Information about Normal Profit

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 retail sales price and the costs of acquisition (whether by harvest, extraction, manufacture, or purchase). A key difficulty in measuring either definition of profit is in defining costs. Accounting profit may be positive even in competitive equilibrium when pure economic profits are zero.

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 is 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 recognised 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 is 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.^[1] 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 = marginal cost at the profit-maximizing position. Since normal profit is economically a cost, there is 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 output multiplied by the difference between the average cost and the price.

Economic profit does not 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 rents.

The social profit from a firm's activities is the normal profit plus or minus any externalities that occur in its activity. A polluting oil monopoly may report huge profits, but by doing relatively little for the economy and damaging the environment. It would exhibit high economic profit but low social profit.

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 and amortization tend to be ambiguous. Within US business, the preferred term for profit tends to be the more ambiguous income.^[2]

Gross profit is profit before Selling, General and Administrative costs (SG&A), like depreciation and interest; it is 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:

• Abnormal profit (or supernormal profit)
• Subnormal profit
• monopoly profit (super 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 cannot be easily duplicated by other firms.

References

• Albrecht, William P. (1983). Economics. Englewood Cliffs, New Jersey: Prentice-Hall. ISBN 0132243458
• Böhm-Bawerk, E, (1959) Capital and Interest, Libertarian Books edition (3-volume set)
• Pyle, William W., and Kermit D. Larson (1981). Fundamental Accounting Principles. Homewood, Illinois: Richard D. Irwin. ISBN 0256023867

Notes

See also

• Comprehensive income
• Consumer surplus
• Economic Value Added
• Externality
• Gross profit
• Income
• Net profit
• Profitability
• Rate of profit
• Superprofit
• Surplus-value
• Tendency of the rate of profit to fall

External links

• Measuring the Long-Run Profitability of the Firm, Salmi - Virtanen (1997)
• Profit and Loss, Ludwig von Mises (1951)
• Entrepreneurial Profit and Loss, Murray Rothbard's Man, Economy, and State, Chapter 8.