UGC NET COMMERCE July 2018 Q15
- Option : A
- Explanation : The Meaning of Profit and Pure Profit
The meaning and source of ‘profit’ have always been a centre of controversy. “The word ‘profit’ has different meanings to businessmen, accountants, tax collectors, workers and economists...”. For example, ‘profit to a layman means all incomes that go to the capitalist class’. To an accountant, profit means the excess of revenue over all paid-out costs including both manufacturing and overhead expenses. For all accounting purposes, businessmen use accountants’ definition of profit.
For all practical purposes, profit or business income means profit in accountancy sense plus non-allowable expenses. Economist’s concept of profit is of ‘Pure Profit’ called ‘economic profit’ or ‘just profit’. Pure profit is a return over and above the opportunity cost, i.e., the income which a businessman might expect from the second best alternative use of his resources. These two concepts of profit are discussed below in detail.
Accounting Profit vs. Economic Profit
The two important concepts of profit that figure in business decisions are ‘economic profit’ and ‘accounting profit’. It will be useful to understand the difference between the two concepts of profit. As already mentioned, in accounting sense, profit is surplus of revenue over and above all paid-out costs, including both manufacturing and overhead expenses. Accounting profit may be calculated as follows:
Accounting profit = TR – (W + R + I + M + OC)
where,
W = Wages and salaries
R = Rent
I = Interest
M = Cost of materials
OC = Other paid out costs like electricity, transportation, etc.
Obviously, while calculating accounting profit, only explicit or book costs, i.e., the cost recorded in the books of accounts, are considered.
The concept of ‘economic profit’ differs from that of ‘accounting profit’. Economic profit takes into account also the implicit or imputed costs. The implicit cost is opportunity cost. Opportunity cost is defined as the payment that would be ‘necessary to draw forth the factors of production from their most remunerative alternative employment’. Alternatively, opportunity cost is the income foregone which a businessman could expect from the second best alternative use of his resources. For example, if an entrepreneur uses his capital in his own business, he foregoes interest which he might earn by purchasing debentures of other companies or by depositing his money with joint stock companies for a period. Furthermore, if an entrepreneur uses his labour in his own business, he foregoes his income (salary) which he might earn by working as a manager in another firm. Similarly, by using productive assets (land and building) in his own business, he sacrifices his market rent. These foregone incomes—interest, salary and rent—are called opportunity costs or transfer costs. Accounting profit does not take into account the opportunity cost whereas all these costs are taken into account while working out the economic profit.
In addition, it should also be noted that in working out economic or pure profit a provision is also made for (a) insurable risks, (b) depreciation, and (c) necessary minimum payment to shareholders to prevent them from withdrawing their capital. Pure profit may thus be defined as ‘a residual left after all contractual costs have been met, including the transfer costs of management, insurable risks, depreciation and payments to shareholders sufficient to maintain investment at its current level’.
Thus,
Economic profit = Total Revenue – (Explicit Cost + Implicit Cost)
In real life situation, if economic profit is greater than zero, one thing is certain that people will their money in business. However, in case economic profit is zero or insignificantly different from zero, people prefer to invest their money in business because it has a better future prospect in spite of risk involved.
