Normal profit is an economic metric reflecting a business’s viability. Normal profit and accounting profit are two different ways of calculation. Before calculating normal profit, we have to know the explicit and implicit costs of the business operation.
Normal profit occurs when the revenue generated from the business operation matches the combined number of explicit and implicit costs. For this reason, normal profit is calculated together with economic profit. Suppose the business would be considered unviable if it does not regularly make normal profit. Let’s learn how normal profit work and what are the advantages and disadvantages associated with it.
- Normal profit is the minimum profit that a firm should earn to keep its operations running in the long run.
- Normal profit includes both explicit and implicit costs and is equal to the opportunity cost of the resources used by the firm.
- When a firm earns only normal profit, it covers its costs and does not earn any additional economic profit.
How does it work?
Normal profit is calculated in a different way than accounting profit. In this calculation, the explicit and implicit costs of the business operation play a major role. For Example, Tom owns a coffee shop earning $150,000 in revenue annually. In this coffee shop, he employs two people and gives them a $25,000 salary, and he takes a $40,000 salary. For the coffee shop, he pays $20,000 in rent and spends $30,000 on business operations.
One day, a financial advisor suggested that his opportunity cost of operating this business was $10,000. Based on this information, Tom finds out his explicit business costs are $25,000 + $25,000 + $40,000 + $20,000 + $30,000 = $140,000. So, the business generates $10,000 in accounting profit. Now the implicit costs of the business operation are $10,000. Based on this information, the coffee shop Tom generates normal profit.
Financial advisors evaluate the viability of any business by calculating normal profit. For this reason, many economists refer to it to find the potential of any business. By using these metrics, anyone can also evaluate how efficiently the business is running and whether it is beneficial to try other opportunities.
Advantages of Normal Profit
Knowing whether any business generates normal profit helps the business owner make crucial decisions. It helps the business owner understand how many opportunities the business has in the long term. These metrics define whether it is a good decision to expand the business or confine it to a limited area.
In another way, this metric defines how efficiently the business is operating. Closely monitoring normal profit can help the business owner explore inefficiencies. In this regard, the normal profit metrics help the business become more profitable.
Disadvantages of Normal Profit
Even though the normal profit number is considered one of the best methods to evaluate the success possibility of a business, it does not consider all factors because calculating the implicit cost of the business can be complicated and varies on multiple factors.
As a result, any financial advisor can underestimate or overestimate this number and come to an incorrect conclusion. For this reason, many financial pundits do not consider the normal profit metrics to measure the core competency of any business. With this metric, anyone can see the current viability of a business but can’t predict its future.
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.