Most entrepreneurs know that profitability matters, but there's more to your bottom line than meets the eye.
Your accounting profit reflects how well you're pricing your goods or services and controlling your costs. It's a measure of business sustainability as well as management competence.
However, accounting profit is strictly limited to business line items and excludes an owner's investment circumstances. Therefore, it's a reasonable indicator of business performance, but not a reliable measure of investment performance.
Your economic profit, on the other hand, includes your required rate of return (i.e. the return that you need to justify your investment risk). Many entrepreneurs under-estimate their required rate of return, and it's not unusual for an owner-run business to make an accounting profit but an economic loss.
For example, consider a business that makes a net profit of R1 million and pays a dividend of R500,000. Many owners would be delighted with these results.
But what if you had to invest 10 years and R10 million to get your business to this point? If you had allocated that same capital over the same timeframe somewhere else, you could have enjoyed a better return with less risk (e.g. you would have more than tripled your capital by simply investing in the S&P 500).
The distinction between accounting profit and economic profit is critical, because your business isn't just a place to work. It's also an asset that can (and should) create wealth for you.
Accounting profit tells you whether your business is making enough money for itself. Economic profit tells you whether it's making enough money for you.