I’m unsure of the following statement, can anyone explain? I know that economics talks about economic profits and economic costs not your accounting profits/costs.
“(Keep in mind that normal profit as an implicit cost is included in ATC as a fixed cost.)”
(Institute 118)
Institute, CFA. 2016 CFA Level I Volume 2 Economics. CFA Institute, 07/2015. VitalBook file.
The citation provided is a guideline. Please check each citation for accuracy before use.
Normal Profit is equal to Economic Profit (terms are interchangeable) and is calculated as the following:
Total Revenue - Total Economic Costs (not just total accounting costs) = Normal Profit
Total Economic Costs are composed of Total Accounting Costs + Opportunity Cost of Capital.
What is the opportunity cost of capital? Simply the required return on invested capital (Investor’s equity to be precise). A good reference is the second best investment option.
When an investor decides to invest in a certain project or company, his capital carries an opportunity cost. I will explain with an example: Assume for a moment an investor has only 2 investment opportunities and not more. The first one is a medium-risk 14% annual return on equity project, and the second is a medium-to-high-risk 16% annual return on equity project.
If the investor chooses the 2nd one, his opportunity cost is 14% annual return on equity, so this second project must yield a return higher than 14% annualy in order to get a positive Normal Profit.
12% return on equity is considered a fixed cost to be covered when calculating economic profit (normal profit), if not, the investor should have better chosen project 1.
In this simplified world of only 2 investment opportunities we are not considering risk-adjusted returns, but let’s skip that for now.
So, from the above reasoning, economic profits or normal profits must equal zero in order to win in an economically sense (our chosen project is equal or better than the forgone opportunity, the second best).
If a project yields 0$ normal profit, does it mean that the investor gest 0$ gain? The answer is No.
Remember that normal profit is calculated using economic costs, not accounting costs. Both differ in the amount assigned as “opportunity cost of capital”, so the investor is indeed receiving money to his pockets.
A numeric example:
An investor has 2 investment options, company A and company B. He decides to invest in company A and invest US$ 1.0 million. Company B yields a 12% annual return on equity. Company A performance numbers are show below:
Total Revenue US$ 5.0 million (% of revenues attributable to this investor)
Total Costs US$ 4.8 million (% of costs attributable to this investor)
Calculate the normal profit of the investor for the first year.
Normal profit = 5.0 - 4.8 - 1.0*(12%) = 80K
Positive normal profit shows that the investor won from picking company A over company B.
Hope this helps.
ATC is the combination of all accounting costs and implicit opportunity costs. For example, if you use your own purchased machine then you are forgoing the opportunity of renting that machine. This is a fixed expenditure. So, this statement is correct.