Types of Profit
In Nigeria, a typical market woman sells her goods for lets say #500,000, while she purchased the raw materials for #300,000. To her, she has made a profit of #200,000. Without the knowledge of management accounting, she does not know about the concept of contribution, accounting profit, economic profit and normal profit, fixed costs and variable costs.
I am writing this post specifically to discuss the concept of accounting profit, economic profit and normal profit. So to kick start the discussion let us take a look at what accounting profit is.
Accounting profit is the bottom line of an organization, while Sales or revenue is regarded as the top-line of the organization. After deducting expenses, interests and taxes, we derive the bottom line which is the accounting profit
Accounting profit can also be regarded to as net income, net profit or net earnings. Lets break down how accounting profit is derived. To get accounting profit, we take our total revenue and subtract all accounting costs from it. Accounting costs are explicit costs that represent actual payments for the resources the firm uses in producing its output. Accounting costs include interest costs and debt financing, but excludes payments made to equity owners as return on invested capital.
The formula for deriving accounting profit is simple. We say Accounting profit= Total revenue – Total accounting costs.
Lets now take an hypothetical example: A Nigerian woman owns a shop and sells frozen chickens. When calculating her accounting profit, we take into cognizance expenses such as electricity, costs of chicken, wages of the sales girl working for her, rent amongst a few.
So we have
Total revenue 500,000
Employee wages paid 50,000
Accounting Profit 230,000
Economic profit also referred to as abnormal profit goes a step further from accounting profit by subtracting implicit costs after deriving accounting profit. Implicit costs are the opportunity costs of resources supplied to the firm by its owners . Generally speaking, implicit costs are the opportunities forgone by the owner by staying in that business.
For private firms or small business owners, implicit costs may include the opportunity cost of the owner, supplied capital, entrepreneurial ability and the time he invests into the business. For public firms, implicit costs are the opportunity cost of equity owners’ investment in the firm.
The formula is Economic profit = Accounting profit – Implicit Accounting costs
Another hypothetical example is as follows: We take the details of the first example, but with some tweaks. Supposing Mrs Ayepe (the market woman) took a pay reduction of #15,000 per year, and at the start of the business invested #600,000 which could have earned a constant annual return of 10 % (#60,000) if she had invested the fund elsewhere.
From the question, we can deduce that the implicit costs are the #15,000 pay reduction, 10% return on #600,000 (#60,000).
Economic profit -= Accounting profit – Implicit opportunity costs
In the above example,
Economic profit = 230,000 – (15,000+ 60,000)
= 230,000 – 75,000
Normal profit is an economic condition whereby the total revenue and total cost equals zero. It is the accounting profit the firm must earn to just cove r the implicit opportunity costs. In the above analysis of economic profit, after the implicit costs were subtracted from the accounting profit, we got a positive number which is greater than zero (> 0). This represents abnormal profit which in essence is the economic profit. Economic profit encourages other firms to enter into the market because of their potential to gain a share of the profit.
Normal profit on the other hand just covers the implicit costs but no extra is made above covering the implicit costs . Firms with zero economic profit (normal profit) are still returning a competitive rate of return to the suppliers of debt and equity capital, paying competitive wages to their workers and also settling the top management for their entrepreneurial ability in running the business successfully. In economics, when the firms are earning zero economic profit (normal profit), they have no incentive to leave the industry, and because they are earning just about the required rate of return for investors, there is also no incentive for firms to enter the industry.
Let us take an example to re-iterate this. Supposing Mr chinedu, a dealer in motor car spare parts generates an average of #400,000 each year, he has two employees, each of which he pays #40,000 annually. Mr chinedu also takes an annual salary of #80,000, while paying an annual rent of #40,000 and #140,000 as cost of the spare part. After meeting a financial advisor, Mr chinedu discovers that if he had looked for a white collar job (based on his educational background) , he would have been earning an annual salary of #60,000.
We can calculate Mr chinedu’s annual explicit cost as #340,000 (40,000+40,000+80,000+40,000+140,000) and his annual implicit cost is #60,000, thereby making his total annual cost #400,000. Mr Chinedu’s annual total cost is equal to his annual total revenues. So we can say that Mr Chinedu’s Spare part business is in a state of normal profit.
Robert Pyndick., Daniel Rubinfield., Microeconomics (8th Edition)
Dominick Salvatore., Schaums outline of microeconomics
Paul Krugman., Robin wells., Microeconomics (4th edition)