Normal Profit. The definition of a normal profit is the income that a business gets from its total outputs less the cost of its inputs minus its expenses. In business terms, it is a positive figure since the income will more than the cost of production. A company that is not experiencing any cost reduction can be said to be in a normal profit cycle. Business cycles tend to run on a forward mode since the starting point is the same every time.
Cost Reduction Normal profit is a non-living principle, it cannot be measured directly. It is an assumption and therefore difficult to calculate. However, there are certain assumptions that we can make use of when determining what is normal profit. One such assumption is that the economic profit that a company makes relies heavily on its cost reduction measures. Since it is an assumption, we can also say that the key to achieving normal profit is reducing the costs inherent in the production process as much as possible.
The meaning of implicit costs is something that is not included in the balance sheet. They are costs that are incurred but are not reflected in the balance sheet of a company. Examples of implicit costs are rent, utility bills, inventory, machinery and labor. Some of these costs are usually considered as an economic loss because they cannot be captured by the firm in its operating process.
The difference between the normal profit and what is implicit cost is the opportunity cost. Opportunity cost refers to the cost that a firm has to bear when it attempts to generate a profit instead of just receiving the full amount of its total revenue. For example, if it processes a $100 product and gets only $35 as profit, it still has to invest for the next hundred transactions in order to get back the investment made. Now this does not mean that it has to spend more money on the goods or on its production process. It just means that it has to bear the loss of earning the entire profit instead of just receiving it.
The difference between what is normal profit and what is implied cost is called the gap cost. GAP means the difference between what is realized through normal operation and what is realized through opportunity cost. It is also called the cost of loss. If a firm has to absorb the loss of earning the full normal profit, then it is said to have absorbed the cost of opportunity. And if it has to absorb the cost of losing the opportunity then it is said to have lost the cost of implicit cost.
If we take our example again of what is normal profit, then we can say that size maintenance are our two basic inputs that produce our economic profit. Our firm’s capital is also called the invested capital. The gap cost is our loss of capital when we do not employ the appropriate management tools. The implicit cost is our loss of potential growth, and the total costs are our investment minus our profit.
Basically, our definition of what is normal profit differs depending on our perspective. However, as we all know that in any industry, what is normal profit is equal to the total economic profit minus the amount of opportunity cost. So if we consider the firm A that produces $A per unit then its total economic profit will be equal to A minus the amount of opportunity cost. If we consider the firm B that produces an equal number of products but produces them at different locations then its total economic profit will be equal to A minus the amount of opportunity cost. That is why, sometimes, it is said that our definition of normal profit is equal to total economic profit minus the opportunity cost.
Now, since the analysis of the above example shows that our definition of normal profit is different depending on the scale of analysis, one might wonder how firms with vastly dissimilar operations can ever have the same or similar expectations of, let us say, their corporate finance models. The answer is that they can. In fact any reasonable financial system for a firm of any size will include some implicit costs as well as opportunity cost and in addition suzie, and these costs and opportunity cost will be different in scale.