Profit

From Wikipedia, the free encyclopedia

Profit, from Latin meaning "to make progress", is defined in two different ways. Under capitalism, profit is a positive return made on an investment by an individual or by business operations. Under the Marxist definition it is a mechanism of class exploitation, where surplus value is extracted by capitalists from their workers and suppliers beyond the point where costs are covered.

Under capitalism, methods of calculation differ between accountants and economists. Often, it is the difference between retail sales price and the costs of manufacture. However, the term is also used more generally to refer to the value added after all the factors of production have been credited their full opportunity cost.

The profit motive—enterprises being free to make as much profit as they can given market conditions—is regarded by capitalists to be a good thing. It is held to give firms incentives for allocative efficiency and technical efficiency. This idea is a corollary of the theorems of welfare economics and utility maximization. However, profits can include economic rents, which do not produce efficiency. For instance, a monopoly can have very high profits but produce less economic welfare. Classical economists use profits to measure the happiness/utility/general welfare, gained by society, and understand that high profits demonstrate the high value of the factors used in the production of such goods.

Economic definitions of profit

Note: these definitions are different from those used by accountants

In economics, a firm is said to be making an economic profit when its revenue exceeds the total opportunity cost of its inputs. It is said to be making an accounting profit if its revenues exceed the total price the firm pays for those inputs.

In a single-goods case, 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 total cost and the price.

(In circumstances of perfect competition, average cost = marginal cost at the profit-maximizing position)

All enterprises constitute investments by their owners of capital. The return to owners' capital under competitive competition is the accounting profit and compensates the owner for not being able to make alternative use of their capital. It is the opportunity costs of a venture.

The accounting profit sometimes 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. In these cases, economists treat returns to risk as part of the accounting profit, as it is also an element of the cost of capital.

Economic profit does not occur in perfect competition, at least not in the long run. Once risk is accounted for, long-lasting economic profit is thus viewed as an inefficiency caused by monopolies or some form of market failure.

Economic profit is sometimes referred to as supernormal profit (also supra-) and accounting profit as normal profit.

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 be 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 like as wages, rent, fuel, raw materials, interest on loans and depreciation. 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 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.

Some economists define further types of profit:

• Abnormal (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.

More varieties of 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.

See also

• Gross profit
• Net profit
• Consumer surplus
• Economic Value Added
• Income
• superprofit
• surplus-value
• rate of profit
• 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.