MEANING AND NATURE OF PROFIT

Profit is the reward of the entrepreneur rather than the entrepreneurial functions. Profit differs
from the return on other factors in three important respects:
(a) Profit is residual income and not contractual or certain income as in the case of other factors;
(b) There are much greater fluctuations in profits than in the rewards of other factors; and
(c) profits may be negative whereas rent, wages and interest must always be positive.

The term "profit" means all excess of income over costs and this includes the earnings of self-
used factors; i.e., entrepreneur's own land, capital and his own labour work called respectively
implicit rent, implicit interest and implicit wage. But in economics, profit is regarded as a reward
for the entrepreneurial functions of final decision making and ultimate uncertainty bearing.
Profits can be expressed in the following different ways.

Gross Profit and Net Profit

A businessman analyses gross profit income available to him after payment is made to
contractual hired factors and taxes, depreciation charges, insurance charges. In other words, it is
the excess of revenue receipt over explicit payment and charges.

Gross profit = Total Revenue – Explicit costs

Net profit, also called as pure profit or economic profit, is the residual balance of income after
making payments to all contractual and non-contractual payments to factors of production.
Implicit costs have to be deducted from gross profit to arrive at net profit, which could be
positive or negative.

Normal Profit and Supernormal Profit

Normal profit refers to that portion of profit which is absolutely necessary for the business to
remain in operation. In other words, it is the minimum necessary to induce the business to remain
and operate. Normal profit forms part of the average cost. The organizer obtains normal profit
when average revenue is equal to average cost (AR = AC).

Super normal profit or abnormal profit could be treated as any return above the normal profit. It
is the residual surplus after paying for explicit costs, implicit costs and normal profit. When
average revenue or price is more than the average cost, the entrepreneur gets super-normal
profits. The existence of this profit is not obligatory to the firm to remain in business like normal
profits.

Accounting Profit and Economic Profit

Accounting profit is the revenue obtained during the period minus the cost and expenses incurred
to produce the goods responsible for getting the revenue.
Economic profits is the difference between total revenue and total cost where revenues are
P1 (Q1 ); and cost are thought of as the highest valued alternative opportunity that is foregone.
In a free enterprise system, economic profits play an important role in guiding the decisions
made by the thousands of competing independent economic units.
Theories of profit
The theories of profits could be analyzed and explained as follows:
 Profit as the reward for risk bearing and uncertainties,
 Profit as the consequence of frictions and imperfections in the economy
(dynamic theory of profits),
 Profit as a reward for successful innovation, and
 Profit as a payment for organizing other factors of production.
Thus, there are several viewpoints in explaining theories of profits.
1. Risk-Bearing theory of profit
Economic profit above a normal rate of returns is necessary to compensate the owner of the
firm for the risk they assume when making their investment. Because a firms share holders
are not entitled to a fixed rate of return on their investments i.e. they are residual claimants to
the firms resources they need to be compensated for this risk in the form of a higher rate of
return.
2. Dynamic Equilibrium or function theory of profits
There exists long run equilibrium normal rate of profit (adjusted for risk) that all firms should
tend to earn. At any point in time, however, an individual firm or firms in a specific industry
might have a rate of return above or below this long run normal return level.
3. Monopoly theory of profit
In some industries, one firm is effectively able to dominate the market and potentially earn
above normal rates of return for a long period of time. This ability to dominate the market
may arise from economies of scale, control of essential natural resources, and control of
critical potent or government restrictions that prohibits competition.
4. Innovation theory of profits
It suggests that above normal profits are the rewards for successful innovations. Firms that
develop unique high quality products (Microsoft, Safaricom) or firms that successfully
identify unique market opportunities such as DHL are rewarded with potential for above
normal profits.
5. Managerial Efficiency theory of profit
This theory maintains that above normal profits can arise because of the exceptional
managerial skills of well managed firms. The ability to earn above normal profits by
exercising high quality managerial skills is a continuing incentive for greater efficiency in
our economic system.