“All failed companies are the same: they failed to escape competition.”
The Real Bottom Line
Business owners are used to thinking about gross profit and net profit, but they rarely consider economic profit. Gross profit tells you how much your product contributes to your operating and sales costs, and net profit tells you what you made in excess of total expenses, but economic profit takes into consideration your opportunity cost. You can only earn an economic profit if you have a competitive advantage.
Gross Profit = Revenue - Cost of Good Sold
Net Profit = Gross Profit - Expenses
Economic Profit = Net Profit - Opportunity Cost
Opportunity cost can be defined in many ways, and it differs based on the situation. You may consider your opportunity cost the amount you would have earned in the stock market had you invested your startup capital instead of starting the business. Or, it could be the amount you would have earned in the same period of time, had you kept your day job.
Why is it so hard to earn economic profit?
In economics, a perfect market is a market where supply and demand intersect at a point of equilibrium; a point where every potential customer is supplied at the maximum price they are willing to pay. There is an elegance to this concept that has had economists swooning for literally centuries, but inherent in an equilibrium is the fact that no individual competing firm actually earns an economic profit.
Let’s take a coffee shop for example. If you did your homework and invested $50,000 to start a coffee shop in an underserved market where there was excess demand, you could charge a premium and things would look pretty good. Let’s assume your monthly revenue is $20,000, gross margin is 50%, and operating expenses consist of a $30,000 per year annual salary to yourself, $4,000 per month in wages, $2,000 per month for rent, and $1,000 in other expenses. That’s a pretty lean operation, and you are doing a lot of the work yourself.
Gross Profit = $20,000 - $10,000 = $10,000
Net Profit = $10,000 - $2,500 - $4,000 - $2,000 - $1,000 = $500
Hey, not bad, you’re making a profit right?
Now let’s factor in the opportunity cost. If you quit a job paying you $60,000 per year, your economic profit would be negative $2,000. The excess income you would have earned at the job you quit would be $30,000 per year, or $2,500 per month.
Economic Profit =$500 - $2,500 = ($2,000)
What if there was no better job? That’s great, and I mean it! It feels good to create an independent future for ourselves, and people should follow their passions! However, in a market where there is economic profit to be made and where there are low barriers to entry, such as in the case of a coffee shop, competition will emerge and competitors will drive prices down until market equilibrium is achieved and economic profit is zero. Ever heard of the invisible hand? That’s a big part of why economists are so enamored with market equilibrium.
Is market equilibrium really so bad?
Obviously not, or economists wouldn’t have been swooning over it for centuries, right? Right!?
But, you can draw some very meaningful conclusions from our basic coffee shop example.
First, If you want to start a business in a highly competitive market, you should love the work, because you will be doing a lot of it. It is unlikely that you will generate enough profit to pay yourself to retire early.
Second, If you intend to build something that will earn an economic profit you must set yourself apart from the competitive market. This is achieved by creating something new that serves a new market where there is no competition. That is called a competitive advantage.
However, not all competitive advantages are created equal. In our example, the coffee shop starts with the competitive advantage of being the first in the neighborhood, but competition catches on quickly. Similarly, advantages like great customer services or high quality interior design can be easily replicated by competition.
The key to sustaining a competitive advantage, and therefore earning an economic profit over the long term horizon, is constant innovation.
Our article can also been seem on Medium.