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# economic profit formula

From Wikipedia

Profit (accounting)

In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise (whether by harvest, extraction, manufacture, or purchase) in terms of the component costs of delivered goods and/or services and any operating or other expenses.

## Definition

There are several important profit measures in common use which will be explained in the following. Note that the words earnings, profit and income are used as substitutes in some of these terms (also depending on US vs. UK usage), thus inflating the number of profit measures.

Gross profitequals sales revenue lesscost of goods sold (COGS), thus removing only the part of expenses that can be traced directly to the production of the goods. Gross profit still includes general (overhead) expenses like R&D, S&M, G&A, also interest expense, taxes and extraordinary items.

Operating profit equals gross profit less all operating expenses. This is the surplus generated by operations. It is also known as earnings before interest and taxes (EBIT), operating profit before interest and taxes (OPBIT) or simply profit before interest and taxes (PBIT).

(Net)profit before tax (PBT) equals operating profit less interest expense (but before taxes). It is also known asearnings before taxes (EBT), net operating income before taxes or simply pre-tax Income.

Net profit equals profit after tax (unless some distinction about the treatment of extraordinary expenses is made). In the US the term net incomeis commonly used. Income before extraordinary expenses represents the same but before adjusting for extraordinary items.

Net income less dividends becomes retained earnings.

There are several additional important profit measures, notably EBITDA and NOPAT.

To accountants, economic profit, or EP, is a single-period metric to determine the value created by a company in one period - usually a year. It is the net profit after tax less the equity charge, a risk-weighted cost of capital. This is almost identical to the economist's definition of economic profit.

There are commentators who see benefit in making adjustments to economic profit such as eliminating the effect of amortized goodwill or capitalizing expenditure on brand advertising to show its value over multiple accounting periods. The underlying concept was first introduced by Schmalenbach, but the commercial application of the concept of adjusted economic profit was by Stern Stewart & Co. which has trade-marked their adjusted economic profit as EVA or Economic Value Added.

Some economists define further types of profit:

Optimum Profitâ€”This is the "right amount" of profit a business can achieve. In business, this figure takes account of marketing strategy, market position, and other methods of increasing returns above the competitive rate.

Accounting profits should include economic profits, which are also called economic rents. For instance, a monopoly can have very high economic profits, and those profits might include a rent on some natural resource that firm owns, where that resource cannot be easily duplicated by other firms.

Profit maximization

In economics, profit maximization is the (short run) process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. The total revenue&ndash;total cost method relies on the fact that profit equals revenue minus cost, and the marginal revenue&ndash;marginal cost method is based on the fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost.

## Basic definitions

Any costs incurred by a firm may be classed into two groups: fixed costs and variable costs. Fixed costs are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages, and general upkeep. Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category. Fixed cost and variable cost, combined, equal total cost.

Revenue is the amount of money that a company receives from its normal business activities, usually from the sale of goods and services (as opposed to monies from security sales such as equity shares or debt issuances).

Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to quantity output. It may also be defined as the addition to total cost or revenue as output increase by a single unit. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to linear interpolation. Calculus is capable of providing more accurate answers if regression equations can be provided.

## Total revenue - total cost method

To obtain the profit maximising output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph. Finding the profit-maximizing output is as simple as finding the output at which profit reaches its maximum. That is represented by output Q in the diagram.

There are two graphical ways of determining that Q is optimal. First, the profit curve is at its maximum at this point (A). Secondly, at the point (B) the tangent on the total cost curve (TC) is parallel to the total revenue curve (TR), meaning that the surplus of revenue net of costs (B,C) is at its greatest. Because total revenue minus total costs is equal to profit, the line segment C,B is equal in length to the line segment A,Q.

Computing the price at which to sell the product requires knowledge of the firm's demand curve. The price at which quantity demanded equals profit-maximizing output is the optimum price to sell the product.

## Marginal revenue-marginal cost method

An alternative argument says that for each unit sold, marginal profit (MÏ€) equals marginal revenue (MR) minus marginal cost (MC). Then, if marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals marginal revenue. If there are two points where this occurs, maximum profit is achieved where the producer has collected positive profit up until the intersection of MR and MC (where zero profit is collected), but would not continue to after, as opposed to vice versa, which represents a profit minimum. In calculus terms, the correct intersection of MC and MR will occur when:

\frac{dMR}{dQ} < \frac{dMC}{dQ}

The intersection of MR and MC is shown in the next diagram as point A. If the industry is perfectly competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal line at a price determined by industry supply and demand. Average total costs are represented by curve ATC. Total economic profit are represented by area P,A,B,C. The optimum quantity (Q) is the same as the optimum quantity (Q) in the first diagram.

If the firm is operating in a non-competitive market, minor changes would have to be made to the diagrams. For example, the Marginal Revenue would have a negative gradient, due to the overall market demand curve. In a non-competitive environment, more complicated profit maximization solutions involve the use of game theory.

## Maximizing revenue method

In some cases a firm's demand and cost conditions are such that marginal profits are greater than zero for all levels of production. In this case the MÏ€ = 0 rule has to be modified and the firm should maximize revenue. In other words the profit maximizing quantity and price can be determined by setting marginal revenue equal to zero. Marginal revenue equals zero when the marginal revenue curve has reached its maximum value. An example would be a scheduled airline flight. The marginal costs of flying the route are negligible. The airline would maximize profits by filling all the seats. The airline would determine the \Pi_max conditions by maximizing revenues.

## Changes in total costs and profit maximization

A firm maximizes profit by operating where marginal revenue equal marginal costs. A change in fixed costs has no effect on the profit maximizing output or price. The firm merely treats short term fixed costs as sunk costs and continues to operate as before. This can be confirmed graphically. Using the diagram illustrating the total cost total revenue method the firm maximizes profits at the point where the slope of the total cost line and total revenue line are equal. A change in total cost would cause the total cost curve to shift up by the amount of

Question:Tanya imports sweaters from Peru and sells them from her home. She collects $400,000 in revenue a year, and spends$200,000 on the sweaters and shipping costs, as well as $25,000 on accounting services and utilities. She used to make$100,000 per year working for an advertising agency. Now she works out of the basement of her house, for which she doesn't have any other marketable use. She has no other expenses. Tanya's economic profit is: A. -$25,000 B.$100,000 C. $75,000 D.$175,000 I know that accounting profit is \$175,000 and the equation for economic profit is economic profit = accounting profit - opportunity cost. I'm just unsure which counts as opportunity cost bc my answer is not one of the choices >< THANKS! SORRY!! The TITLE of the question is wrong...i meant ECONOMIC PROFIT!

Answers:Tanya would get 100'000 in ad agency as opportunity profit. But she gets 175'000 instead. So just calculate difference 175'000-100'000=75'000 Correct answer is "C" Economic profit is 75'000.

Question:1. Promote the equal distribution of real assets and wealth 2. Achieve full employment and price level stability 3. Contribute to a more equal distribution of income 4. reallocate resources from less desired to more desired uses. I think 4 but am looking for a second opinion...please help.

Answers:4 is correct. free market increases inequality, so 1&3 are out. and as recession demonstrates, it does not always achieve full employment and price level stability

Question:For my A2 economics coursework i have to look at a companies financial performance and this involves using two major ratios the Acid Test Ratio and the Asset turnover ratio, can someone please help explain what these two ratios show, in english please, and also an easy wy of calculating them both as i am very confused right now.

Answers:A stringent test that indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. The acid-test ratio is far more strenuous than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory assets. Calculated by: Cash+Accounts Received+Short -Term Investments over the Current Liabilities What Does Asset Turnover Mean? The amount of sales generated for every dollar's worth of assets. It is calculated by dividing sales in dollars by assets in dollars. Formula: Asset Turnover=Revenue __________ Assets Asset turnover measures a firm's efficiency at using its assets in generating sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.