Economic income
Economic income - is everything that remains after deducting all alternative costs: explicit and implicit expenses for wage, rent, interest, and normal revenues from the company's total revenues. The economic income may be either positive or negative. Hicks also defines economic income as "the maximum amount which can be spent during a period if there is to be an expectation of maintaining intact the capital value of the prospective receipts (in money terms)", meaning the costs that can be freely spent without damaging company's or person's stable well-being[1].
Sources of economic income
The source of economic income, different from the managerial, innovation and risk functions of entrepreneurs, is also the presence of a certain degree of economic power and ability to take risks. Since the future is difficult to predict in a dynamic economy, the entrepreneur is compelled to take risks. Hence, profits can be considered partly as a reward for this risk. By linking economic income with uncertainty and risk, it is difficult to distinguish between insured and non-insured risk. Some types of risk - for example, the risk of a fire, flood, theft, an accident with employees - can be calculated by insurance companies that precisely predict the average number of such accidents. Thus, such a risk can be insured. Businesses can avoid accidents or take certain measures to prevent them by spending a fraction of their money on insurance premiums. The uninsured risk, the one linked with decisions of an entrepreneur, is a potential source of economic profit. In addition, the source of economic profit is the existence of a monopoly. Due to the ability to restrict production and restrain competitors, the monopolist can permanently withdraw economic profits, provided that demand is closely linked to costs. Such profits are due to the ability of the monopolist to restrict production and influence the price of the product in their favour. The main functions of economic income are[2][3].:
- an incentive to increase national production. Expectation of income motivates firms to introduce innovations that increase investment costs, that in turn increase the volume of multiplicative production;
- an incentive for an efficient allocation of resources among alternative types of production. Entrepreneurs are trying to make a profit and avoid losses. The emergence of economic income in any industry encourages entrepreneurs to make more product in this industry and increase the expenses of resources on this product.
Accounting Income vs Economic Income
While economic income or loss includes realized and unrealized gains or losses, accounting income or loss includes only realized gains or losses. In more detail the differences are as follows[4]:
| Notion | Accounting income | Economic income |
|---|---|---|
| Fundamental measurements | Transactions | Future expected net cash flow (NCF) |
| Cash flows | Actual, past | Future expected |
| Interest | Actual | Selected discount rate |
| Separate concepts of capital and profit | Both present | Neither present |
| Concept of capital | Concept of capital | "Capitalised" present value |
| Concept of profit | Periodic monetary gain P(t) = R(t) - E(t) | Periodic monetary gain P(t) = R(t) - E(t) |
| Concept of revenue | Executed contract of sale | Not distinguished |
| Depreciated expense | Allocation of net cost | "Change in present value" |
Economists made attempts to reconcile accounting income and economic one: Accounting income + Unrealized changes in the value of tangible assets during the period - Amounts realized during this period in value changes of tangible assets which took place in previous periods + Changes in the value of intangible assets during the period = Economic income.
Gross income vs economic income
Gross income is the income that a company gains from its main business, usually from the sale of goods or services to customers. In many countries, the term gross income is synonymous with the term turnover. Some companies may receive gross income from interest, dividends, or royalties paid by other companies. The surplus of gross income over accounting (external) expenses constitutes accounting income. The surplus of gross income over economic expenses (a set of external and internal costs) makes an economic impact. In order to calculate it, the accountants subtract internal costs, taking into account normal profits from accounting income[5][6].
Examples of Economic income
- Accounting profit - This is the income which remains after subtracting all explicit costs such as wages, rent, and interest from total revenues. It does not include any implicit costs such as opportunity costs.
- Gross Domestic Product (GDP) - This is the total value of all final goods and services produced within a country in a given period of time. It is calculated by subtracting the cost of production from the total revenue generated from the production.
- Market Value Added (MVA) - This is the difference between the market value of a company and the capital employed in its operations. It is a measure of the economic income generated by the company.
- Net Investment Income - This is the difference between the income generated by a company’s investments and the cost of financing those investments. It is a measure of the company’s economic income.
Advantages of Economic income
Economic income provides important insights into a company’s economic performance and can be used to assess a firm’s overall profitability. The following are some of the advantages of economic income:
- It reflects the true economic costs incurred by a business, including both explicit and implicit costs, such as wages, rent and interest.
- It is a measure of the company’s financial performance over a period of time, which can be used to compare the performance of different businesses.
- It is a good indicator of the company’s ability to generate profits, as it takes into account all costs associated with running the business.
- It can provide an important insight into a company’s long-term prospects, as it gives an indication of the company’s ability to generate future profits.
- It is a useful tool for decision making, as it can be used to assess the financial viability of a particular project or venture.
Limitations of Economic income
Economic income has several limitations, including:
- It fails to account for the economic costs of externalities, such as environmental damage, which can have a long-term impact on the economy.
- It does not account for the costs of opportunity, such as lost potential income from investments.
- It does not consider the full cost of production, including the cost of wages, rent, and other labor-related expenses.
- It does not factor in the social costs associated with certain activities, such as increased health care costs due to pollution.
- It ignores the effect of inflation on income levels.
- It does not account for the effects of taxation and government regulations on business.
Introduction: There are other approaches to economic income calculation, such as:
- Gross Operating Surplus (GOS) - It is a measure of the profits earned by businesses, calculated as total revenue minus total costs. It is used to examine the growth of business profits over time.
- Net Domestic Product (NDP) - It is an economic measure of the value of all final goods and services produced domestically in a given period of time. It is calculated as Gross Domestic Product minus depreciation.
- Consumer’s Surplus - It is a measure of the amount that consumers benefit from a good or service by paying a price lower than the amount that they are willing to pay for it.
- Social Surplus - It is the total benefit received by society from the consumption of goods and services, calculated as the sum of consumer’s surplus and producer’s surplus.
- Producer’s Surplus - It is the difference between the price a producer is willing to accept for a good and the price the producer actually receives for it.
In summary, there are various approaches to measuring economic income, such as Gross Operating Surplus, Net Domestic Product, Consumer’s Surplus, Social Surplus, and Producer’s Surplus. Each approach provides a different perspective on the value contributed to an economy by a particular good or service.
Footnotes
| Economic income — recommended articles |
| Cost-income ratio — Contribution margin ratio — Combined Ratio — Ebitda ratio — Net cost — Bank efficiency ratio — Degree of financial leverage — Book profit — Market value added |
References
- Hicks, J.R. (1946)Value and Capital, Oxford University Press
- Pignataro, P. (2013) Financial Modeling and Valuation, Wiley Finance Series
- Piros, C.D. (2013) Economics for investment decision makers, CFA Institute
- Ryan, J. (2007) The relationship between accounting profit and economic income, Australian accounting review
- Solomons, D (1961)Economic and Accounting Concepts of Income, American Accounting Association
Author: Kamil Piszczek
