How Much Profit Are Businesses Making? The Answer Is More Complicated Than You Might Think

We need more than basic accounting to get to the bottom of this question

Wednesday, September 7, 2022

Image Credit|Public Domain

Peter Jacobsen

Recent headlines claim corporate profits are at a 70 year high in the United States.

The claim isn’t unambiguously true. While some indicators, like total gross profit after tax are reaching new highs, it’s important to note that this number is driven somewhat by inflation and is merely an aggregate and therefore not indicative of the performance of a particular industry or business.

But regardless of the truth of the matter, this claim paired with the inflation of the last year has led many to suggest corporate greed has caused higher inflation.

Many, including FEE’s own Brad Polumbo, have explained why greed doesn’t make sense as an inflation driver.

But this still leaves an important question. What then do we make of apparently record-high profits? While answers on this may differ, we should be careful not to make too much of the data on corporate profits because it is, at best, incomplete.

The truth of the matter is we don’t really know how much profit businesses make.

Accounting for Opportunities

There are two types of profit that economists talk about. The type most people think of when they hear the word is what you see on a modern corporate profit statement. Those numbers reflect what economists call accounting profit. To understand accounting profit, consider an example: you start a lawn mowing business and spend $100 on a mower and $50 on gas.

If you make $200 in revenue mowing lawns and you paid $150 for inputs (the mower and gas), the leftover $50 is your accounting profit.

Total Revenue	Explicit Costs	Accounting Profit
$200	$150	$50
Lawn Revenue	Mower + Gas	$200-150

_{Table 1: Accounting profit from mowing}

Accounting profit is total revenue minus the dollars spent on inputs (e.g. land, labor, and capital). Economists call this spending on the mower and gas explicit costs.

But the explicit costs don’t tell the full story, and this is where the other kind of profit comes in.

Imagine that, instead of starting a lawn-mowing business, you had the option of starting a painting business. In the same time it takes you to make $200 in revenue from lawn mowing, you could make $600 painting while spending $200 on equipment.

In the case of the painting business, your accounting profit would be $400.

Total Revenue	Explicit Costs	Accounting Profit
$600	$200	$400
Painting Revenue	Equipment	$600-$200

_{Table 2: Accounting profit from painting}

When we compare these two alternatives, we can begin to see what’s missing if we just look at accounting profit. If you mow lawns over the summer you pay $150 for your gas and mower, but that doesn’t represent the full cost of mowing lawns.

If you choose to mow lawns, you also give up the opportunity to paint and the $400 accounting profit that comes with it.

In other words, the full cost of mowing lawns is spending $100 on a mower, $50 on gas, and losing $400 of accounting profit you could have received from painting. Economists call this type of cost an implicit cost.

So your revenue is $200, but your total opportunity cost (explicit + implicit) is $550 ($100+$50+$400). This loss of $350 represents a negative economic profit, and it comes from the fact that a painting business makes you $350 more than the lawn mowing business.

But now say you pursued the painting business. Then your economic profit is $350 ($600-$200-$50). Thus, you make an economic loss by mowing lawns, but you make an economic profit by painting.

A person armed with this information will choose to open a painting business, all else equal.

Total Revenue	Explicit Costs	Lost Accounting Profit from Painting Business	Economic Profit
$200	$150	$400	-$350
Lawn Revenue	Mower + Gas	Table 2 Accounting Profit	$200-$150-$400

_{Table 3: Economic Profit from Lawn mowing}

As we can see, economic profit is different from accounting profit because it includes the cost of your highest valued alternative. In other words, economic profit is total revenue minus the entire opportunity cost (not just explicit costs).

Immeasurable Profit

So what’s the purpose of economic profit? Why do we care? Well, the reason it matters is businesses make decisions based on economic profit, not accounting profit.

So long as economic profit from a particular business activity is more than $0, individuals will continue to pursue that activity. But this isn’t true for accounting profit.

Returning to our above example, let’s say instead that painting made you a revenue of $251 and the cost of equipment was $200. In this case, your accounting profit from painting would be $51. This $51 is still greater than the $50 available for lawn mowing. If you take into account the opportunity cost of mowing lawns, your economic profit would be $1 ($251-$200-$50).

Total Revenue	Explicit Cost	Lost Accounting Profit from Lawn Mowing Business	Economic Profit
$251	$200	$50	$1
Lawn Revenue	Equipment	Accounting Profit Table 1	$251-$200-$50

_{Table 4: Economic Profit from Painting Business}

In other words, $1 in economic profit means you’ll be $1 better off than the next-best opportunity.

Why does this matter? Well, it shows that no matter how high your accounting profits are, you could be just a few dollars away from shutting down your business, because other lucrative opportunities always beacon, and the cost of pursuing your current path includes foregoing those opportunities.

Imagine an oil company which is making a new record accounting profit of $1,000,000 (oil company profits are larger in the real world, but the number makes the example easier). Now imagine that this same oil company could use its property to become a shipping business which would earn it $995,000 in accounting profit.

You might think that a $6,000 tax on oil companies wouldn’t be enough to close them down if they’re making record accounting profits, but the logic of economic profit shows otherwise.

If you tax the oil company that amount, the accounting profit falls to $994,000. When we subtract the forgone revenue from not being a shipping business, the oil company is making an economic loss of $1,000. If such conditions persist, they may very well transition away from oil altogether. Oil is “highly profitable” for them in a sense, but not in the sense that ultimately matters for future decisions.

So while “record profits” may sound nice, the data can be deceptive. Businesses make their decisions based on economic profit rather than accounting profit, and economic profit requires us to consider the whole opportunity cost, not just easily visible costs.

Thus, policy makers must contend with the fact that economic profits are based on the subjective evaluations entrepreneurs make with respect to their alternate possibilities. This imposes strong limits on any policy-maker trying to use profit data to regulate businesses— record breaking profits or not.