Profit

Profit

dollars stacked increasing
Profit is obtained by subtracting the total cost of a firm from its total revenue.  A profitable firm can always attract investors because they will be compensated for providing funds to the business especially if what they will earn from the firm is more than what they can earn elsewhere.  Besides, other investors will enter a competitive industry provided there is an opportunity to earn more than the opportunity cost of resources. Unprofitable firms turn off lenders preventing the business from embarking on an expansion of its operations.


Types of profit
Normal profit
Normal profit is the least possible amount of profit that a firm has to make in order to continue supplying its resources in the market. It occurs when total revenue and total cost are equal or when average revenue is equal to average cost.  It may be thought that the firm has made neither profit nor loss (or reached a break-even point) since the difference between revenue and cost is zero. But it must be noted that normal profit is included in the total cost of the firm. The payments made for all inputs used in production are included in total cost in order to determine profit.  They are rent for land, wages and salaries for labour, interest for capital and profit for the enterprise. Normal profit is the compensation paid for risk-taking by an enterprise and it is part of the costs of the firm. It is  an opportunity cost because any resource provided by the entrepreneur could have attracted income if put into an alternative use.  Opportunity costs are implicit costs because they are not directly paid for by the firm. Expl/icit costs are costs that are directly paid for by the firm, e.g. salaries, material cost, interest on a bank loan, etc. Implicit costs are not usually considered when accountants are calculating the firm’s profit. 

Abnormal profit
There is abnormal profit when total revenue exceeds the total cost, i.e. profit made by the firm above the normal profit. This means that the average revenue is more than the average cost. Abnormal profit is also called supernormal profit, economic profit or positive economic profit.  

Subnormal profit
When a firm’s total cost exceeds total revenue, there is a subnormal profit, economic loss or negative economic profit. The average revenue of the loss-making firm is lesser than its average cost. If this situation continues for a long time, the entrepreneur is better off taking his/her resources elsewhere where a decent return can be made. 

Accounting profit versus economic profit
Accounting profit = total revenue –  total explicit costs
Economic profit = total revenue – (total explicit costs + total implicit costs)
Total accounting costs = total explicit costs
Total economic costs = total explicit costs + total implicit costs


Example on the calculation of accounting profit and economic profit
Mr.  Ray started a business with a capital of $150,000 which he withdrew from his past savings. In the first year, he spent $40,000 on raw materials, $20,000 on labour costs and $30,000 on electricity.  Mr. Ray forfeited $20,000 which was the yearly salary in his previous employment.  He earned interest of 10% per annum on his savings. His office was an apartment in his house which was previously rented out for $10,000 per annum.  If the total sales revenue for the first year was $145,000 calculate his:

(i) total accounting costs;  (ii) total economic costs;  (iii) accounting profit;   (iv) economic profit.

Solution:
(i) 
cost of raw materials    $40,000
labour costs    $20,000
electricity    $30,000
total accounting costs = $40,000 + $20,000 + $30,000 
                                         = $90,000

(ii)
salary forfeited     $20,000
interest on savings   $15,000 (10% of $150,000)
rent forgone     $10,000
total implicit costs = $20,000 + $15,000 + $10,000 = $45,000

total economic costs = total accounting costs + total implicit costs
                                      = $90,000 + $45,000
                                      = $135,000

(iii) accounting profit = total sales revenue  – total accounting costs
                                        = $145,000 – $90,000 = $55,000

(iv) economic profit = total sales revenue – total economic costs
                                     = $145,000 – $135,000 = $10,000