Profit and loss
General Introduction
With the introduction of Money and Economics the concept of Profit emerged. The word Profit comes from Latin and means "to make progress", which is nowadays defined in two different ways;
- Economic profit: This is the increase in wealth that an investor has from making an investment, taking into consideration all costs associated with that investment including the opportunity cost of capital.
- Accounting profit: This is the difference between retail sales price and the costs of acquisition (whether by harvest, extraction, manufacture, or purchase).
A key difficulty in measuring either definition of profit is in defining costs. Accounting profit may be positive even in competitive equilibrium when pure economic profits are zero. In short profit is the amount of capital left after all costs and investments have been deducted. If the costs and investments are not recovered one speaks about loss.
The calculation of profit
Despite the relative simplicity of the notion of profit, various calculations of profit are around. Some examples are given below;
Accounting versus Economic Profit
Economic Profit / Economic Value Added (EVA)
The difference between the revenue received from the sale of an output and the opportunity cost of the inputs used. This can be used as another name for "economic value added" (EVA). In calculating economic profit, opportunity costs are deducted from revenues earned. Opportunity costs are the alternative returns foregone by using the chosen inputs. As a result, you can have a significant accounting profit with little to no economic profit [1].
Accounting Profit
A company's total earnings, calculated according to Generally Accepted Accounting Principles (GAAP), and includes the explicit costs of doing business, such as depreciation, interest and taxes. Accounting profits tend to be higher than economic profits as they omit certain implicit costs, such as opportunity costs [2].
Example
If you do an investment of US$200,000 in a specific year, and in that same year turn this sum into $250.000. The accounting profit will be US$50.000 (US$250.000 - US$200.000). Economic profit takes also into account whether you could have done else with other oppurtunities; say that same year you could have won the lottery and turned your investment of US$200,000 into a sum of US$2.000.000, this makes that your economic loss is $1.950.000 (US$250.000 - US$200.000 - US$2.000.000) (Let it be clear that a lottery is not a sound investment, but just for the sake of this example...)