Types of Profit

Imagine that you left a job that paid $100,000 per year to start a company as a sole proprietorship, and at the end of the year your company brought in $200,000 and had expenses of $150,000. Did you make a profit? It seems like a straightforward question, but the answer depends on who you ask! An accountant would say you brought in $200,000 and spent $150,000, so you made a profit of $50,000! But look what you had to turn down. Did you know that accountants and economists have two distinctly different definitions of profit? Well they do! Which one matters most to you? Which one do you think matters most to firms? Read on to find out more about them...

Overview of Types of Profit in Economics

Most firms want to make a profit, among other things. But arguably, most of these other things are aimed at increasing profit, so let’s focus on profit. So, what is profit? Profit is all the money made by the firm minus all the money spent by the firm. Let’s look at the standard definition of profit in economics.

Mathematically, this is written as:

$Profit=TR-TC$

The definition of profit mentions total revenue and total production cost. What are these? The total revenue is all the money acquired from selling the firm’s products at a given price. Total cost, on the other hand, refers to all the costs incurred during production.

Mathematically, this is written as:

$TR=P\times C$

As mentioned in the definition of total revenue, price refers to the monetary value for which the product is sold, whereas quantity refers to the number of units of the product sold by the firm.

Now, you should keep in the back of your mind that there are two types of profit. These are accounting profit and economic profit. To help you understand the distinction between the two, let’s look at implicit and explicit costs, which are the two types of costs.

Let’s explain implicit cost and explicit cost with an example.

First, there is an explicit cost, which refers to the amount of money paid directly as fees for enrolling in the master’s program.

Second, there is an implicit cost, which refers to the amount of money the student would have made by finding a job instead of continuing school.

Types of Profit: Accounting Profit vs Economic Profit

Let’s consider the example of a coffee processing company to understand the different types of profit.

From this, we can now see that accounting profit considers both explicit costs and depreciation.

$AccountingProfit=TotalRevenue\left(TR\right)-ExplicitCost\left(EC\right)-Depreciation\left(D\right)$

This means the accounting profit of the coffee processing company is $\$10,000-Depreciation$

For economic profit, looking at the same example, if the coffee processing company contemplates whether to keep running the business or open another business, opportunity cost comes into the picture. This is because the company must consider the total revenue, the implicit costs, and the explicit costs.

Implicit costs can include opportunity cost not just of the equipment or machinery, but also of the founder's time. Implicit costs can also include the cost of incurring risk, since starting up a new company can be very risky.

Economic profit is different from accounting profit because the accounting profit does not consider the implicit costs incurred by the business. Thus, generally speaking, the inclusion of implicit costs will make the economic costs higher than the accounting cost. As a result, economic profit is usually lower than accounting profit.

Why is implicit cost important? Because there is a limited amount of resources, and the decision to own equipment or even operate a given business means that the firm does not have enough resources to operate other businesses (where there are other benefits).

Looking at this, it becomes clear that the firm actually responds to economic profit, rather than accounting profit. This is because when there are alternatives, the company must make sure that it is putting its resources into the best alternative. Look at the example below.

Figure 1 summarizes the types of profit.

Types of Profit: Definition of Normal Profit

There is another term that economics use, and it is normal profit. A firm makes a normal profit when the firm's economic profit is zero, and the firm is just breaking even. Economists tend to believe that in the long run, due to competitive pressures, firms can only make a normal profit and no more.

Types of Profit: Formula for Economic Profit

So, what is the formula for economic profit? Economic profit considers the total revenue, implicit cost, and explicit cost in the following formula:

Here's a visual illustration of the formula in Figure 2.

Types of Profit: Economic Profit Calculation

Let’s calculate economic profit from the example below using the formula:

In this example, the total revenue is $20,000, explicit cost is $10,000, and implicit cost is $5,000.

Therefore, $EconomicProfit=\$20,000-\$10,000-\$5,000=\mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{000}.$

Types of Profit: Accounting Profit Formula

Accounting profit looks at the total revenue, the explicit cost, and depreciation. So, what is the formula for accounting profit? It is as follows:

$AccountingProfit=TotalRevenue-ExplicitCosts-Depreciation$

Let’s calculate accounting profit from the example below using this formula.

In this example, the total revenue is $20,000, explicit cost is $10,000, and depreciation is $2,000.

Therefore, $AccountingProfit=\$20,000-\$10,000-\$2,000=\mathbf{\$}\mathbf{8}\mathbf{,}\mathbf{000}.$

The accounting profit formula is illustrated in Figure 3.

Types of Profit: Economic Profit and Accounting Profit Examples

Economic profit is the total profit after taking out all costs of production and all the benefits forgone by not using the firm’s resources for alternative purposes. For example, a corn processing company subtracts the cost of processing and packing the corn as well as the benefit it would have gained by choosing to process an alternative product.

Accounting profit, on the other hand, is the total profit after taking out all costs of production and depreciation on equipment. For example, if that same corn processing company uses processing machinery that it owns, rather than rents, then those machines reduce in value after one year of use. This reduction in value is then taken into consideration as depreciation when calculating accounting profit for the corn processing company.

Congrats! You have reached the end of this article. To know the things firms spend on as part of production costs, read our article on Factor Markets.