What is Profit? | Firm | Economics

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The businessperson produces goods and services for his customers with the hope of earning a profit by efficient operation. A profit in the business sense is the difference between the selling prices of a good (or service) and its total cost.

Different views:

Profit in an economic sense differs from profit in a business sense. In economics, profits are what is left-over after paying for land, labour and capital. Economic profit is the excess of total revenue of an enterprise over its total costs, which are the sum of the rent paid for land, wages paid to all employees and the interest paid for capital.

The economist first deducts as a cost interest rate required to secure the use of all capital where there is relatively no risk. The businessperson includes as a cost only the interest paid on borrowed capital. He includes, as part of his profits, the return on the capital that he provides.

In economies, this return is called normal profit. Any return above this is called pure (net) profit. This is economic profit, which excludes implicit cost. But accounting profit in­cludes implicit cost. Therefore, economic profit is less than monopoly profit. Confusion is certain to arise unless the different uses of the word ‘profit’ are kept in mind.

Profits in economics is usually seen as the return to ownership of capital and the return to the entrepreneur. Where ownership and entrepreneurship coincide as in a single proprietorship in which the owner’s own capital is used to run the firm, this notion perhaps has some meaning.

Most modern firms, however, are not of that type. Capital is extensively borrowed and most owners of equity have little to do with plant management or entrepre­neurship. In practice, separate returns to ownership, management and entrepreneurship are difficult to identify.

Where capital is partly owned and partly borrowed, accounting conven­tions denote a return to borrowed capital as interest while including return to the owned capital as profit. Where owners work in managing their firm, the value of their labour of management services is usually included in profit (called normal profit which is the opportunity cost of the entrepreneurship), except to the extent that owners formally pay themselves salaries.

In fact, there are various concepts of profit. This include profits reported by public companies to their shareholders, often called, financially reported earnings; profits reported on corporate income tax returns; profits data reported in analyses of the stock market, such as earnings per share for widely followed stock market indices; and profits measures included in the national income and product accounts used to calculate gross domestic product. All these measurements have their own deficiencies. Different measures are used for different kinds of analyses. These measures are discussed below.

The profit margin:

This notion of profits refers to the difference between the cost price and the selling price per unit. This is the kind of relationship found in the business world.

For example, suppose cost price is 50p and selling price is 55p. So, profit is 5p.

a percentage profit = 5/50 x 100/1 = 10 %

A percentage return on turnover:

In the previous example profit was expressed as a percentage of the cost price. It is a very common business practice to calculate profit as a percent­age of total sales revenue.

For example, sales revenue = Rs 1,50,000/Rs10,00,000 x 100/1 = 15%

This is a very useful view of profit to the trader, because the sales figure is the one which is most immediately available to him, and he can assess the movements in his profits on a day to day basis.

A rate of return on capital employed:

In this case, the profit is expressed as a percentage yield on the value of capital employed in the business.

For example:

Suppose, sales receipts are Rs 10, 00,000; total costs are Rs 8, 00,000; capital Rs 2, 00,000; and profit Rs 2, 00,000. Here,

Return on capital = Rs 2,00,000/Rs 12,00,000 x 100/1 = 16.66%

Economists are concerned with profit as an income and not as a percent­age differential on individual transactions. The most relevant view of profit is that of a return on the capital employed, because it is this measurement which enables profit to serve as an important indicator to potential inves­tors.

In any discussion of profit it is important to be aware of the particular view of profit which is being employed. A crude rate of profit can be very misleading. As an example, we may now consider two firms, one making a very small profit on each unit sold, but having a large turnover, the other making a large profit on each unit, but having a small turnover. Each firm has the same amount of capital employed in the business. Profit margins are expressed as percentages of the selling prices.

Firm A:

Capital employed Rs 10, 00,000; Sales Rs 50, 00,000; Profit margin 5% and Profit Rs 2, 50,000.

a Return on capital employed = (Rs 2,50,000/Rs 10,00,000) x (100/1) = 25%

Firm B:

Capital employed Rs 10, 00,000; Sales Rs 5, 00,000; Profit margin 20% and Profit Rs 1, 00,000.

b Return on capital employed = (Rs 1,00,000/Rs 10,00,000) x (100/1) = 10%.

Although Firm B is operating with a profit margin four times as great as Firm A, the return on its capital is very much less than that earned by Firm A. This example should help us to understand why firms which carry large stocks in order to provide a wide choice, such as jewellers and ladies’ fashion shops, have much larger profit margins on the goods they sell than do supermarkets. In the case of the jewellers and fashion houses, the stock ‘turns over’ very slowly whereas in the supermarket the stock ‘turns over’ very quickly.

From this discussion, it should be quite clear that profit and capital are inter-related and interdependent.

Theories and Sources of Profits:

One the basis of the work done by two great classical economists of English origin, viz., N. Senior and J.S. Mill, the great American economist Francis L. Walker developed the rent theory of profit. According to the theory, profit is the rent of ability. Rent arises due to differences in the fertility of the soil. Similarly profit arises due to differences in the ability of entrepreneurs.

According to Ricardo, rent on superior land is determined by the differences in the productivity of the marginal and super-marginal lands. Similarly, according to Walker, the profit of the superior entrepre­neurs (or, rent of ability) is determined by the difference in the ability of the marginal and super-marginal entrepreneurs. Just as there is marginal land in Ricardo’s theory, there is marginal entrepreneur or no-profit entrepreneur.

The marginal entrepreneur gets only marginal wage. He does not derive any extra income in the form of profit. He is a high cost producer. So, the market price of his product is exactly equal to his cost of production. His cost of production thus does not include profit. However, the profit of the super-marginal entrepreneur can be measured on the basis of the performance of the marginal entrepreneur.

In Ricardo’s theory the price of corn is deter­mined by the cost of production of the marginal entrepreneur. Similarly, in Walker’s theory the market price of the product is determined by the cost of production of the marginal entrepreneur. Thus, like rent, profit does not enter into price.

Criticisms:

Walker’s theory is not quite satisfactory.

It has been criticised on the follow­ing grounds:

1. First, profit is akin to rent because both are surplus income. But they are not exactly the same. Rent can at best zero (as on marginal land) but not negative. But, profit can be negative. Negative profit is known as loss.

2. Secondly, profits may arise due to chance factors. The entrepreneur often makes windfall gains. It may arise due to chance factors. It may also arise due to frictions and monopoly. So, it is not necessarily the reward of business ability.

3. Thirdly, there can be no-rent land. But, in practice, it is difficult to find out a no-profit entrepreneur. If an entrepreneur is not able to make any profit he will transfer his capital elsewhere for getting a better return.

4. Fourthly, profit must enter into price, at least in the long run. It is because what is surplus income in the short run is very much a necessary income in the long run. So, it is wrong to say that like rent profit does not enter into price. If an entrepreneur continues to incur losses he leaves the industry in the long run.

5. Fifthly, Walker has traced out only one source of profit. But, there are other sources of profit as well.

6. Sixthly, Walker has misunderstood the true meaning and nature of profit. According to him, profit, arises because the entrepreneur has to take risk. Critics point out that an efficient entrepreneur can avoid risk through his superior skill and ability. In this sense profit is not the reward for the avoidance of risk.

7. Finally, the theory fails to explain profits in a joint stock company. In such a company shareholders get return on their capital in the form of dividend. Such dividend income has no relation with any business acumen or ability.