Accounting Profit
We generally look at profits from accounting perspective. From the
perspective of an accountant,
profit is the difference between total
revenue and total actual expenses incurred by the firm’s actors of
production.
These are the explicit costs incurred by the firm. Explicit costs are the monetary payments to resource owners.
Accounting Profits = Total Revenue – Explicit Costs
Let’s say the company earned a total revenue of $100,000, and
their
explicit costs such as raw material cost, labour cost, etc., were
$80,000.
The company’s accounting profit will be:
Accounting Profit = 100,000 – 80,000 = $20,000
Economic Profit
Economists on the other hand have a different view of what
constitutes profits.
They not only consider the explicit costs but also
implicit costs (opportunity cost).
Implicit costs are the returns foregone by not taking owners’ resources to market.
Economic Profit = Total Revenue – Explicit Costs – Implicit Costs
Let’s continue with our example.
If the owners had invested this
money elsewhere they would have earned $10,000 on it.
This is the implicit cost. The economic profit will be calculated as follows:
Economic Profit = 100,000 – 80,000 – 10,000 = $10,000
Economic profit is also called abnormal profit.
Normal Profit
Note that the difference between the accounting profit and economic
profit is the implicit costs.
This is the normal profit, i.e., the opportunity cost of the resources supplied by a firm’s owners.
Normal Profit = Accounting Profit – Economic Profit
In other words, we can say that normal profit is the accounting
profit that makes economic profit zero.
In our example, if accounting profit was 10,000, then economic profit would be zero.
A firm aims at earning positive economic profits. If accounting
profits are greater than implicit costs,
the firm would earn a positive
economic profit and should stay in the business.
If accounting profits
are less than implicit costs,
the economic profit would be negative and in such a situation the firm should exit the business.
In equilibrium we have zero economic profit, i.e., the firm is
covering all implicit and explicit costs
and both debt holders and equity holders are earning their required rate of return.
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