Profit and Loss

What It Means

In any capitalist society businesses exist to make a profit. Profit, also called net income, is commonly defined as the money left over after all of a business’s expenses are paid. If a business’s expenses are larger than its revenues (total sales), then the business suffers a loss. To continue operating, a business must operate at least at its break-even point, the point at which revenues equal expenses.

A company’s profit or loss is often called its bottom line, because profits are often listed on the last line of income statements, documents that break down, by listing all expenses, how a firm’s revenues are transformed into either a profit or a loss. Income statements also commonly list gross profits, a figure that represents revenues minus the cost of producing the goods or services sold. Gross profit does not include overhead costs (ongoing costs required to run the business), payroll costs (payments made to workers in the form of wages, salaries, bonuses, and benefits), taxes (payments made to the government), or interest (payments made to banks or other lenders for the use of borrowed money).

For instance, say that your T-shirt shop brought in a total of $100,000 in sales (revenue) over the course of its first year in operation. If you paid out, from that $100,000, $30,000 to T-shirt wholesalers, $25,000 in wages, $15,000 in rent, $7,500 in taxes, and $2,000 in utilities, your T-shirt shop would have made $70,000 in gross profit (since the only direct expense required to generate sales was the cost of the products themselves). After subtracting your company’s remaining expenses, however, net income or profit would be $20,500.

Though business owners and investors think of profit and loss in the terms described above, economists define profits as the amount of money left over after both explicit costs and opportunity costs have been taken into account. Explicit costs are all those costs described above (costs required to do business). Opportunity cost is the revenue you give up when you choose one form of business activity over another. The opportunity cost of your T-shirt store might include the salary you gave up at your previous job in order to start your own business, as well as the yearly interest you stopped collecting when you used your savings to start up your T-shirt store. If an economist were to determine your store’s profits or losses, he or she would add opportunity costs to explicit costs before subtracting from your revenues.

Say that you were making $45,000 at your previous job as a nurse, and that your savings of $20,000, which you used to start your business, would have brought you a 5 percent yearly return ($1,000 during your T-shirt shop’s first year in operation). From the figure of $20,500 (your net income, or profit), the economist would subtract your implicit costs of $46,000. From the economic point of view, then, your T-shirt store registered a first-year economic loss of $25,500.

Economists define profit in this way because they believe that people make real-world business decisions based not only on concrete figures like explicit costs but also on the less tangible, but very influential, implicit costs that they undertake when they do business. Indeed, as a T-shirt store owner, even if you had never heard of the concept of implicit costs, you would not be likely to forget that you had put $20,000 of your own money into your business nor that you used to be guaranteed $45,000 a year in your nursing days. In deciding whether to renew your lease and stay in business for another year, you would almost certainly take these factors into account.

When Did It Begin

No doubt businesspeople throughout history have always tried to make a profit wherever possible, but in precapitalist systems the profit motive was not the primary engine of economic activity. Many ancient and medieval societies were dominated by monarchs and other nobles who controlled virtually all land and, therefore, all political power and wealth. Workers in such societies practiced their trades as dictated by traditions and the direct commands of these authority figures. Even when there were markets, places where buyers and sellers of various products came together, these seemingly capitalist phenomena were limited to that portion of a farmer or tradesman’s produce that was left over after his obligations to authority figures had been fulfilled.

Land was necessary for the acquisition of wealth as well as power in most precapitalist societies. Those who inherited large plots of land were able to use that land to add to their wealth, and others could become wealthy by being given land by a monarch or by being made the ruler of a large amount of land. Julius Caesar, for instance, began to build his power and wealth when he was appointed governor of what is now Spain. Though Caesar and others in similar positions throughout history could amass great wealth simply by claiming it from those who lived in their territories, this was not profit. The more power and land a person could obtain, the more wealth he could obtain essentially by force.

The rise of capitalism in sixteenth- to eighteenth-century Europe dramatically changed this situation, however. Once markets (any place where buyers and sellers come together to do business) became the central way of organizing economic activities, capitalists—or those who conducted business with a view toward profiting—began outstripping aristocratic landowners in both wealth and power. The Industrial Revolution, the drastic change in daily life brought about by new technologies that radically increased the efficiency with which businesses could produce goods and services, cemented capitalism as the dominant mode of wealth creation in the eighteenth and nineteenth centuries. Capitalist societies, which could not exist without the motivating forces of profit and loss, have dominated world history since this time. Attempts have been made since the Industrial Revolution to create societies not fueled by the desire of individuals to make profits. The most notable of these is perhaps the Soviet Union, which existed as a socialist state (in which profits are commonly redistributed among the population to serve social goals) from 1922–91. Such societies have so far proven less enduring than their capitalist counterparts.

More Detailed Information

The motivating powers of profit and loss are crucial to the operation of a capitalist system. One of the chief assumptions made by economists is that all economic decision-makers (buyers and sellers at the individual or the group level) are motivated by the desire to maximize profit. Profit maximization involves combining resources in the most efficient ways, so that the difference between revenue and expenses grows to maximum possible levels.

Businesses in competitive industries do not have control over prices. Sellers must compete against one another for buyers, and vice versa. All sellers want the highest possible prices for their goods and services, but they cannot set prices too high because their competitors could undercut them, and they would not be able to find buyers. Likewise, buyers compete with other buyers for the products they want, and this combined force of self-interested individuals keeps prices from falling too low.

With prices thus beyond their control, businesses find as many ways of cutting costs as is possible. As a result, they develop the most efficient possible methods for producing their goods and services. The urge for profit maximization therefore results in maximum efficiency throughout the economy. Resources such as land, labor, and equipment are combined in ways that allows all of them to contribute the maximum amount of usefulness to society.

The self-interested drive to profit also results in markets that are, according to economists, able to respond more effectively and quickly to the desires of consumers, and to changing circumstances more generally, than are any other systems for organizing production and distribution.

For instance, assume that an economy produces an equal amount of beef and chicken, but that, for whatever reason, a large number of buyers suddenly prefer chicken to beef. All of those chicken buyers will compete against one another for a limited supply of chicken, and this heightened demand will mean that chicken sellers can raise prices. Once chicken farming has become more profitable, more farmers will rush to allocate their resources to the raising of chickens, and fewer to the raising of cattle, which is what that large group of buyers was asking for in the first place. When the supply of chicken begins to equal the demand for chicken, prices will begin to fall.

Thus, according to mainstream economic theory, prices in a competitive market will eventually approach the break-even point, the point at which revenues and expenses balance one another out. This is the minimum level of revenue that a company must obtain in order to stay in business. If prices fall so far that chicken farmers’ expenses outweigh their revenues and losses result, farmers will stop producing chicken.

If profit theoretically disappears as competition balances the market forces determining the price of any good over the long term, why do profits exist? Some economists throughout history have theorized that profits exist only because of the behavior of business owners. The economist, philosopher, and revolutionary Karl Marx (1818-83), for example, suggested in his book Das Kapital that profits, which should not exist in competitive industries but that, in reality, often do exist, must consist of the capitalist business owner’s unfair seizure of wages that rightfully belonged to workers. Though this idea has been very influential over time, economists largely disagree with it because it is based on a theory that the prices of goods are based strictly on the cost of producing them rather than on other factors as well, such as consumer demand.

Mainstream economists, accordingly, have developed a variety of explanations for the existence of profits. Most of these theories hold that profit is the legitimate product of certain attributes of capitalists. Among these attributes is the business owner’s willingness to delay his or her gratification. Rather than consuming all of his or her income and resources in the present, the owner of a profitable business firm invests in capital (physical things that add to the productive capacity of his or her business) that will bring in more money in the future.

Another explanation for profit is that it is sometimes a reward for the capitalist’s willingness to take risks. Some investments inevitably fail, so anytime a capitalist puts money into a business enterprise, he or she stands to lose it. The riskier a business enterprise is, in general, the more profitable that enterprise must potentially be.

Yet another way that capitalists are said to generate profits is through any combination of innovation, organization, and entrepreneurial ability. Those who have the ability to invent new products or to find new ways of maximizing the difference between revenue and expenses have, in this view, earned the profits that result.

Recent Trends

In addition to the aforementioned three ways in which capitalists are said to generate profits, there are at least two other explanations for the existence of profit in today’s world. One of these is market imperfections, or situations in which prices may vary for identical products without good reason. You may buy a pair of shoes online at a price that seems reasonable, only to find later that day that the same pair of shoes costs $10 less at the mall in your town. In this situation the seller of the overpriced shoes has made a profit that cannot be accounted for by market forces. While such imperfections are likely to persist in all market economies, they make up a small portion of total profits in any economy today.

Another undesirable form of profit creation happens when there is a monopoly in any industry. When a single business firm dominates an industry, it has the power to set higher prices than would be possible under conditions of perfect competition and therefore to make profits independently of any value its owners have created. Profits from monopolies were a larger part of economies in the nineteenth and early twentieth centuries than they are today. Those monopolies that exist in rich societies today tend to have less power than their predecessors because the economy in a rich society is typically based on sales of luxury products and products for which there are many viable substitutes. In the United States, for instance, Major League Baseball has a monopoly on a particular form of entertainment, but if prices for watching games in person or on television were to rise unreasonably, Americans could easily choose to focus on other forms of entertainment.

One monopoly that continues to profit greatly from its status, despite the many forces arrayed against monopoly creation in the present age, is the De Beers diamond monopoly. De Beers controls 80 percent of the world diamond market, and it therefore has the power to set quantities and prices for all diamonds sold in the world, ensuring itself profits that comfortably exceed the natural returns that would be dictated by a competitive market.