Everything about Profit totally explained
Profit generally is the making of gain in business activity for the benefit of the owners of the business. The word comes from Latin meaning "to make progress," is defined in two different ways, one for
economics and one for
accounting.
Pure economic profit is the increase in
wealth that an
investor has from making an investment, taking into consideration all costs associated with that investment including the
opportunity cost of
capital. Accounting profit is the difference between
price and the
costs of bringing to market whatever it's that's accounted as an enterprise (whether by harvest, extraction, manufacture, or purchase) in terms of the component costs of delivered goods and/or services and any operating or other expenses. A key difficulty in measuring either definition of profit is in defining costs. Pure economic monetary profits can be zero or negative even in
competitive equilibrium when accounted monetized costs exceed monetized price.
Economic definitions of profit
» Note: these definitions are different from those used by accountants
In
economics, a firm is said to be making a
normal profit when total
revenues equal total
costs. These normal profits then match the rate of return that's the minimum rate required by equity investors to maintain their present level of investment. Economically, the "normal profit" is thus treated as a
cost, and recognized as one of the two components of the
cost of capital.
An
economic profit arises when its
revenue exceeds the total (opportunity) cost of its inputs, noting that these costs include the cost of equity capital that's met by "normal profits." A business is said to be making an
accounting profit if its revenues exceed the accounting cost the firm "pays" for those inputs. Economics treats the normal profit as a cost, so when deducted from total accounting profit what is left is economic profit (or economic loss).
All enterprises can be stated in
financial capital of the owners of the enterprise. The economic profit may include an element in recognition of the risks that an investor takes. It is often uncertain, because of
incomplete information, whether an enterprise will succeed or not. This extra risk is included in the minimum rate of return that providers of financial capital require, and so is treated as still a cost within economics. The size of that return is commensurate with the riskiness associated with each type of investment, as per the
risk-return spectrum.
"Normal profits" arise in circumstances of
perfect competition when
economic equilibrium is reached. At equilibrium, average cost equals marginal cost at the profit-maximizing position. Since normal profit is economically a cost, there's no
economic profit at equilibrium. In a single-goods case, a positive
economic profit happens when the firm's average cost is less than the price of the product or service at the
profit-maximizing output. The economic profit is equal to the quantity of output multiplied by the difference between the average cost and the price.
Economic profit doesn't occur in
perfect competition in long run equilibrium. Once risk is accounted for, long-lasting economic profit is thus viewed as the result of constant cost-cutting and performance improvement ahead of industry competitors, or an
inefficiency caused by
monopolies or some form of
market failure.
Positive economic profit is sometimes referred to as
supernormal profit or as
economic rent.
The
social profit from a firm's activities is the normal profit plus or minus any
externalities that occur in its activity. A firm may report relatively large monetary profits, but by creating negative externalities their social profit could be relatively small.
Profitability is a term of economical efficiency. Mathematically it's a relative index – a fraction with profit as numerator and generating profit flows or assets as denominator.
Accounting definitions of profit
» Note: these definitions are different from those used by economists
In the accounting sense of the term,
net profit (before tax) is the
sales of the firm less
costs such as wages, rent, fuel, raw materials, interest on loans and
depreciation. Costs such as depreciation, amortization, and overhead are ambiguous. Revenue may also be ambiguous when different products are sold as a package, or "bundled." Within US business, the preferred term for profit tends to be the more ambiguous
income.
Gross profit is profit before Selling, General and Administrative costs (SG&A), like depreciation and interest; it's the Sales less direct Cost of Goods (or services) Sold (COGS),
Net profit after tax is after the deduction of either corporate tax (for a company) or income tax (for an individual).
Operating profit is a measure of a company's earning power from ongoing operations, equal to earnings before the deduction of interest payments and income taxes.
To accountants,
economic profit, or EP, is a single-period metric to determine the value created by a company in one period - usually a year. It is the
net profit after tax less the
equity charge, a risk-weighted cost of capital. This is almost identical to the economist's definition of economic profit.
There are commentators who see benefit in making adjustments to economic profit such as eliminating the effect of amortized goodwill or capitalizing expenditure on brand advertising to show its value over multiple accounting periods. The underlying concept was first introduced by
Schmalenbach, but the commercial application of the concept of adjusted economic profit was by Stern Stewart & Co. which has trade-marked their adjusted economic profit as EVA or
Economic Value Added.
Some economists define further types of profit:
Optimum Profit - This is the "right amount" of profit a business can achieve. In business, this figure takes account of
marketing strategy,
market position, and other methods of increasing returns above the competitive rate.
Accounting profits should include economic profits, which are also called
economic rents. For instance, a
monopoly can have very high economic profits, and those profits might include a rent on some natural resource that firm owns, where that resource can't be easily duplicated by other firms.
Further Information
Get more info on 'Profit'.
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