An important problem in discussing the profitability of a firm is the ambiguity of the term. It’s quite possible for a firm to generate positive profit but still fail to survive in the long run. In Economics we attempt to eliminate this seeming contradiction by redefining profitability in such a way that it is a good predictor of firm long-term persistence.
Let’s start by breaking out costs two different ways. First, there is the well understood distinction between fixed and variable costs. The lease payment a business must pay is generally a fixed cost, at least in the short run. How much they sell doesn’t affect the amount to be paid. While the cost of the goods they sale is generally variable with cost increasing with sales.
But we can also delineate between explicit and implicit costs. Explicit costs are those costs that require an actual payment. Rent and materials costs are both generally explicit costs. But there are also costs that must be covered, but for which no explicit payment is made.
When Tesla Motors made the decision to focus solely on all-electric vehicles, it gave up the potential sales of hybrid vehicles. While there was no explicit charge to Tesla for doing this, this implicit opportunity cost was still very relevant. If the decision had proven incorrect, with hybrid technology being strongly preferred by the market, investors would have reallocated their investment dollars away from Tesla toward hybrid producing manufacturers.
As a simple example, consider Deonna. She gave up a steady job as a chef where she earned $40,000 per year in order to pursue her dream of being a professional psychic. Nowhere in her future financial statements will she ever record “gave up $40,000 job”, nor does she have to write a check to her virtual self for $40,000. But that foregone $40,000 is most definitely relevant to her decision to continue in this line of work.
Perhaps she generates $37,000 a year in revenue and must pay $12,000 in rent for her shop, another $3,600 in utilities, and $1,400 in miscellaneous expenses. By the standard definition of profitability, we’d say her business is profitable.
But that $20,000 is only half of what she was able to make before. Ignoring the psychic benefits (sorry) of fulfilling her dream, her business isn’t a success. The loss of half her income, assuming the same results persist, will be too much to bear and she will likely return to her previous job as a chef.
In Economics, we extend the standard definition of profitability to include implicit costs in addition to explicit costs. By including all relevant costs, we are able to more accurately predict the sustainability of a given business. This broader definition of profit suggests that Deonna is actually losing $20,000 per year.
$37,000 Revenue
-12,000 Rent
-3,600 Utilities/Phone/Internet
-1,400 Miscellaneous Overhead (Tarot Deck, taxes, etc)
= $20,000 Profit (but not “Economic Profit”)*
-40,000 Implicit Cost of foregoing steady job
= -$20,000 Economic Profit
Had this number been positive, we would conclude that she is doing better in this activity than in her next best option. In that case, we’d expect her to continue and, depending on the barriers to entry, perhaps signal to other would-be professional psychics that this is an attractive line of work to undertake.
This concept of Economic Profit is important to conducting industry analysis. For example, how long will farmers continue to grow alfalfa when they could be making more money growing corn? And so, when an industry exhibits negative Economic profits, we tend to see a decline in the number of firms in that industry, which in turn impacts the direction of market price.
Finally, why do we persist in reporting “Accounting Profit” when Economic Profit is more useful. Accounting standards exist to provide comparability across firms for investors. The subjective nature of most implicit costs makes it all but impossible to measure accurately and comparably. But decision makers, particularly investors, do pay attention to these other costs. And so, Economic Profit is an important concept to understand.
*The $20,000 isn’t “Accounting Profit” either, by the way. We’ve deliberately ignored depreciation. Although an important concept in financial accounting, we ignore it in calculating Economic Profit because depreciation doesn’t represent an actual opportunity cost to anyone.