Profit
Profit is fundamentally understood as a financial gain, occurring when a company's earnings exceed its expenditures. In capitalist systems, the primary objective for businesses is to generate profit by selling goods or services. Profit can be categorized into different forms, with accounting profit—also known as net income—being the most commonly referenced; it is calculated by subtracting explicit costs from total revenue. Explicit costs include expenses like wages and rent, while costs can further be divided into fixed and variable categories. Another important concept is the profit margin, which measures a company's financial health as the ratio of profit to revenue, expressed as a percentage.
Economists differentiate between accounting profit and economic profit, with the latter accounting for both explicit and implicit costs, reflecting the potential earnings lost from alternative opportunities. A business may show accounting profit while still facing economic loss if the implicit costs outweigh its earnings. Furthermore, not all organizations aim for profit; nonprofits operate to provide public benefits, with any surplus reinvested into their programs rather than distributed to owners. Understanding these distinctions can provide deeper insights into the financial dynamics of various organizations and their operational goals.
Profit
Profit is defined as a financial gain. If a company is earning more money than it is spending, it is profitable. If a company spends more money than it earns, then it suffers a loss. In capitalist societies, the goal of most businesses is to make a profit. In fact, a business, by definition, is an organization that intends to make a profit by selling goods or services.
A company’s profit belongs to the owners of the business. The business owners can do what they choose with the profits. They can put the money back into the business to create more products and provide more services, or they can keep the money and benefit from it personally.
Accounting Profit
When most people use the term profit, they are referring to accounting profit. Accounting profit, also called net income, is a company’s total revenue minus explicit costs. Revenue is the amount of money that a company earns by selling products or services. Explicit costs, or expenses, are costs that the company pays to run the business, such as wages and office supplies.
Costs are divided into two categories: fixed costs and variable costs. Fixed costs are those that do not vary, such as rent, salaries of full-time employees, and insurance. Variable costs increase or decrease depending on the number of items the company creates or sells, or the amount of services it provides. Examples of variable costs are product packaging, transportation costs, and wages of part-time employees.
Income Statements
Profit is usually determined for a certain period, such as one quarter or one year. An income statement lists a company’s revenue and expenses for that period. The income statement is then used to calculate net income, or profit.
For example, an income statement for the East Side Flower Shop would include the following information: revenue $300,000.00; salaries $65,000.00; wholesale flowers $120,000.00; rent $24,000.00; utilities $3,500.00. Its total expenses (salaries, whole flowers, rent, and utilities) equal $212,500.00.
To find the profit (net income) for the flower shop, use the formula for accounting profit.
Accounting Profit = Revenue – Explicit Costs
Accounting Profit = $300,000.00 – $212,500.00
Accounting Profit = $87,500.00
The East Side Flower Shop had a profit of $87,500.00.
Profit Margin
Profit margin is a measure that is used to gauge the financial health of a business. It is defined as the ratio of profit to revenue. Profit margins are expressed as percentages. This percentage shows what part of every dollar the business actually keeps. Profit margin is the ratio of profit (net income) to revenue.
The following example shows the profit margin for East Side Flower Shop.
Profit Margin = Net Income ÷ Revenue
Profit Margin = $87,500.00 ÷ $300,000.00
Profit Margin = 0.291666
The profit margin for East Side Flower Shop is about 29%.
Accounting Profit vs. Economic Profit
Economists define profit differently. Economic profit is similar to accounting profit, but economic profit subtracts both explicit costs and implicit costs from revenue. Implicit costs have no direct payment. They are costs associated with missed opportunities—choices made by a business.
For example, the owner of a chain of clothing stores might have one store that is performing poorly financially. The owner could invest time in that store or close it. If he or she chooses to invest time in that store but could earn more money by closing it, then the time spent working on the store is an implicit cost. The implicit cost associated with the best possible business choice is called the opportunity cost.
As another example, an entrepreneur left a full-time job to start a business. An economist would consider the salary from the business owner’s previous full-time job an implicit cost of opening the new business. If the owner had continued working at that job, he or she would still have that salary. Therefore, if the first year’s accounting profit for the new company is $40,000, but the owner left a job with a $65,000 salary, the new company would suffer an economic loss of $25,000.
Economic profit is a better measure for the overall value of a business than accounting profit. Opposed to just looking at the bottom line (a company's profits or losses), a business owner can use economic profit to make more informed business decisions.
Because economic profit is accounting profit minus implicit costs, economic profit is always less than or equal to accounting profit. Economic profit and accounting profit are only equal if the implicit costs are zero. It is even possible for a business to have an accounting profit and an economic loss. For example, say that a business has an accounting profit of $100,000. If that business owner could have earned a greater profit by pursuing another business opportunity, then the business has an economic loss.
Nonprofits
A nonprofit organization (NPO), also called a not-for-profit, is an organization that does not exist to make a profit. The goal of a nonprofit organization is to provide programs or services for the benefit of the public. A profit earned by a nonprofit is called a surplus. This surplus may not benefit the leaders of the nonprofit. Any surplus earned must be invested back into the organization for future programs and services.
Bibliography
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