Meaning of Profit in Economics

Profit means different things to different people. The word ‘profit’ has different meanings to business, accountants, tax collectors workers and economists. In a general sense, profit is regarded as income of the equity shareholders. Similarly wages getting accumulated of a labor, rent accruing to the owners of any land or building and interest getting due to the investors capital of a business, are a kind of profit for labors, land owners and investors. To an accountant, profit means the excess of revenue over all paid out costs including both manufacturing and overhead expenses. It is much similar to net profit. In economics, profit is called pure profit, which may be defined as a residual left after all contractual costs have been met, including the transfer costs of management insurable risks, depreciation and payment to shareholders, sufficient to maintain investment at its current level.

Profit is usually perceived as earnings and measured by subtracting costs from revenues. However, there are different types of costs: explicit and implicit. Explicit costs can be directly measured and expressed in monetary terms, for example, wages, rent, and utility costs. Implicit costs refer to the opportunity costs, that is, the cost of choosing one way to utilize the firm’s resources over another. Based on what costs are subtracted from revenues, economists distinguish between accounting and economic profit. Accounting profit is measured by subtracting explicit costs from the revenues, while economic profit is the difference between the firm’s total revenues and both explicit and implicit costs. Thus, one way to measure economic profit is to calculate explicit and implicit costs and subtract them from the revenue.

Therefore pure profit can be calculated with the help of following formula.

Pure Profit = Total Revenue – (explicit costs + implicit costs)

Economic or pure profit also makes provision for insurable risks, depreciation and necessary minimum payments to shareholders to prevent them from withdrawing their capital. Pure profit is considered to be a short-term phenomenon. It does not exist in the long run, especially under perfectly conditions. Because of this, they may either be positive or negative for a single firm in a single year.

Overall, economic profit is a concept that determines whether the business is economically successful. It serves as an important instrument for investors to assess how effectively the company uses its assets and contributes to a long-term increase in shareholders’ wealth. Therefore, another way to measure a company’s economic profit is by calculating the economic value added (EVA). To determine EVA, one should multiply capital invested by the weighted average cost of capital and subtract this product from the net operating profit after tax. All the elements necessary for calculating EVA can be retrieved from the information that is usually available in companies’ financial statements. This indicator not only shows the company’s true financial performance in terms of increasing shareholders’ wealth but also allows for comparing different companies and helps shareholders decide which firms to invest in.

The concept of economic profit differs from that of accounting profit. Economic profit includes the opportunity costs for taking one action versus another in the period. Economic profit is determined by economic principles, not by accounting principles. Economic profits recognize the implicit costs, those costs include cost paid to its suppliers for product ingredients, the general operating expenses, like salaries to factory managers and marketing expenses also the depreciation expenses related to investments in building and equipment and interest payments for borrowed funds. On the other hand, Accounting profit is the amount of money left over after deducting the explicit costs of running the business. Explicit costs are merely the specific amounts that a company pays for those costs in that periodfor example, wages. Typically, accounting profit or net income is reported on a quarterly and annual basis and is used to measure the financial performance of a company.

There are two schools or perspectives on where the main sources of economic profit come from. The Industrial Organization perspective assumes that the industry is definitive regarding the opportunities for the businesses’ economic profit since some industries are just more profitable than the others. This perspective utilizes Porter’s Five Forces theory which defines the critical elements of the industry that make it more or less profitable. Therefore, the most potentially profitable industries are characterized by high barriers to entry, low buyer power, low supplier power, a low threat from substitutes, and low levels of rivalry between existing firms.

Another school or perspective is called Resource-Based View or RBV. This approach implies that some businesses within one particular industry operate better than others due to their superior resources. From this perspective, the resources are defined as the tangible and intangible assets firms use to meet their goals and implement their business strategies. Examples of tangible resources are equipment, financial capital, and real estate; intangible resources are knowledge, brand, and organizational culture. Importantly, RBV assumes that resources are immobile or resistant to copying and transferring, whereas more valuable and rare resources lead to superior performance or the ability to bring above-average profit.

Thus, the sources of economic profit, both internal and external to the firm, were explained. Economic profit is something different from accounting profit since it covers opportunity costs related to the particular business. Internal economic profit resources are considered from the Resource-Based View, which implies that the companies with the rare and valuable resources can have superior performance. External economic profit resources are determined by the industry opportunities.

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