Tuesday, June 7, 2011

Opportunity Cost, Normal Profit, Economic Profit and Accounting Profit

Opportunity Cost:

Supply of economic resources is limited. Scarcity is fundamental to the study of economics. If certain resources are used somewhere, it can no longer be used anywhere else. When such limited resources are used to satisfy certain wants or needs, it means many alternative uses of those resources automatically get overlooked. All those alternatives that get overlooked can be evaluated in terms of returns or satisfaction that could have been derived out of them, had the resources in question been put into use in each of such alternatives, or had each of such alternatives been pursued. The highest valued return or satisfaction thus foregone in the pursuit of one activity is called the Opportunity cost. This is because of the mutually exclusive nature of the use of such economic resources. Doing one thing means foregoing many others. Economic wants are unlimited but resources are limited. Thus opportunity cost is the highest valued foregone or sacrificed return from an alternative use.

Put in another way, Opportunity cost is the benefits or returns a firm could have received by taking an alternative course of action.

An opportunity cost can be either explicit, usually involving a monetary payment, or implicit, which does not involve a monetary transaction. Opportunity cost is also known as economic cost. In economics, cost primarily means economic cost. It is different from the term 'cost' used by accountants, which is more financial by nature. However, all economic costs are not accounting costs and vice versa.

Opportunity cost does not consider all alternatives foregone. It is concerned only with the foregone alternative use that would have fetched the highest return or satisfaction. When a particular activity is pursued, it is assumed that it is the most beneficial and economic use of the resources that are being used to pursue that activity.

Normal Profit:

Normal profit is the opportunity cost of using entrepreneurial abilities in the production of a commodity, or the profit that could be received by entrepreneurship in another business venture. Entrepreneurship used in the production of a certain commodity can as well be used in the production of another commodity. But both cannot be done together. Profit that could have been earned from the venture that is foregone is the opportunity cost of the venture that is undertaken. This is termed as the normal profit. Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an entrepreneur.

Use of every resource has an opportunity cost. Like the opportunity cost of all other resources, normal profit (foregone profit) is deducted from revenue to determine the economic profit. It is however, never included as an accounting cost when accounting profit is calculated.

Thus, normal profit is the profit that could be earned in another activity elsewhere. It is the profit that could be earned in an alternative venture.

Normal profit is different from accounting profit because opportunity cost is taken into consideration.

Normal profit is the minimum level of profit needed for a firm to remain competitive in the market.

Normal Profit + economic profit = accounting profit (current activity profit)

Or, Current activity profit (accounting profit) - normal profit = economic profit

If economic profit is greater that zero, Then the current activity is better; it is giving more earning.

If economic profit is less than zero, (though accounting profit from current activity is positive), switching entrepreneurship to the other activity is advisable. That would generate more earning.

Normal profit is not deducted from revenue to calculate accounting profit. The foregone profit is the opportunity cost of entrepreneurship and is deducted from revenue to calculate economic profit.

Economic Profit:

Economic profit is the difference between the total opportunity cost of production and the total revenue received by a firm. Economic profit is what remains after all opportunity costs associated with production, including normal profit (entrepreneurial opportunity cost) is deducted from the revenue generated by the production. Opportunity costs are the alternative returns foregone by using the chosen inputs.

Economic profit acts as an indicator when the focus is turned towards efficiency. In a perfect world, no firm receives economic profit. Firms receive economic profit only when price exceeds opportunity cost of production (including entrepreneurial opportunity cost).

Economic profit = Total revenue - total (opportunity) cost (including normal profit).

A firm can stay in business without economic profit or supernormal profit or above-normal profit. It can continue producing goods and services so long as it is able to pay all opportunity costs. One critical opportunity cost is normal profit. Because accounting profit is generally the combination of normal profit and economic profit, zero economic profit does not mean zero accounting profit. A firm can continue by earning normal profit only.

Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)
= Economic profit

Total Revenue - $100 million
Total Cost - $60 million
Entrepreneurial opportunity cost or normal profit (Profit that can be earned from alternative venture) - $30 million

Current activity profit (accounting profit) = $(100 - 60) million = $40 million

Current activity profit (accounting profit) - normal profit = economic profit
That is, $(40 - 30) million = $10 million (economic profit)

In another way,

Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)

= Economic profit

That is, ${100 - (60+30)} million = $10 million (economic profit)

Accounting Profit:

Accounting profit is the difference between total revenue earned and the explicit accounting costs incurred to earn the revenue.

Accounting profit differs from economic profit because there is a difference between accounting cost and economic cost. Some accounting costs are not economic costs, and vice versa.

In reality, opportunity costs of all other resources associated with production tends to be equal to explicit accounting cost incurred to earn the revenue.

10 comments:

  1. Good post but I was wondering if yοu coulԁ write
    a litte more оn this subjeсt? I'd be very grateful if you could elaborate a little bit further. Appreciate it!
    My page > clothing Express

    ReplyDelete
    Replies
    1. I amm already so late in replying. So sorry!!!!!!!!! I will surely try to make out some time away from my fine art work and give an elaborate explanation on this. Thank you so much!!!!!!!!!

      Delete
  2. I am grateful to you for this great content.I am reading your article and its very nice, useful & helpful for those guys who wanna know about the same. Thanks for sharing....
    Not for profit accounting

    ReplyDelete
    Replies
    1. Thank you so much!!!!!! dear friend. It is so great a reward for me. Hope to share more such topics with passage of time. Wishing you a nice, prosperous life.

      Delete
  3. Amazing explanation!God bless...

    ReplyDelete
  4. Great article!Keep up the good work.:)Though I had a slight doubt in your article; in this part; "Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an entrepreneur." Since we know normal profit is implicit cost of entrepreneurship how can there be an explicit opportunity cost?Simply put normal profit is the foregone profit by an entrepreneur in using his/her skills in venture over another then how would there be explicit opportunity cost?
    Thanks:)

    ReplyDelete
    Replies
    1. Thanks for your query. There surely are explicit opportunity costs involved. Explicit opportunity costs are those opportunity costs that most likely is associated with some monetary payment. Hope this explains.................

      Delete
  5. Great article!Keep up the good work.:)Though I had a slight doubt in your article; in this part; "Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an entrepreneur." Since we know normal profit is implicit cost of entrepreneurship how can there be an explicit opportunity cost?Simply put normal profit is the foregone profit by an entrepreneur in using his/her skills in venture over another then how would there be explicit opportunity cost?
    Thanks:)

    ReplyDelete
    Replies
    1. Thanks for your query. There surely are explicit opportunity costs involved. Explicit opportunity costs are those opportunity costs that most likely is associated with some monetary payment. Hope this explains.................

      Delete

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