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BBA I Semester Managerial Economics Nature Functions Profit Study Material Notes: The Concept of profit Gross profit and net profit Functions of Profit Nature of profit Accounting profit and economic profit Exercises ( This Post is Most Important for BBA I Semester Students )
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NATURE AND FUNCTIONS OF PROFIT
THE CONCEPT OF PROFIT
The concept of profit entails several different meanings. Profit may mean the compensation received by a firm for its managerial function. It is called normal profit which is a minimum sum essential to induce the firm to remain in business. Profit may be looked upon as a reward for true entrepreneurial function. It is the reward earned by the entrepreneur for bearing the risk. It is termed as supernormal profit analysis. Profit may imply monopoly profit. It is earned by a firm through extortion, because of its monopoly power in the market. It is not related to any useful specific function. Thus monopoly profit is not a functional reward. Profit may sometimes be in the nature of a windfall. It is an unexpected reward earned by a firm just by mere chance, an inflationary boom.
Profit is the earning of an entrepreneur. To the economist, the most significant point about profit is that it is a residual income. However, the term profit has different connotations. In short, the following are the distinctive features of profit as a factor reward :
Nature Functions Profit Study
(i) It is not a predetermined contractual payment.
(ii) It is not a fixed remuneration.
(iii) It is a residual surplus.
(iv) It is uncertain.
(v) It may even be negative. Other factor rewards are always positive.
Nature Functions Profit Study
Gross Profit and Net Profit
In ordinary language, profit is the surplus of income over expenses of production according to a businessman. It is the amount left with him after he has made payments for all factor services used by him in the process of production. But he may not have been careful in calculating all such expenses of production in the economic sense. Therefore, economists regard a businessman’s profit as gross profit as distinct from pure or net profit because it includes the following constituents.
(1) Rent on Land. The businessman may have used his own land for erecting the factory so that he may be saved of the botheration of paying rent to some other landlord. This rent is included in his profit. This is implicit or imputed rent which is not a part of his profit. Had he hired land from some other person, he would have paid its rent. In calculating net profit, implicit rent should be deducted from gross profit.
(2) Interest on Capital. Similarly, he may have used his own capital in his business in order to avoid the inconvenience of borrowing from some other person. This implicit interest is again included in his gross profit. If he had borrowed the same amount of capital for investment in his business, he would have paid interest on it. This implicit interest should, therefore, be subtracted from his gross profit to arrive at net profit.
(3) Wages of Management. The businessman may have been busy in organizing, coordinating and managing the entire business himself. But he may have been contented with income received after meeting all expenses of production. If he had not performed the work of management himself, he would have employed a manager to whom he would have paid wages. Thus his gross profit included implicit wages which are required to be deducted for calculating net profit. In all joint-stock companies, profits are received by shareholders, but the managers and managing directors are all salaried persons whose salaries are included in the expenses of the firms.
(4) Depreciation Charges. During the process of production, machinery and plants depreciate and become obsolete. Expenses incurred on their repairs and replacements are a part of the cost of production. Hence they should be excluded from gross profit for the purpose of calculating net profit.
(5) Insurance Charges. Every firm gets itself insured against fire, accidents and losses of other kinds for which it pays large premiums annually to insurance companies. They are a charge on the revenue of the firm, and therefore do not form part of gross profit.
All these elements are present in gross profit even in the long-run, as they are relatively stable. Frequent and violent changes occurring in gross profit are due to the presence of net profit within the former. It is, therefore, net profit that may be positive or negative.
(6) Net Profit. Net, true, economic or pure profit is the residue left to the entrepreneur after deducting all the items enumerated above from gross profit. Net profit, however, includes the following elements within it.
(i) Reward for Uncertainty Bearing. Pure profit which an entrepreneur receives is the reward of bearing uninsurable risks and uncertainties. Uncertainty-bearing is one of the main functions of an entrepreneur in the present capitalist system which leads to profit.
(ii) Reward for Coordination. The present system of production is one of coordinating the right quantity of factors in right proportions. An entrepreneur who combines them in the right way is able to produce larger quantities of the product with the minimum of cost and thus earns the largest amount of profit.
(iii) Rent of Ability. Net profit accruing to the businessman also includes the rent of his ability. An entrepreneur with a superior business acumen is able to earn larger profit than the others.
(iv) Reward of Innovation. An entrepreneur who innovates by bringing out a new product or technique of production earns higher profit than others.
(v) Monopoly Gains! The modern market system is characterised by the existence of imperfect markets. Some of the shrewd entrepreneurs are able to push up their sales by making their products appear distinct and superior to others. In this process, they also succeed in raising the prices of their products. Thus their profits swell when they create semi-monopolistic conditions for themselves.
(vi) Windfalls? Pure profit earned by an entrepreneur may also include fortuitous or chance gain. The demand for his product may suddenly rise either due to the outbreak of war or as a result of the closing down of some of the other firms for some time on account of labour trouble. He, therefore, earns higher profit which is like a windfall.
We may conclude that an economist’s profit is quite distinct from a businessman’s profit. The former is concerned with net profit which is arrived at by deducting from the businessman’s gross profit the remuneration for the latter’s own land, labour and capital.
We may write in equation form:
Gross Profit=Net profit +Implicit Rent+ Implicit Interest + Implicit Wages +Depreciation and Insurance Charges.
Net Profit=Gross profit-Implicit Rent + Implicit Interest + Implicit Wages +Depreciation and Insurance Charges).
Nature Functions Profit Study
Accounting Profit and Economic Profit
An accountant looks at profit as a surplus of revenues over costs, as recorded in the books of accounts. An accountant is interested in accounting, auditing, planning and budgeting profit. The accountant does not take care of implicit or opportunity cost. Accounting profit is also called residual profit. For the business firm, accounting profit is very important. Accounting profit is defined as the revenue realised in a given period after providing for expenses incurred during the production of a commodity. A firm while making accounting profits may be incurring economic losses. Such a firm would have to withdraw from business in the long run. In the balance sheet of a firm, accounting profit occupies an important place.
The economist, however, does not agree with the accountant’s approach to profit. The accountant would only deduct the explicit or actual costs from the revenues to determine profit. The economist points out that in addition to the deduction of explicit cost, imputed cost, i.e., the cost that would have been incurred in the absence of the employment of self owned factors, should also be deducted. Their examples are:
(i) Entrepreneur’s wages that he could earn by working for some one else,
(ii) rental income on self-owned land and building employed in the business, and
(iii) interest on self owned capital that could have been earned by investing it elsewhere.
Thus the profit arrived at after deducting both explicit and imputed costs may be called economic profit. From the managerial point of view, economic profit is very important because this alone shows the viability of a firm.
The determination of accounting and economic profit is explained as under:
Suppose a person invests Rs. 1,00,000 in a retail store below his house. He receives only profit and no rent and no salary or wages. His income statement as prepared by an accountant is
Sales Rs. 1,00,000 Less: cost of goods sold Rs. 40,000
Gross profit Rs.60,000 If he had worked in some other store, he could receive Rs. 50,000 which is his inplicit salary or wages. If he had rented the place, he would have paid Rs. 12,000 which is his implicit rent. Similarly, if he had put Rs. 1,00,000 in a bank @10%, it is his implicit interest.
Accounting Profit or Gross Profit= Rs. 60,000
Less: Implicit costs:
Foregone wages Rs. 50,000
Foregone Rent Rs. 12,000
Foregone Interest Rs. 10,000
Economic profit is equal to accounting or gross profit minus implicit costs, i.e. Rs. 60,000 – Rs. 72,000 – Rs. 12,000. Nature of Profit
The nature of profit has ever been the most perplexed and troubled problem for economists. Prof. Tausig referred to it as “that mixed and vexed income.” It is a mixed income because it is made up of a number of sources and vexed because economists are unable to decide which source of profit to include or exclude.
The early classical economists regarded profit as accruing to the capitalist who supplied capital and owned the business. They did not distinguish between interest and profit. At best, profits were residually determined after making all necessary payments from the total income of the business.
Marshall explained profit in terms of demand and supply of entrepreneurs. Profits were regarded by him “as the average remuneration necessary to bring into existence and to keep in existence, a sufficient supply of entrepreneurs.” In the long-run, an entrepreneur can earn only normal profits which form part of the cost of production. Profits are thus akin to wages. But Marshall’s explanation is one-sided because it neglects the factors that determine the demand for entrepreneurs. It fails to explain the nature of high profits persisting in the long-run in certain competitive industries, and those earned by monopoly concerns.
To Walker, profit is the reward of the entrepreneur with a superior ability than others. It is the reward for his organisational and co-ordinating activities. Hawley regarded profit as the reward of the entrepreneur’s risk-taking. The greater the risk undertaken, the larger the profit. Profit is the residual income which the entrepreneur receives because he takes risks. Profit is an excess of payment above the actual value of risk. But Hawley does not clarify the meaning of risk.
According to Knight, risks are of two types : insurable and non-insurable. Risks proper refer to insurable risks. Such risk-taking does not give rise to profit because they can be covered by payment of premium to the insurance company. Such risks relate to risk of fire, theft and death. There are certain risks which are non-insurable and uncertain. Such risks relate to changes in prices, demand, supply, etc. Knight calls these risks as uncertainties and profit is the reward of bearing non-insurable risks and uncertainties.
According to Schumpeter, profit arises due to dynamic changes resulting from an innovation. It is the reward to the entrepreneur for innovating. The emergence of profit due to an innovation is not peculiar to only one industry. Innovation in one field may induce other innovations in related fields. The lure of profit leads entrepreneurs to innovate and when an entrepreneur innovates, profit emerges.
The Marxian economists regard profit as unearned income and attribute it to the existence of institutional monopolies established by a few capitalists. Monopoly profits arise because a monopolist is able to restrict output and keep the price of his product much above the average cost of production. According to Hobson, monopoly element is also traceable under competitive conditions when an entrepreneur profits more at the expense of the other factors of production through his superior bargaining power.
Nature Functions Profit Study
Functions of Profit
Profit plays a crucial role in the business world and serves certain social ends. As such, it performs the following functions:
1 It also relates to the Role of Profit. Index of Performance. The goal of every business manager is to earn a surplus above cost to carry on his firm. According to Prof. Ducker, it is an index of the performance of the firm. High profits are a signal that buyers want more product of that firm. These profits provide the incentive for the firm to increase output and for new firms to enter the industry.
2. Regulator of Business Operations. Profits are a regulator of efficiency and effectiveness of business operations. Those firms which produce with the least cost make the maximum profits. They are able to use their human and material resources better than others.
3. A Premium to Stay in Business. The survival of a firm and the employment of labour and management depend on the firm’s ability to cover its costs and make a profit. As pointed out by Prof. Drucker, profit is a premium to cover costs of staying in a business.
4. Guiding Mechanism in Increasing Production. Profits are the guiding mechanism that directs productive capacity towards what consumers want. As demand patterns change towards certain goods, their prices rise relative to costs. When their demand increases, firms earn more profits.
5. Supply of Reinvestable Funds. Another function of profit, according to Prof. Drucker, is that it ensures supply of reinvestable funds. Profits influence the utilization and allocation of funds among different uses. Profits supply funds for innovation and expansion which lead to investment, more production and employment.
6.Encourages Expansion of Business. Profits encourage people who have spare capital to invest that leads to the existence of business on a small scale. Gradually, as such business expands, it leads to the establishment of business on a large scale. Ford in America and Ambani in India are the famous examples.
7. Encourage Risk-taking. Another important function of profit is to reward entrepreneurs for taking the risk associated with their business decisions. All business decisions carry the risk that money will be lost. Such risks will not be taken, if there is no gain in the form of profit. Thus business decisions are taken in anticipation of earning profit.
8. Social Functions. Profit also plays a very useful social functions. It encourages firms to develop new products, to lower production costs and to provide better service by providing employment opportunities to people.
9. Increase in Government Revenues. Last but not the least, profits are an important source of income for the government because larger the business profits, larger the revenues to the government from profits.
1 What do you mean by profit?
2. Distinguish between gross profit and net profit.
3. Explain how accounting profit is different from economic profit.
4. Discuss the nature of profit.
5. What is profit? Explain the functions of profit.
Nature Functions Profit Study
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