic profit provides a more complete view of performance—one that acknowledges capital is not “free” even when it comes from shareholders rather than creditors.

Economic profit can be calculated using several equivalent approaches, each offering slightly different insights:

The standard formula is:

Economic Profit = Total Revenue – Explicit Costs – Implicit Costs

Or alternatively:

Economic Profit = Accounting Profit – Opportunity Costs

In practice, the most common formulation for businesses focuses on capital costs:

Economic Profit = Net Operating Profit After Taxes (NOPAT) – (Invested Capital × Cost of Capital)

This latter approach is particularly useful because it separates operating performance (captured in NOPAT) from capital efficiency (reflected in the capital charge).

Consider a manufacturing company with the following financial data:

• Revenue: $10 million
• Operating expenses: $7 million
• Net operating profit after taxes (NOPAT): $2.4 million
• Invested capital: $15 million
• Weighted average cost of capital (WACC): 10%

Step 1: Calculate the capital charge

Capital Charge = Invested Capital × WACC Capital Charge = $15 million × 10% = $1.5 million

Step 2: Calculate economic profit

Economic Profit = NOPAT – Capital Charge Economic Profit = $2.4 million – $1.5 million = $0.9 million

This company is generating economic profit of $900,000, meaning it’s creating value beyond what investors require given their capital investment and assumed risk.

Economic profit plays a central role in microeconomic theory, helping explain market dynamics across different competitive structures.

In perfect competition, economic profit tends toward zero in the long run. When companies earn positive economic profit, new competitors enter the market, increasing supply and driving prices down until economic profit disappears. While firms still earn accounting profits sufficient to keep them in business (covering their explicit costs and normal returns), the absence of economic profit indicates they’re not extracting excess returns.

In monopolistic competition, companies can earn positive economic profit in the short term through product differentiation, but competition eventually erodes these advantages, pushing economic profit toward zero in the long run.

In oligopolies and monopolies, barriers to entry allow firms to maintain positive economic profit over extended periods. The persistence of economic profit signals potential market inefficiencies and explains why these market structures attract regulatory scrutiny.

This theoretical framework helps investors identify companies with sustainable competitive advantages—those rare businesses capable of generating positive economic profit despite competitive pressures.

Beyond its theoretical importance, economic profit has profound practical applications for business management and investment analysis.

Traditional performance metrics like accounting profit or earnings per share can incentivize behaviors that boost short-term results at the expense of long-term value. Economic profit provides a superior alternative by:

• Encouraging efficient use of capital resources
• Discouraging value-destroying growth initiatives
• Aligning management incentives with shareholder interests
• Promoting long-term thinking in strategic decisions

Companies like Coca-Cola, Briggs & Stratton, and Hershey have linked executive compensation to economic profit metrics, helping ensure management decisions truly create shareholder value.

Economic profit provides a powerful framework for evaluating potential investments and allocating capital efficiently:

• Projects with positive expected economic profit create value and warrant investment
• Projects with negative expected economic profit destroy value and should be rejected
• Comparing economic profit across different business units highlights where capital can be deployed most effectively

Unlike ROI or payback period metrics that might miss capital costs, economic profit ensures all investments are evaluated against their full opportunity cost.

Economic Value Added (EVA), developed and trademarked by consulting firm Stern Value Management (formerly Stern Stewart & Co.), represents the most widely adopted application of economic profit in corporate settings.

The EVA formula is essentially identical to economic profit:

EVA = NOPAT – (Capital × Cost of Capital)

What distinguishes EVA is its implementation methodology, which includes specific accounting adjustments to better align financial reporting with economic reality. These adjustments typically address issues like:

• R&D expenditures (capitalizing rather than expensing)
• Operating leases (treating them as debt and assets)
• Goodwill amortization (removing non-economic charges)
• Provisions and reserves (eliminating earnings smoothing)

Companies implementing EVA systems often experience improved capital efficiency, better strategic decision-making, and stronger alignment between management actions and shareholder interests. Notable EVA adopters have included Coca-Cola, Eli Lilly, Briggs & Stratton, and Herman Miller.

Economic profit offers distinct advantages over other common financial metrics:

While each metric has its place in financial analysis, economic profit uniquely combines operating performance, capital efficiency, and risk considerations in a single, theoretically sound measure.

Despite its conceptual strength, economic profit presents several practical challenges:

Accurately measuring economic profit requires estimating inputs that aren’t directly observable:

• Cost of Capital Estimation: Calculating WACC involves assumptions about risk premiums, beta values, and capital structure targets
• Invested Capital Calculation: Determining what constitutes invested capital and how to value it (historical cost vs. replacement value)
• Accounting Adjustments: Deciding which accounting conventions to adjust for economic reality

These measurement challenges create room for manipulation or inconsistency if not carefully addressed.

Companies implementing economic profit systems often encounter:

• Complexity: Economic profit can be harder for employees to understand than simpler metrics
• Data Requirements: Calculating economic profit demands more sophisticated financial systems
• Short-term Pressures: Economic profit may initially fall when companies invest in long-term value creation
• Cultural Resistance: Managers accustomed to traditional metrics may resist new performance standards

Despite these challenges, the theoretical soundness of economic profit makes it worth the implementation effort for many organizations.

For investors, economic profit offers valuable insights for evaluating companies:

• Competitive Advantage Assessment: Sustained positive economic profit signals durable competitive advantages
• Management Effectiveness: Consistently positive economic profit reflects skilled capital allocation
• Valuation Input: Future expected economic profit forms the basis for discounted cash flow valuation
• Industry Analysis: Comparing economic profit across competitors reveals relative performance

Research suggests companies generating positive economic profit tend to outperform in the stock market over time, though this relationship isn’t always immediate or direct.

Certain businesses consistently generate positive economic profit due to strong competitive positions:

• Technology Leaders: Companies like Microsoft, Apple, and Google maintain high economic profit through network effects, intellectual property, and scale advantages
• Consumer Brands: Firms like Coca-Cola and Nike leverage brand power to earn returns exceeding their capital costs
• Specialized Manufacturers: Niche industrial companies with proprietary technology or dominant market positions often generate strong economic profit
• Platform Businesses: Marketplace companies like Visa, MasterCard, and stock exchanges create economic value through network effects

These companies typically trade at premium valuations reflecting their ability to generate returns beyond their cost of capital.

Economic profit stands as one of the most powerful and theoretically sound metrics for evaluating business performance. By incorporating the full opportunity cost of capital, it provides a clearer picture of true value creation than traditional accounting measures. For managers, economic profit offers a superior framework for strategic decision-making, capital allocation, and performance measurement. For investors, it helps identify companies with sustainable competitive advantages capable of generating superior long-term returns.

While calculating economic profit presents certain challenges, the insights gained make it worth the effort. Companies that focus on economic profit rather than merely accounting profit typically make better strategic decisions, allocate capital more efficiently, and create more shareholder value over time.

For investors seeking to apply economic profit concepts in their analysis, tools like InvestingPro offer streamlined access to key metrics and comparisons across companies and industries. By incorporating economic profit thinking into your investment approach, you can move beyond surface-level financial measures to understand which companies are truly creating value in excess of their capital costs—the ultimate driver of long-term investment returns.