Profit and Theories of Profit – Explained!

In simple terms, profit refers to an income that flows to investors. In accountancy, profit implies excess of revenue over all paid-out costs.

In economic terms, profit is defined as a reward received by an entrepreneur by combining all the factors of production to serve the needs of individuals in the economy.

Profit in economics is termed as pure profit or economic profit or just profit.

Profit differs from the return in three respects namely:

i. Profit is a residual income, while return is a total revenue

ii. Profits may be negative, whereas returns, such as wages and interest are always positive

iii. Profits have greater fluctuations than returns

According to modem economists, profits are the rewards of purely entrepreneurial functions. According to Thomas S.E., “pure profit is a payment made exclusively for bearing risk. The essential function of the entrepreneur is considered to be something which only he can perform. This something cannot be the task of management, for managers can be hired, nor can it be any other function which the entrepreneur can delegate. Hence, it is contended that the entrepreneur receives a profit as a reward for assuming final responsibility, a responsibility that cannot be shifted on the shoulders of anyone else.”

Different people have described profit differently. Individuals have associated profit with additional income, revenue, and reward. However, none of the description of profit is said to be right or wrong; it only depends on the field in which the word profit is described.

On the basis of fields, profit can be classified into two types, which are explained as follows:

i. Accounting Profit:

Refers to the total earnings of an organization. It is a return that is calculated as a difference between revenue and costs, including both manufacturing and overhead expenses. The costs are generally explicit costs, which refer to cash payments made by the organization to outsiders for its goods and services. In other words, explicit costs can be defined as payments incurred by an organization in return for labor, material, plant, advertisements, and machinery.

The accounting profit is calculated as:

Accounting Profit= TR-(\V + R + I + M) = TR- Explicit Costs

TR = Total Revenue

W = Wages and Salaries

R = Rent

I = Interest

M= Cost of Materials

The accounting profit is used for determining the taxable income of an organization and assessing its financial stability. Let us take an example of accounting profit. Suppose that the total revenue earned by an organization is Rs. 2, 50,000. Its explicit costs are equal to Rs. 10,000.

The accounting profit equals = Rs. 2, 50,000-Rs. 10,000 = Rs. 2, 40,000. It is to be noted that the accounting profit is also called gross profit. When depreciation and government taxes are deducted from the gross profit, we get the net profit.

ii. Economic Profit:

Takes into account both explicit costs and implicit costs or imputed costs. Implicit cost implies the income that is foregone which an entrepreneur can gain from the next best alternative use of resources. Thus, implicit costs are also known as opportunity cost. The examples of implicit costs are rents on own land, salary of proprietor, and interest on entrepreneur’s own investment.

Let us understand the concept of economic profit. Suppose an individual A is undertaking his own business. He can work as a manager in an organization. In such a case, he sacrifices his salary as a manager because of his business. This loss of salary will be an opportunity cost for him from his own business.

The economic profit is calculated as:

Economic profit = Total revenue – (Explicit costs + implicit costs)

Alternatively, economic profit can be defined as follows:

Pure profit=Accounting profit – (opportunity cost + unauthorized payments, such as bribes)

Economic profit is not always positive; it can also be negative, which is called economic loss. Economic profit indicates that resources of a business are efficiently utilized, whereas economic loss indicates that business resources can be better employed elsewhere.

Now, let us discuss different theories of profit which are given below.

1. Innovation Theory of profit:

Joseph Schumpeter propounded a theory called innovation according to which profits are the reward for innovation. He advocated that innovation is the introduction of a new product, new technology, new method of production, and new sources of raw materials. This helps in lowering the cost of production or improving the quality of production. Innovation also includes new policy or measure by an entrepreneur for an organization.

In general, innovation can take place in two ways, which are as follows:

i. Reducing the cost of production and earning high profit. The cost of production can be reduced by introducing new machines and improving production techniques.

ii. Stimulating the demand by enhancing the existing improvement or finding new markets.

According to innovation theory, profit is the cause and effect of innovations. In other words, it acts as a necessary incentive for making innovation.

Schumpeter’s innovation theory is criticized on two aspects, which are as follows:

i. Ignores uncertainty as a source of profit

ii. Denies the role of risk in profit

According to Stigler, “These profits may exist for a considerable time because of the ignorance of other firms of their (innovations) existence or because of the time required for the entry of new firms. More important, the successful innovator can continuously seek new disequilibrium profits since the horizon of conceivable innovations is unlimited.” The innovation theory of profit is criticized because in innovation theory, uncertainty and risk that is the major source of profit has been ignored.

2. Uncertainty Bearing Theory:

The uncertainty-bearing theory of profits, which was propounded by Prof. Knight. According to the theory, profit is a reward for the uncertainty bearing and not the risk taking. Knight divided the risks into calculable and non-calculable risks.

Calculable risks are those risks whose probability of occurrence can be easily estimated with the help of the given data, such as risks due to fire and theft. The calculable risks can be insured. On the other hand, non-calculable risks are those risks that cannot be accurately calculated and insured, such as shifts in demand of a product.

These non-calculable risks are uncertain, while calculable risks are certain and can be anticipated. According to Knight, “risks are foreseen in nature and can be insured”. Thus, risk taking is not a function of an entrepreneur, but of insurance organizations. Therefore, an entrepreneur gets profit as a reward for bearing uncertainties and not for risks that are borne by insurance organizations.

The theory of uncertainty bearing is criticized on the following grounds:

i. Assumes that profit is the result of uncertainty bearing ability of an entrepreneur, which does not always hold true. The profit can also be the reward for other aspects, such as strong co-ordination and market share.

ii. Fails to show any relevance with the real world.