An economic profit or income is the excess amount that a company has got from the outputs it has produced compared to the amount it has invested in its inputs, which include the raw materials, working capital and other fixed assets. This excess can be considered as an added value and is referred to as surplus.
Surplus is not a bad thing, as it gives a company a financial and operating flexibility to achieve higher profitability. The company can buy raw materials at lower prices and thus increase production, which will mean more profit for the company. However, if the company buys too much, then it is said to be over-supplied. If the company is under-supplied, then it will have to make cutbacks and pay higher prices to get its required goods.
For the purposes of calculating the economic profit, the factors to be considered are the amount of raw materials bought and used, the rate at which raw materials are made available and the rate at which the raw materials are sold. The factors that need to be taken into account include the amount of fixed assets employed in production. This may include machinery, raw material and office space. The firm has to consider not only its own expenses but also the fixed assets used by the firm and any surplus that the firm could earn. The firm also has to take into account the effects of market fluctuations and how it affects the firm’s operations.
The importance of considering market fluctuation cannot be over emphasized. The firm needs to calculate the market value of its fixed assets, as well as the market value of fixed assets used in production. It needs to measure and compare the value of the fixed assets with its own costs and the market value of the fixed assets with its own costs. It should be noted that the value of fixed assets includes the cost of making raw materials, the price paid for raw materials, the fixed costs and so on.
To calculate the economic profit of the firm, the company needs to look into the various factors that affect the firms’ costs and the results of the firm’s activities. These factors include the extent of competition, the type of firm, the firm’s structure, the firm’s nature and size, the nature of the output and the firm’s financial structure.
The importance of accounting principles in calculating the firm’s costs and profit can be understood through the use of examples. Suppose, that there is competition among manufacturers of a particular kind of metal. In that case, the price that the company pays for a given amount of metal will not change as much as the price that another manufacturer is likely to charge for the same metal. The firm therefore incurs the same expenses. to purchase this metal in bulk, the firm would save money.
Economic profit will also be calculated when the firm considers the effect of changes in the price of raw materials on the firm’s costs. In case the firm gets the raw materials at lower prices than its costs, the firm will end up earning less profit and will have to cut down production levels to save money.
However, if the firm has to buy the raw materials at higher prices than its costs, then the firm will end up earning more profit. On the other hand, if the firm has to spend more on raw materials than its costs, then the firm is said to have an excess. This excess can be used for investments and can be used for buying raw materials, machinery and capital equipment.