CFA® Program Curriculum, Volume 2, page 97 Accounting Profit
Accounting profit may be referred to as net income, net profit, net earnings, or the bottom line (of the firm’s income statement). It is equal to total revenue less all accounting costs. Accounting costs are explicit costs that represent actual payments for the resources the firm uses in producing its output. Accounting costs include the interest cost on debt financing but not any payments to the firm’s equity owners as a return on their invested capital.
accounting profit = total revenue — total accounting (explicit) costs
Example: Calculating accounting profit
Given the following financial information for the most recent accounting period, calculate the accounting profit for Patrick’s Surfboard Company:
Account Amount
Total revenue $340,000
Expenses
Fiberglass $100,000
Electricity 30,000
Employee wages paid 55,000
Interest paid on debt 5,000
Answer:
total accounting (explicit) costs = $100,000 + $30,000 + $55,000 + $5,000
" = $190,000
accounting profit = total revenue - accounting (explicit costs)
= $340,000-$190,000 = $150,000
Economic Profit
Economic profit is also referred to as abnormal profit. It is equal to accounting profit less implicit costs. Implicit costs are the opportunity costs of resources supplied to the firm by its owners. For private firms, these costs may include the opportunity cost of owner- supplied capital and the opportunity cost of the time and entrepreneurial ability of the firm’s owners. For publicly traded firms, implicit costs are typically only the opportunity cost of equity owners’ investment in the firm. Total economic costs include both implicit and explicit costs.
economic profit = accounting profit - implicit opportunity costs or
economic profit = total revenue - total economic costs Example: Calculating economic profit
Study Session 4 Answer:
economic profit = accounting profit - implicit opportunity costs
= $150,000 - ($50,000 + $60,000) = $40,000
Note that entrepreneurs typically earn payment or compensation in the form of profit.
Note also that economic profit is lower than the accounting profit. This is because an economic profit considers both explicit and implicit costs.
Example: Economic profit for a firm
RideRight, Inc., a publicly traded company, reported $450,000 of revenue, $400,000 in expenses, and $500,000 in equity capital for the most recent accounting period. The required rate of return on RideRight’s equity is 10%. Calculate RideRight’s economic profit.
Answer:
For publicly traded companies, it is assumed that the cost of equity capital is the largest implicit/opportunity cost:
economic profit = accounting profit - cost of equity capital
= ($450,000 - $400,000) - (0.10 x $500,000) = $0
RideRight’s accounting profit just covered the cost of equity capital.
Normal Profit
Normal profit is the accounting profit that makes economic profit zero. It is the accounting profit that the firm must earn to just cover implicit opportunity costs. Given this definition, it follows that:
economic profit = (accounting profit - normal profit) = 0
When accounting profits exceed implicit opportunity costs, economic profit is positive and we have:
economic profit = (accounting profit - normal profit) > 0
When accounting profits are less than implicit opportunity costs, economic profit is negative and we have:
economic profit = (accounting profit - normal profit) < 0
The important thing to remember is that an economic profit of zero is what we expect in equilibrium. That’s why economic profits are called abnormal profits. Firms with zero economic profit are covering all the costs of production, both explicit and implicit.
Firms with zero economic profit are returning a competitive rate of return to the suppliers of debt and equity capital, paying competitive wages to their workers, and compensating top management for the opportunity cost of their entrepreneurial talent.
In economics, when firms are earning zero economic profit, they have no incentive to leave the industry, and because they are just earning their required rates of return, there is no incentive for firms to enter the industry either.
With reference to RideRight, economic profit is zero, and accounting profits are
$50,000, so normal profit must be $50,000.
With reference to Patrick’s Surfboard Company, accounting profit is $150,000, and economic profit is $40,000, so normal profit = $150,000 — $40,000 = $110,000.
Economic Rent
Economic rent is used to describe a payment to a factor of production above its value in its next highest-valued use (its opportunity cost). Economic rent has been defined variously in the literature, but “the payment to a resource in excess of the minimum payment to retain resources in their current use” is fairly representative. Alternatively, we can think of economic rent as the portion of a payment to a resource that does not increase the quantity supplied. If we think of a supply curve as the marginal opportunity cost of an input, a perfectly inelastic supply curve would indicate that any payment to the factor is greater than its opportunity cost and would be economic rent. In the case of a perfectly elastic supply curve for a factor, there is no economic rent. We illustrate both of these cases in Figure 1.
The term rent is used to describe payments for the use of land for just this reason.
The supply of land (think Manhattan Island) is fixed, so that supply is inelastic, and a higher price does not increase the quantity supplied. The supply of certain other factors of production may be inelastic because of government restriction (e.g., patents and copyrights) or because the natural supply is limited (oil and gold). When resources owned or otherwise employed by the firm generate economic rents, the firm earns economic profits as a result because total revenues exceed the sum of explicit and implicit costs. Firms that earn economic profits attract competition, but if the firm’s resources are very difficult to replicate and produce accounting profits in excess of opportunity costs, the firm will continue to earn rents. Consider a company that owns a gold mine when the price of gold in the world market rises sharply. As its gold is in fixed (or almost fixed) supply, the price increase will generate rents to this factor, and the firm’s economic profit will rise as a result. The abnormal profits of the firm will attract
Study Session 4
Figure 1: Economic Rent to Factors of Production
(a) Perfectly elastic supply (b) Perfectly inelastic supply
Price No Price
Comparing Measures of Profit
In the short run, the normal profit for a firm may be considered fixed. In the long run, it will vary with the required rate of return on equity investments. However, because accounting profit is often highly variable in both the long run and the short run, economic profit is highly variable in both the short run and long run as well.
Normal profit is a minimum requirement for a firm to continue operating in the long run. A firm unable to earn a normal profit (a firm with negative economic profit) will find it more difficult to raise equity capital, and the value of its equity in the market is likely to decline. Overall, earning a positive economic profit will increase the value of a firm’s equity, and negative economic profit will decrease the value of a firm’s equity.