Let’s move from the accountants definition of profit (link)to the economists’ definition.
For an economist, profit is the difference between revenue and opportunity costs, not actual costs.
I’m sorry about the jargon – and I accept it’s one of the reasons why business people find finance daunting – but opportunity cost is an important concept.
Opportunity cost is the value given up by not using the best alternative use of a resource.
An Example Of Opportunity Cost
Let me give you an example to show what I mean.
Imagine you have some spare cash and you can earn 5,000 pounds or dollars in a year by putting your money into a bank.
Then a finance adviser tells you that if you invest all that spare money in his scheme, you will earn a 20,000 return in a year. I’m not going to keep saying pounds or dollars.
The extra profit of the investment is 15,000.
That’s the return of 20,000 less the gain from the next best alternative of 5,000.
It works the other way around as well.
If the investment doesn’t work out as well as the financial adviser predicts and you just get your money back, the adviser may try to reassure you that you’ve lost nothing.
But an economist will tell you that you’ve lost the 5,000 return from the safe investment in the bank account and you are worse off than you would have been.
A Powerful Tool For Assessing Your Decisions
It’s a different way of looking at things and it helps you to decide whether you made a good decision or not and therefore it helps you to learn.
Return to P1M2 What is Profit (link)