Introduction

When looking at profit, economists also distinguish between normal profit and economic profit.

Take a look at the profit position of Thabo, which is based on the above data:

Total revenue

minus explicit cost

minus implicit cost

 R 750 000

R 200 000

R 510 000
Profit R 40 000

This profit of R40 000 is known as economic profit because this amount indicates that total revenue exceeds total cost (including the opportunity cost).

If the total revenue is equal to the total cost, then no economic profit is earned – only normal profits. Remember that included in the total cost is the opportunity cost of self-owned resources.

If the total revenue is less than total cost, an economic loss is made.

In the case of Thabo, as a society, we are paying him more than is necessary to keep him in his current position. According to his revenue and cost data, we are not only covering his explicit and implicit costs – we are paying him an additional R40 000. By only paying him R710 000, he would still be doing what he is doing since we have been compensating him for his opportunity cost.

To summarise:

  • Accounting profit is the difference between total revenue and explicit cost.
  • Economic profit is the excess between a firm's total revenue and the sum of its explicit and implicit costs.
  • Normal profit occurs when total revenue equals total cost (explicit and implicit).
  • Economic loss occurs when total revenue is less than total cost (explicit and implicit).

Activity

Do the following activity to see if you understand the different cost and profit concepts:

Consider the following scenario:

You run your own business and your total revenue is R100 000. Your actual payments towards your costs are R40 000. If you did not work for yourself, you could have earned R60 000 working for another firm.

If I tell you that the total cost of your business is R100 000, have I calculated your accounting cost or your economic cost?

Think again. The actual payments, which are what the accountant calculates, are R40 000. This is the explicit cost only

Correct. The actual payments, which are what the accountant calculates, are R40 000. This is the explicit cost only. The economic cost is equal to the explicit cost plus the implicit cost. It includes both the R40 000, which is the actual payments (explicit cost), and the R60 000 you could have earned (the implicit cost), which is equal to R100 000.

Consider the following scenario:

Steven owns his own auto repair shop.

He uses his own premises as a workshop. If he had rented his premises to someone else, he would have received R18 000 in rent.

He initially invested R50 000 in his business to buy tools and machines. If he had invested the money, he could have earned 10% per year on the money, which is R5 000 per year.

If he did not work for himself, he could have earned a salary of R60 000.

 

His expenditure for the year consisted of the following:

Oil, petrol, sparkplugs, fan belts and other materials: R70 000

Salary for two junior mechanics: R35 000

Admin costs: R15 000

Assume that the total revenue of the auto shop is R230 000.

  1. Identify and calculate his explicit costs.
  2. Identify and calculate his implicit costs.
  3. Calculate his total economic costs.
  4. Calculate Steve’s accounting profit.
  5. Calculate Steve’s economic profit.
  6. If Steve’s revenue is R203 000, will he be making a normal profit only?
  1. Yes
  2. No
Click to Show Answer

a. His explicit costs are as follows:
Oil, petrol, sparkplugs, fan belts and other materials:       R70 000
Salary for two junior mechanics:                                            R35 000
Admin costs:                                                                               R15 000
Total explicit cost:                                                                     R120 000

b. His implicit costs are:
Use of his own premises:                                                         R18 000
Return on investment:                                                             R5 000
Opportunity cost of working for himself:                             R60 000
Total implicit cost:                                                                    R83 000

c. His total economic cost = explicit costs + implicit costs = R120 000 + R83 000 = R203 000.

d. His accounting profit is:
Total revenue – explicit costs = R230 000 – R120 000 = R110 000.

e. His economic profit is:
Total revenue – economic costs = R230 000 – R203 000 = R27 000.

f. Yes. Normal profit occurs when total revenue equals total cost (explicit and implicit). Included in his implicit cost is his opportunity cost.