Meaning of Profit
Different people define profit differently. Profit means different things to different people, including business owners, accountants, tax collectors, workers, and economists, and it is frequently used in a polemical sense that obscures its true meaning. Profit is generally defined as income accruing to equity holders in the same way that wages accrue to labour, rent accrues to owners of rentable assets, and interest accrues to money lenders. Profit, in layman's terms, is the excess of income that flows to investors. Profit, according to an accountant, is the excess of revenue over all paid-out costs, including both manufacturing and overhead expenses. It is roughly equivalent to 'net profit.' Profit (or business income) means profit in the accounting sense plus non-allowable expenses for all practical purposes. Profit figures published by businesses are profits in accordance with the accounting concept of profit. Economists define profit as 'pure profit,' also known as 'economic profit' or 'just profit.' Pure profit is defined as a return that exceeds the opportunity cost, or the income that a businessman could expect from the second best alternative use of his resources.
Business versus Economic Profit
Profits are defined as the excess of revenue over the cost of production. Revenue is the income earned by a company from the sale of its output. There are two types of costs: explicit costs and implicit costs. Explicit costs are payments made to hired factors of production such as wages for hired labour, interest on borrowed capital, rent on land and buildings, expenditure on raw materials, and so on. These expenses are reflected in the firm's cash outlays. The opportunity cost of self-employed factors of production, on the other hand, is referred to as implicit cost. These costs are not reflected in the firm's cash outlays, but are associated with missed opportunities.
Economic profit is calculated by taking both explicit and implicit costs into account. Thus, economic profit is defined as the excess of total revenue over both explicit and implicit costs.
i.e. Economic Profit Revenue - (Explicit Cost + Implicit Cost)
The definition of the term profit itself is contentious. Profit is typically defined in terms of accounting concepts. Profit, as defined by accounting, is the residual of sales revenue less the explicit cost of doing business. Accounting profit is the total income available for ownership after all other factors used by the firm have been paid.
Accounting Profit = Revenue - Explicit Cost
Profit is also defined by accountants as the excess of revenue over the cost of doing business. However, economists believe that payments should be made for the entrepreneurial function, capital, and other factors supplied by the firm's owner in order to retain current employment. When calculating profit, economists also consider the normal rate of return on equity and the opportunity cost of self-employment. The normal rate of return on equity is the minimum rate of return required to attract and retain investment in a specific use. Similarly, an entrepreneur's opportunity cost is the opportunity cost of foregoing current activities. As a result, economists consider both cost and opportunity cost of self-employed factors of production.
Consider Ram, an officer at Prime Commercial Bank, who used to be paid Rs. 30,000 per month. He had deposited Rs 250,000 in a bank that pays 10% per year. With his money, he decided to start a bakery. His company produces 2000 bakery items per month at a cost of Rs 10 per unit. He must pay Rs 60,000 in rent and Rs 120,000 in salary to his employees. The following are the economic and accounting profits:
i. Total revenue = 20,000 × 10 =200,000
ii. Salary to assistant (-) = 120,000
iii. Rent (-) = 60,000
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Account profit = 20,000
iv. Interest foregone from bank =2,000
v. Salary foregone = 30,000
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Economic profit = 12,000
The account profit is Rs 20,000, but the economic profit is negative. This means Ram would earn Rs 12,000 more if he kept his job at Prime Bank instead of starting a business.
Implicit costs are critical and must be considered when calculating profit; otherwise, resources in the economy may not be allocated efficiently. An implicit cost in relation to a business firm in economics includes the cost of foregone alternative activities. Such costs are associated with the lost benefits of any single transaction when a company uses its own capital and employs itself as labour. Implicit costs or costs associated with missed opportunities are not reflected in the firm's cash expenditures. Any rational business economic decision making context must include implicit costs.
Sometimes economically unprofitable businesses are kept running because implicit costs are not understated. Rational decision making necessitates the consideration of all relevant costs, both explicit and implicit, in order to select the best alternative option. Economic profit, which accounts for both explicit and implicit costs, is a more useful management tool than accounting profit.
Functions of Profit
The sole goal of the firm, according to classical economists, is to maximise profit. Profit is the driving force behind every business. Profit always provides an incentive for a company to produce goods and services. Firm tries to reduce production costs by utilising new technology, search market for product to increase revenue, and maximise profit. Firms do not produce goods and services for the sake of producing them; rather, they produce to profit. Profit is simply the factor that motivates the producer to produce goods and services. Profit serves the following functions:
1.Higher profits are a signal that you should expand: Consumers want more of the firm's output. In the long run, high profits provide an incentive for firms to expand output and more firms to enter the industry. Lower profits or losses, on the other hand, indicate that consumers want less of the commodity. In such a case, the firm will be unwilling to expand.
2.To Ensure Future Capital: The firm may require additional capital in the future to expand production. A company's current profit may be used to purchase capital that will be needed in the future. If a company makes a profit now, it can put it into a reserve to meet future capital requirements. Profit earned today is thus useful for tomorrow.
3. To Attract New Investors: The firm may require new investors in the future to continue its growth. A new investor may play a dual role in the company. On the one hand, they bring capital, and on the other, they bring new ideas. As a result, the firm's capacity may be increased in the future with the addition of a new investor. New investors are only interested in investing in an existing firm when it is profitable. As a result, profit serves as an enticement for new investors.
4.Research and Development: Research and development necessitates a substantial investment. Firm must conduct research to develop new products and respond to market demand. Profit functions as a source of capital for research and development.
5. Risk Taking: A firm's future is uncertain. A new competitor could enter the market. The firm may lose a customer due to a change in the consumer's taste and preference. Similarly, future demand for the product may decrease due to a recession. If a company is not profitable, it cannot bear the risk. However, if the firm is currently profitable, it can bear the risk in the future. As a result, profit can withstand the risk that may arise in the future.
6. Profit plays a critical role in the operation of a free market economy. In a free market economy, businesses produce goods and services with the expectation of profit. In a free market economy, goods and services would not be produced if profit was not present.
7. Indicator of Success: Profit is a good indicator of the firm's status. If the company is profitable, it is said to be well-known. People will have a negative perception of a company if it is losing money.
