Gross profit is the surplus that accrues to a firm when it subtracts its total expenditure (explicit expenditure) from its total receipts. In ordinary language, the term ‘profit’ is used in the sense of gross profit. If, however, we analyze the term ‘gross profit’ we will find that it includes several items which are not profits in the strict sense of the term. The following four items are included in gross profits.
(1) Remuneration for the Factors of Production contributed by the Entrepreneur himself- Sometimes the entrepreneur contributes his own capital to the business, or he may himself act as the manager of the business. In that case, the interest accruing on his capital and his salary in lieu of his work as manager will be included in his gross profits. While calculating net profits, the entrepreneur should subtract these items (also called implicit costs) from his gross profits.
(2) Depreciation and Maintenance Charges- This can be discussed under two sub-heads-
- Depreciation Charges- The depreciation undergone by machinery and plant during the course of production is an item of expenditure, and as such should be deducted from gross profits to arrive at net profits.
- Insurance Charges- The premiums paid by the firm on the insurance of the firm’s property, such as, buildings, machinery, plant, etc., are also a part of the firm’s expenditure. Such expenditure has also to be subtracted from the gross profit to arrive at net profit.
(3) Extra-personal Profit- This is of two types-
- Monopoly Profit- It is possible that the entrepreneur is a monopolist in his field. As such, he will earn a monopoly profit. Such a profit cannot be considered his net profit because it has been earned not on account of his business acumen or ability, but on account of the fact that he holds a monopoly in his particular field. The monopoly profit has, therefore, to be deducted from gross profit to arrive at net profit.
- Chance Profit- It is possible that the entrepreneur earns high profit due to some favorable chance, say, the outbreak of war. The price of his product goes up and he earns a huge profit thereby. Such a profit is called chance profit or conjunctural gain. Now this profit is due not to any special ability on the part of the entrepreneur, but to mere chance. Such a profit has also to be deducted from gross profit to arrive at net profit.
(4) Net Profit- The balance which remains after deducting the above three items from gross profit is called net profit. The net profit is the reward for the following three functions performed by the entrepreneur.
- Reward for Coordination- The entrepreneur organizes and coordinates the work of production. It is he who draws up the plan of the business and takes steps to give it a concrete shape.
- Reward for Risk-taking- The entrepreneur has to undertake considerable risk under the capitalist system. He has to make estimates of costs and revenues. In case, his estimates turn out to be wrong, he may suffer heavy losses.
- Reward for Innovation- He may originate new production techniques or bring out altogether new products, thus, earning huge profits for himself.
We, thus, find that net profit is only one of the constituents of gross profit. It is arrived at by deducting all contractual and non-contractual payments from gross profits. In short, gross profits minus explicit costs minus implicit costs minus certain other elements = net profits. It is possible for the net profits to be either positive or negative. If the total expenditure (explicit as well as implicit) exceeds the total receipts, the net profits will be negative. Profit is the only reward (of a factor of production) that can be negative. Rent, interest, and wages are always positive.