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Profit and loss

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The word profit is derived from the Latin "proficio", meaning "to make progress".[1]

From a financial perspective the concept of profit emerged with the introduction of money and economics. It comes down on what is left after deducting costs made. When approaching profit from this perspective two major definitions exist; economic versus accounting profit. Another important related concept is taxes set by government or governmental bodies.

One can also discuss profit from an non-financial perspective, think then of intangible issues like quality-of-life, environment, etc. This aspect does receive more and more attention nowadays with firms issuing, besides the financial year reports, social or environmental year reports. However, the reporting standards and legislation on these areas are not as advanced as those of the financial sector. Although the metrics for this kind of profit are more difficult to calculate, therefore often costs are still assigned to "social" or "environmental" issues.

Financial profit

Financial profit is nowadays defined in various ways, in these variations one can discern two distinct views on profit;

  • 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.

When defining profit it is important to have all results of a period available. Also one should be well in the know of legislation and accounting rules, because these determine how costs, investments, taxes (and losses) can be reported. This can severely affect the resulting profit. Adding to this are the tax rules, differing per country. There are many examples around of countries trying to attract businesses with attractive tax-rates, so these businesses can make more 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 [2].

Accounting profit

A company's total earnings, calculated according to the applicable accounting standards (e.g. 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 [3].

Example on economic versus accounting profit

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 opportunities; 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...)

Calculation of profit: variable costing versus absorption costing

From an accounting perspective (so not an economic profit perspective) costs for products (and therefore profit) can be calculated in different ways. The most important distinction is made in assigning costs to products or to a specific period. Directly this does not affect an organization's cost and profit, although these calculation lay at the basis of decisions which can affect the organizations level of costs and profit.

Simply stated; if one does not exactly know what costs are made, one cannot arrive at a fair price for a product. One can then ask too much resulting in lower sales, which can end in a loss) or ask too less (resulting in not recovering costs and investment made, which can end in a loss).

Two distinct ways of calculating costs (and therefore profit) are Variable Costing (VC) versus Absorption Costing (AC)[4]

Variable costing

Under variable costing (VC) only costs are incorporated in the value of the inventory, which vary in direct relation to number of units of the production/output. E.g. therefore the term variable costs. Other (fixed) costs are expended in the period in which these occur, instead of assigning these to the specific products

Absorption costing

The absorption costing method assigns fixed costs to individual products (instead to a period, as under variable costing (VC)). For this "absorption" rates are calculated, based on these a portion of the total fixed costs are assigned to an individual product. A disadvantage of this method is that over- or under-recovery of costs can occur because more or less products are produced and sold then budgeted [5][6].

Example: variable versus absorption costing

Profit and taxes

Profit is important for internal decision makers in an organization, to assess whether an the functioning of an organization is sound. However, to be able to make a distinction between the (internal) functioning of an organization and the effect of taxes on the organization profit is generally calculated before and after taxes. This way it becomes clear what the impact of tax is on the profit of an organization.

In order to calculate the tax charge an organisation must pay, it is usually necessary to start with the profit for the period per the financial statements and make adjustments for expenses that are not deductible for tax purposes and income which is not taxable.

In many countries it is possible for an organization to relieve a loss ("negative" profit) against taxable profits made by the organization in future periods or losses made by other organizations under common ownership.

References

  1. http://www.sunsite.ubc.ca/LatinDictionary/
  2. http://www.investopedia.com/terms/e/economicprofit.asp
  3. http://www.investopedia.com/terms/a/accountingprofit.asp
  4. Book: Sutton, Tim (2000): Corporate Financial Accounting and Reporting, second edition. p260-261.
  5. Book; Corporate Financial Accounting and Reporting, p260-261
  6. Book; Management & Cost Accounting, p205-206