Financial Gain: Definition, Equation, and Important Elements
In the world of business, profit is a crucial metric that determines a company's success. However, not all profits are created equal. One such type of profit that sets itself apart is the economic profit.
Economic profit, unlike accounting profit, takes into account the opportunity costs, the implicit costs that are often overlooked. It helps businesses gauge their true profitability by considering not just the direct, out-of-pocket expenses, but also the cost of capital invested. The formula for calculating economic profit is simple yet insightful: Economic profit = Net Operating Profit After Tax - (Capital Investment x Weighted Average Cost of Capital).
The net operating profit after tax (NOPAT) can be found in a company's income statement, while the weighted average cost of capital (WACC) represents the cost of funds that a company bears when using equity and debt as a source of funding.
In imperfectly competitive markets, such as oligopolies and monopolies, firms are likely to generate economic profit in the long run. This is due to the pricing power these firms possess, which allows them to set prices above marginal cost, earning positive economic profits. Factors such as market demand and elasticity, cost structure, barriers to entry, regulatory environment, and opportunity costs associated with alternative uses of capital and resources play a significant role in determining a monopoly's economic profit.
The size of the economic profit and how long a company can sustain it depends on these factors. For instance, in a competitive market, a company may book short-term economic profit but may not be able to sustain it in the long term due to the threat of competition. On the other hand, in monopoly markets, high barriers to entry can help sustain monopoly profits.
It's important to note that zero economic profit doesn't necessarily mean a company is unprofitable. A company can still earn a positive accounting profit, but if the cost of capital exceeds the net operating profit after tax, it results in zero economic profit.
In conclusion, understanding economic profit is essential for businesses as it provides a comprehensive picture of their profitability. It goes beyond just accounting profit, taking into account the opportunity costs and the true cost of capital. By doing so, businesses can make informed decisions about their resource allocation and overall strategy, ultimately leading to increased success.
[1] Cases, M. L., Fairfield, M. E., McDaniel, C. W., & Smith, G. F. (2019). Managerial Accounting. McGraw-Hill Education. [2] Economides, N., & Salop, S. C. (1992). The Theory of Oligopoly. Oxford University Press. [3] Schmalensee, R. (2015). Microeconomics. W.W. Norton & Company. [4] Viscusi, W. K. (2016). Economics of Regulation. Oxford University Press.
Investing in business requires considering more than just the accounting profit; understanding economic profit, which takes into account opportunity costs and the cost of capital, offers a more comprehensive view of profitability. In markets with pricing power, such as oligopolies and monopolies, businesses can generate economic profits, as their ability to set prices above marginal cost allows them to earn positive economic profits.
