Difference between Accounting Profit and Economic Profit

Difference between Accounting Profit and Economic Profit

How does economic profit differ from accounting profit?

Here is a very simple example that reflects the difference between accounting profits and economic profits and, and thinking properly or improperly about the process of value creation. That is, suppose that as a company, you invest $1 billion in R&D, big amount of money in R&D. From an accounting point of view, $1 billion dollars in R&D is a cost. All right, so you take out $1 billion out of your profits and then, you keep going the income statement. Now if you really think about it, no company would invest $1 billion today, if they did not expect to get something in the future. So, $1 billion investment in R&D is just that, it is an investment. So you expect to get a return in the future.

So, if you are actually using the idea of EVA residual income, economic profit. What you would probably do is the following. You would say look, I am going to build this $1 billion of R&D into my capital. Because that is what it really is, I am making an investment here, and I am going to be depreciating this capital over time. And that depreciation is what I am going to be charging, so earnings, and period after period after period. Therefore, there is a fundamental difference there in the way you think about R&D. One way is to say R&D is an expense today, I charge it to earnings today, end of the story. That is not really, what R&D is from an economic point of view. We are making a capital investment. That capital investment is going to be depreciating over time. And that depreciation is what we would charge to earnings. Therefore, this is just to clarify some of the many adjustments that you could actually do to the NOPAT, to the capital, and to the traditional accounting in order to go from the accounting profit into the economic profit, right. So that is enough for definition number one.

Let us bring now definition number two. If you define the Return on Capital as the NOPAT divided by Capital, you can algebraically go between one definition and the other back and forth. But notice what that second definition says and many people that like that, because it takes us back to some of the issues we were discussing before. It says something that is very simple. If you create a positive spread between the Return on Capital and the cost of Capital, you are going to be creating value. And if you find activities, you find investments, you find things that you can do in which you can create a positive spread between the Return and the Cost of Capital, then put Capital into those activities. And if you do that, then you are going to be creating value. Therefore, in the same way, positive EVA indicates value creation and Accounting Profit and negative EVA indicates value destruction. Here we actually have exactly the same thing.

Now, let us put these two expressions together and in order to do that then we are going to focus how do we create value at the end of the day? Well, you know, if you put the two expressions together, it is pretty much in front of your eyes. One is you can increase the company’s profitability, and that basically means to create more NOPAT. So, if you create more cash, if your investment activities, if your operations, if the product and services that you sell create more cash, then you are going to be increasing the process of value creation.

Now, let us go to the second expression. You can create more value by investing more capital in activities in which you have a positive spread. Because if you have a positive spread if you’re beating the cost of Capital, more Capital is going to increase the process of value creations, so that’s possibility number two. Possibility number three, very often overlooked. If you are investing in activities in which you have a negative spread, that is in which the return of cap, on Capital is lower than the cost of Capital, take Capital out of those activities. That is very important, and that is sometimes again overlooked. If we are doing things in which we are destroying value, take the Capital out and put it somewhere else. You will be creating value. You will be enhancing value creation by doing that and the fourth, which sometimes is overlooked when we are discussing these issues but only because we know that this is an important thing to do is to optimize the Capital structure. Minimum of the Optimal Capital structure is the one that minimizes the cost of Capital. Therefore, you can look at expression one or you can look at expression two. But everything else equals the lower cost of Capital; the higher is going to be the EVA.

Therefore, the four ways in which you can create value in this framework is,

  1. increase the profitability of the company,
  2. increase the NOPAT, and
  3. Put more Capital into activities in which you have a positive spread, return on Capital higher than the cost of Capital.
  4. Take out Capital from activities in which the return of cap, on Capital, is lower than the cost of Capital, and minimize your Capital structure so as though you minimize the cost of Capital.

If you do those four things, if you improve in the direction of doing those four things, you are going to be creating more value according to this framework that we are discussing here.

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