It is important for project managers to have a sound grasp of basic accounting and economic principles. This is especially true during the capital budgeting process when executives decide which projects to pursue and which to reject. The target profit executives set for a project is a function of the riskiness of the project.
What is Accounting Profit? We have a good understanding. It is the amount of money remaining after we have subtracted the costs of the project. We can also call it the Nominal Profit. It is unrelated to the time value of money.
Economic Profit is different. It is the profit that remains after we account for the opportunity cost, and is related to the time value of money (and net present value). The rate of return we apply (or the hurdle rate) is project-specific and relates to the level of risk associated with the project. Note that a project could have a positive accounting profit and a negative economic profit. For example, if an organization determines that a project’s risk warrants a target profit of 10% and that project ends up realizing an 11% profit, the accounting profit is 11% but the economic profit is only 1%. Another example is a less risky project with a 7% hurdle rate. If that project realized a 5% profit, then although the accounting profit is 5%, the economic profit would be negative 2% or an economic loss of 2%.