What it means
Explicit costs are the ones that get an invoice, a payslip or a journal entry: materials, wages, rent, utilities, interest and depreciation. Add them up, subtract them from revenue, and the result is accounting profit.
The measure matters because it is the common language of tax authorities, lenders and shareholders. It sets the tax bill, it feeds the covenant tests in loan agreements, and it usually determines whether a dividend can legally be paid.
Where accounting profit falls short is in decision-making about whether a business is genuinely worth running. An owner who takes $30,000 a year out of a business but could earn $110,000 elsewhere is bearing a real cost that never appears in the accounts, and economic profit exists to capture exactly that gap.
A related nuance is the difference between accounting profit and cash profit. Depreciation reduces accounting profit without any money leaving the building, while repaying loan principal drains cash without touching profit at all, so a business needs to watch both figures.
Accounting profit is also quoted at several different levels, which causes endless confusion in meetings. Profit before interest and tax, profit before tax and profit after tax are all accounting profit, and the difference between the first and the last can easily be a third of the number.
For owner-managed companies there is one more adjustment worth making before drawing conclusions. Directors often take a mix of small salary and dividends for tax reasons, so the reported accounting profit reflects a pay structure rather than the true cost of running the business.
Anyone valuing or lending to such a company will normalise those costs back to a market salary first.
In practice
Real-world examples.
Example
A dental practice reports accounting profit of $240,000. The two partners use that figure to agree profit shares and to support a mortgage application, because it is the number the lender's underwriting model recognises.
Example
A furniture importer shows accounting profit of $95,000 but has spent $310,000 building stock ahead of a product launch. The profit is real under the rules, yet the business needs an overdraft facility to get through the next quarter.
Example
A freelance photographer compares her accounting profit of $58,000 against a $76,000 salaried job offer. On an economic basis the business is losing money, which prompts her to raise day rates rather than close the studio.
Formula
Calculation
Accounting Profit = Total Revenue - Total Explicit Costs
A neighbourhood bakery records revenue of $620,000 for the year. Its explicit costs are ingredients of $180,000, wages of $210,000, rent of $60,000, utilities of $20,000 and depreciation on ovens and fittings of $30,000. Those costs total $180,000 + $210,000 + $60,000 + $20,000 + $30,000 = $500,000.
Accounting profit is therefore $620,000 - $500,000 = $120,000.
If the owner could earn $85,000 working for a large bakery chain, that forgone salary is an implicit cost. Economic profit would be $120,000 - $85,000 = $35,000, which is still positive but a far less comfortable margin than the headline figure suggests.Case study
Seen in the real world.
Coppervane Cycles is a fictional bicycle repair chain used here purely as an illustration. Across four workshops it reported revenue of $1,850,000 and accounting profit of $148,000, a result the two founders described as steady.
A prospective investor rebuilt the numbers on an economic basis. Both founders worked full time for a combined $70,000, well below the $190,000 the market would pay for equivalent skills, and $500,000 of family capital was tied up in the business earning nothing. On those adjusted figures, the chain was destroying roughly $60,000 of value a year despite a positive accounting profit.
Coppervane did not dispute the accounting profit, which was correctly prepared. Instead, the founders closed the weakest workshop, raised labour rates by 12% and put proper market salaries into their own budget so that future accounting profit measured something closer to genuine surplus.
Watch out
Common mistakes.
- Treating accounting profit as proof that a business is a good use of the owner's time and capital, when it excludes every opportunity cost.
- Forgetting that owner-managers who pay themselves below market rate inflate the accounting profit of their own business.
- Assuming a positive accounting profit means there is cash available to distribute.
Questions
People also ask.
Is accounting profit the same as net income?
In most contexts yes, though net income specifically means the figure after interest and tax, while accounting profit is sometimes quoted before tax.
Why is accounting profit almost always higher than economic profit?
Because economic profit subtracts implicit costs such as forgone salary and the return that invested capital could have earned elsewhere.
Does depreciation reduce accounting profit even though no cash is paid?
Yes, and that is deliberate, because it spreads the cost of an asset across the years in which the asset is used.
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