Normal ProfitDefined with Formulas & More

Written By:
Lisa Borga

What is Normal Profit?

Normal profit is a crucial factor that businesses need to consider in order to remain competitive in their industry.

Normal profit is a situation in which the revenue a business generates is equal to its total costs.

Normal profit is frequently thought of when considering economic profit as well.

Both of these types of profits are economic concerns, whereas accounting profits are the profits that businesses report every period when they prepare their financial statements.

Economic profits and normal profits are metrics that a business might want to consider if it has a considerable amount of implicit costs.

Normal profits are achieved when the economic profit a business earns is zero, or it may occur when revenues are equal to implicit and explicit costs.

Economic Profit vs Normal Profit

Economic profit occurs once a company accounts for implied costs and accounting costs.

Economic Profit = Revenues – Explicit costs – Implicit costs

Normal profit happens if economic profit is zero or if revenues are equal to explicit and implied costs.

Total Revenue – Explicit Cost – Implicit Cost = 0

or

Explicit + Implicit Costs = Total Revenue

Implicit costs are costs that affect normal and economic profits.

These costs are also called implied costs or opportunity costs.

Businesses are in a condition of normal profit if their economic profit is $0.

For this reason, normal profit is sometimes known as zero economic profit.

This type of profit takes place when all of a company’s resources are used in an efficient manner, and these resources cannot be used more efficiently elsewhere.

In situations where there are substantial implied costs, normal profit could be thought of as the lowest amount of earnings a business needs to justify its existence.

This is different than an accounting profit in that normal profit as well as economic profit consider the opportunity costs or implied costs incurred by a specific enterprise.

It is essential to consider the factors that make up total cost when trying to calculate either normal or economic profit.

These components are explicit and implicit costs.

Explicit costs, or as they are also known accounting costs, can be readily quantified and typically consist of a transaction that is related to an expense.

Some examples of these costs are wages and labor, raw materials, owner compensation, and rent.

Implied costs need to be considered if a business is refraining from other sources of income to take an alternative approach.

A couple of examples of implied costs would be the salary a business owner would give up by deciding to operate a business instead of working for another person or the rent a business would give up by choosing to use a building instead of renting it out.

Businesses might consider normal and economic profits when deciding whether to stay in business. They may also consider these profits when considering potential new costs.

Normal Profit Example

Giving an example of how normal profit works may make it easier to understand.

Assume that Bob owns a fast food restaurant called Bob’s Burgers.

This restaurant produces approximately $200,000 in revenue annually.

Bob employs three people and pays each of them $15,000 a year.

Additionally, Bob pays himself a salary of $55,000 each year.

Bob spends $25,000 a year for supplies, including ingredients, and pays rent of $25,000 each year.

Bob also learned that considering his education and experience, his opportunity cost for operating Bob’s Burgers is $50,000.

By using this information, Bob determined that his average accounting costs are $150,000 ($15,000 + $15,000 + $15,000 + $55,000 + $25,000 + $25,000).

This gives Bob an accounting profit of $50,000 before taxes.

However, after Bob includes his implied costs of $50,000, he finds his total average annual costs will be $200,000 ($150,000 + $50,000).

Therefore, his burger restaurant is achieving a normal profit since his total costs equal his total revenues.

Normal Profit in Macroeconomics

Normal profit, when referred to in macroeconomics, means economic areas that include more than one business.

However, it can also be used in reference to a whole market or industry.

According to macroeconomic theory, normal profits normally take place in a situation in which economic equilibrium and perfect competition exist.

This is due to the fact that when a market becomes competitive economic profits end. In fact, economic profits can be used as a way to better understand how profits are currently working in an industry.

When companies do earn economic profits in an industry, it can actually provide an incentive for other businesses to move into the market since it shows there are potential profits to be earned.

Then, if more businesses do enter the market, the amount of goods in the market will increase, thus lowering the market price of the product and starting to equalize the profits.

In time, normal profits will occur in the industry as prices become more steady and profits are lower.

Until this happens, businesses trying to obtain an economic profit might take measures to achieve a more dominant position in the market by trying to lower indirect costs or improve their operations to decrease direct costs.

A combination of actions of all of the businesses in an industry can lead to the amount of total costs and revenue necessary for a normal profit level.

A reverse situation could occur in a market with an economic loss occurring.

Theoretically, when there is an economic loss in an industry, businesses will begin to leave the industry.

Then, once enough businesses leave the industry, competition will have decreased enough for the remaining businesses to move closer to or even make a normal profit.

Economic profits are more common when a monopoly exists because, in these cases, the company involved has more power when it comes to deciding pricing or the amount of goods that will be sold.

Whether this type of situation is likely to exist depends on whether there are considerable barriers to entry.

These barriers make it more difficult for other businesses to enter the market.

If more businesses do enter the market, costs go down and make it more difficult for a company to maintain a monopoly.

Oftentimes, governments intercede in markets to improve competition in markets where a monopoly exists.

Typically, laws are put in place to prevent successful large companies from reducing prices until they eliminate the competition.

Normal Profit Applications

Business owners can use normal profit to compare their business’s profits to the profits of other potential business endeavors.

An example of this would be if Bob’s Burgers wanted to start selling hot dogs.

Bob would want to get estimates that would show the changes in revenues and expenses as well as opportunity costs that could be expected from this change.

Then, once Bob considers the expected normal, economic, and accounting profits, he should be able to make a knowledgeable choice on whether or not to expand his business to include serving hot dogs.

Normal profits are also useful in macroeconomics.

They can help to indicate whether or not a particular industry is performing well or not.

Economists might decide to use normal profit projection balances along with economic ones when they are examining antitrust issues or macroeconomic metrics.

It is also possible to use normal profit metrics to ascertain whether or not a company has a monopoly within an industry or whether a group of companies has an oligopoly.

It can also be used to help develop a plan for legislators to follow in establishing a more competitive industry.

Some examples of implied costs that are used in computing normal profit might include salary income that was given up to run a business or investment gains passed up from investing at a certain projected rate of return vs. a different one.

Additional Considerations

Normal profit doesn’t mean that a company is not actually making money.

This is due to the fact that normal profit takes opportunity costs into consideration.

Therefore a business could operate with no economic profits and yet have a normal profit that shows a considerable accounting profit.

Additionally, it should be remembered that implied costs are an essential factor when computing normal profit.

However, implied costs need to be estimated, and it is hard to do this accurately.

Therefore, if a business is considering expanding, any additional opportunity costs could be inaccurate or may contain new risk that has not yet been accounted for.

This does affect the ability of a business to fully rely on any calculations of normal profit.

Key Takeaways

• Economic and normal profits are not the same as accounting profits because accounting profits do not consider implicit costs.
• Normal profits are often considered in concert with economic profits.
• It’s possible for a company to have accounting profits that are high and yet still have normal profits due to high opportunity costs.
• Normal profits occur when an industry or a company has an economic profit of zero.