FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

Normal Profit

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Normal Profit?

Normal Profit is an economic term that when the profit is zero after considering both the implicit cost and the direct cost and the overall opportunity costs. It occurs when all the resources are efficiently utilized and cannot be used for a better purpose. If the residual gain is non-zero, then it is called supernormal profit.

Key Takeaways

  • Normal profit is an economic term referring to zero profit after considering both implicit and explicit costs, including opportunity costs. It signifies efficient resource allocation, where no alternative use of resources can yield greater returns. If there is any profit above zero, it becomes a supernormal profit.
  • Normal profit is linked to economic profit in a company or industry. A zero economic profit indicates an ideal situation in a perfectly competitive industry.
  • Negative economic profit may lead to excessive competition, causing some firms to incur unmanageable losses and eventually wind up, bringing the profit back to zero.

Normal vs Economic Profit

Economic Profit

It is said to occur when the firm earns from the revenue after accounting for explicit costExplicit CostExplicit costs are the culmination of all direct and indirect expenses recorded in a company’s ledger. read more and implicit costsImplicit CostsImplicit cost is the opportunity cost of the organization's resources where the organization calculates what the business would have earned if the resource had been employed for some other purpose instead of the business activity.read more.

Economic Profit = Total Revenue – Implicit costs – Explicit Costs

Normal Profit

However, it is said to have occurred when economic profitEconomic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.read more is zero or in other words, the revenue is equal to implicit cost and explicit costs.

Total Revenue – (Implicit Costs + Explicit Costs) = 0

Or Total Revenue = Implicit Costs + Explicit Costs

  • Implicit cost is also called as the opportunity cost of a particular enterprise. It is not easily quantifiable.
  • Explicit costs are easily quantifiable as it denotes the actual expenses made by the firm towards raw material, labor wages, rent, owner remuneration, and other expenses for running the business.
Normal-Profit.jpg

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Normal Profit (wallstreetmojo.com)

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Example of Normal Profit

Consider Elvis running a corporation with a revenue of $100,000. He has to pay rent for the office at $25,000, and the staff’s wages and other office expenses equal $ 40,000. He met with an expert who assumes that the time and capital spent by Elvis should be equal to $ 35,000 annually.

Calculation of Total Cost

Normal Profit Example 1

Here, the total costs (including the opportunity costsOpportunity CostsThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.read more) = 25000 + 40000 + 35000 = 100,000

Thus, total costs = total revenue

Hence, the firm can be said to working at a normal profit.

Normal Profit in Macro Economics

When an industry is said to be earning a normal profit, it is considered that the industry is in a state of perfect competition. All the resources are utilized efficiently. Further, there is no economic profit in the industry.

It can be considered an ideal situation for both the producers and the consumers. The consumers receive goods at competitive prices, and all the goods produced by the producers are consumed.

However, whenever an industry has an economic profit, more entrepreneurs and firms will enter the industry, thus raising competition and putting price pressures. It makes the industry highly competitive and will reach a stage of normal profit.

The above concept can be reversed in case the industry has economic losses. The companies will tend to close down and leave the industry because there is no profit. The industry will remain with few companies, thus reaching a state of normal profit.

Advantages 

Disadvantages and Limitations

It includes the opportunity cost of the firm. This opportunity cost is difficult to measure since it is a subjective measure. If the opportunity cost is not measured accurately or by taking appropriate assumptions, the calculation of normal profit may lead to different and wrong decisions. This limitation is also a disadvantage of using this measure since it may lead to bad decision-making.

Important Points

It is linked to the economic profit of the company or industry. If it is zero, then it is considered the ideal situation of perfect competition in the industry. However, if this profit changes positive to negative, then:

  • More firms will open up in the same industry if it is positive to earn money. It will lead to more competition in the industry and decrease profit.
  • If it is negative, too many firms are competing in the industry, and some will close down due to unbearable losses. It will make the profit zero.

Conclusion

Normal profit is said to occur when the company earns revenue equal to the implicit and explicit cost of the company. It includes the opportunity costs of the company. The situation in macroeconomics occurs when the industry experiences perfect competitionPerfect CompetitionPerfect competition is a market in which there are a large number of buyers and sellers, all of whom initiate the buying and selling mechanism. Furthermore, no restrictions apply in such markets, and there is no direct competition. It is assumed that all of the sellers sell identical or homogenous products.read more. In such a scenario the economic profit of the firm is zero.

Frequently Asked Questions (FAQs)

1. What is normal profit and supernormal profit? 

Normal profit refers to the minimum level of profit required to keep a business in operation, covering both explicit and implicit costs. On the other hand, Supernormal profit is the excess profit earned by a business above and beyond the normal profit level.

2. What is normal profit also known as? 

Normal profit is also known as “break-even profit” or “zero economic profit.” It denotes the point at which a business generates just enough profit to cover all costs, including opportunity costs, without earning any additional economic profit.

3. Why is normal profit a cost? 

Normal profit is considered a cost because it represents the opportunity cost of using resources in a particular business instead of pursuing alternative opportunities. It includes both explicit costs (actual expenses) and implicit costs (opportunity costs) and is essential for a business to continue operating in the long run. Without normal profit, a business may not be sustainable in the market.

This has been a guide to Normal Profit and its definition. Here we discuss the difference between normal and economic profit along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *