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Normal Profit

The total revenues of a company are equal to the total costs in a perfectly competitive market

What is Normal Profit?

Normal profit is an economic term that refers to a situation where the total revenues of a company are equal to the total costs in a perfectly competitive market. It means that the company makes sufficient revenues to cover the overall cost of production and remain competitive in its respective industry. When a company reports a normal profit, it means that its economic profit is equal to zero, which is the minimum amount that justifies why the business is still in operation.

 

Normal Profit

 

When measuring the normal profit of a company, we consider the opportunity cost of using the resources elsewhere. If a company reports a normal profit, it means that the compensation it receives for remaining in business is higher than the opportunity cost that it loses by using the resources to produce the good. However, a company is said to incur losses if its compensation is lower than the opportunity cost lost to produce the good.

 

Summary

  • Normal profit is the minimum compensation that justifies a company, and it occurs when the total revenues equal the total costs.
  • It includes both the implicit costs and explicit costs, and the opportunity costs of foregoing the next best alternative.
  • Normal profit occurs when the economic profit of a business is equal to zero.

 

Normal Profit vs. Economic Profit

When calculating normal profit, we consider the total revenues and total costs, where the latter includes implicit and explicit costs. Implicit costs refer to the opportunity cost of factors of production that the company already owns, and that it must give up to utilize its resources.

On the other hand, explicit cost refers to the actual expenses that a company incurs towards labor wages, landowner rent, raw material cost, and other expenses. Explicit cost is easy to quantify, whereas implicit cost is not easily quantifiable.

Normal profit occurs when economic profit is zero, or when the total revenue of a company equals the sum of implicit cost and explicit cost. It is the point where the business utilizes all the available resources efficiently, and the compensation is higher than the opportunity cost lost to produce the product.

If implicit costs take up a majority of the total costs, the normal profit will be the minimum threshold of earnings that the company must earn to stay in business. Although normal profit equals to zero, it does not mean that the company is making zero profits. Rather, it compares how well the company utilizes its resources to generate revenues.

Economic profit is the difference between total revenues and the total costs of a business, where the total cost includes both explicit and implicit costs. Economic profit can be either a positive value, zero value, or a negative value.

Economic profit is positive when the compensation earned is greater than the normal profit, and it creates an incentive for other companies to enter the market. If the economic profit is zero, it means that the compensation earned is equal to the normal profit, and the company is earning the same amount as it would if the resources were used in the best alternative, and other businesses lack the incentive to enter or leave the market.

Lastly, if the economic profit is negative, it means that the compensation earned by the company is less than the normal profit. Companies operating in the market have the incentive to exit the market because their resources can be more profitable in other markets. The formula for economic profit is as follows:

 

Economic Profit = Total Revenues – (Implicit Costs + Explicit Costs)

 

The amount of economic profit earned by a business depends on the level of market compensation and the duration under consideration. For example, in a competitive market, the economic profit can be positive in the short term and zero in the long term because other companies will want to penetrate the market.

Once new companies enter the market, there will be an increase in the supply of commodities. It will cause a significant decline in product prices, and in the long term, the economic profit will be zero.

On the other hand, in uncompetitive markets, companies earn positive economic profits due to the market power of dominant businesses, the lack of competition, and the existing barriers to entry. The companies can collude to restrict the supply of commodities and keep the prices artificially high.

 

Normal Profit vs. Accounting Profit

Accounting profit is the difference between the total revenue and the total costs of a business in a single period, such as a fiscal year. It is calculated using the Generally Accepted Accounting Principles (GAAP), and it takes the items on the debit and credit side of the balance sheet.

The main difference between accounting profit and normal profit is that the former considers only explicit costs, such as production wages, cost of raw materials, and landowner rent. Normal profit considers both implicit costs and explicit costs of the business.

Therefore, the accounting profit is the amount remaining after all costs associated with the production of a good, depreciation, amortization, and after the payment of taxes.

 

More Resources

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Accounting Profit vs Economic Profit
  • Fixed and Variable Costs
  • IFRS vs US GAAP
  • Financial Accounting Theory

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