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Accounting Profit

Accounting Profit

Author: Kate Eskra
Description:
This lesson will explain Accounting Profit
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Tutorial

ACCOUNTING PROFIT

Video Transcription

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Hi, welcome to Economics. This is Kate. This tutorial is called Accounting Profit. As always, my key terms are in red and my examples are in green.

So in this tutorial, I'll show you how to calculate accounting profit. We'll be defining total revenue and total cost.

OK, so get in the mindset of a business. And obviously, the point of owning a business, for most business owners, is to make a profit. And profit is simply revenues minus costs. So revenues are all the money that we take in, or sales, from selling our item. And costs is everything it costs us to get the product to market. If we're leftover with any money, then we know we've made a profit.

For the purposes of this tutorial, we're talking about specifically an accounting profit, which is simply total revenue minus total cost, where total cost includes only explicit costs. And this is really what makes it accounting profit.

So we know that profit is total revenue minus total cost. Total revenue-- we abbreviate it TR a lot-- is we take the price of the product-- so what we're selling it for-- times however many we sell. So price times quantity is total revenue. Total cost is the cost per unit times the quantity.

So I think it's easier when we use an example. So let's say that's Sue is opening a diner. And she wants to know after her first year if she's made an accounting profit. So I'm really simplifying this. I'm saying that she sold 15,000 meals at $10 each in that first year. And she figured out that her overall cost per meal was about $8. And that factored in all of her explicit costs, like the food costs, the labor costs, any overhead costs.

So let's see how she did. In terms of an accounting profit, again, we just take total revenue minus total cost. So total revenue side, she sold them for $10. She sold 15,000 of them. So her total revenue, or her total sales, were $150,000.

Her cost per unit, like we said, was $8 times that 15,000. So here costs were only $120,000. So that leaves her with an accounting profit of $30,000.

But we need to make a couple notes here. There's two things that I'd like to mention. First of all, really, the costs can be impacted by the scale of production.

So let's say if Sue expands her business, she might really enjoy some cost savings from buying in bulk or something like that. Whenever you can spread out those overhead costs and your average costs start to fall, we call that economies of scale. So those can definitely be impacted by how small or how large you are as a business.

But another really important thing to note here about that cost per unit is that businesses don't necessarily sell everything that they produce. It's actually pretty rare for them to sell everything that they produce. So I mean, what if Sue had actually produced more than the 15,000 meals that she sold?

For example, maybe she had to throw out some, maybe some customers were dissatisfied with them, maybe she just over purchased and wasn't able to use all of her food. So let's look at the change. I obviously highlighted the changes here in this pink color.

So her revenue stayed the same. She sold, in fact, 15,000 and sold them for $10 each. So her total revenue would still be $150,000.

But let's say instead that of the 15,000 that she sold, she actually produced more. She produced 16,000 and had to throw 1,000 away. 1,000 went to waste. But you still need to account for this on the cost side. So her cost was still $8 per unit, but she produced 16,000 of them. That would bring her total cost up to $128,000. And notice that that eats into her profit. So her accounting profit here, instead of $30,000, would only be $22,000. So those are just a couple of things to note about the cost that we need to keep in mind.

So in this tutorial, we talked about how accounting profit is simply total revenue minus total cost and those costs are explicit costs. Cost per unit can be affected by the scale of production, how big or how small you are in terms of producing. And firms often produce more than they sell. Thank you so much for listening. Have a great day.

Notes on "Accounting Profit"

Terms to Know

Accounting Profit

Total revenue minus total cost, where total cost includes only explicit costs. 

TR - TC

TR = price x quantity sold

TC = cost per unit x quantity produced