Practical Use Of Economic Profit To Assess The Effectiveness Of Activities

Determination and calculation of the value of economic and normal profit

Russian and foreign scientists are conducting research on this issue.

Fischer et al. (1999) emphasize “the need to identify alternative cost of using a resource, which can be obtained in the best alternative use of the resource” (p. 131). Ilyashenko (2016) believes that the normal profit is "this is the minimum rate of return on invested capital that any person engaged in economic activity" (p. 91-92). Raizberg et al. (2019) consider normal profit as the average level of return on invested capital that can be obtained by using capital, for example, in real investment.

Also, Raizberg et al. (2019) define normal profit as the level of profit sufficient to maintain break-even production and sale of goods, including taking into account the costs of the entrepreneur himself (the costs of his personal labor, the use of personal property), which are not reflected in the accounting documentation.

Thus, economists agree on the need to take into account alternative uses of the organization's resources and determine the normal profit of the organization, and with it, the assessment of economic profit. At the same time, there are no clear methods for determining the alternative cost of using resources, the minimum rate of return on invested capital.

Use of economic and normal profit to analyze the financial results of the organization

The source of information for the analysis of financial results is the accounting financial statements of the organization. The financial statements do not contain data on the alternative cost of using resources, the amount of normal profit or economic profit (Ministry of Finance of the Russian Federation, 2010). Traditionally, the methods of analyzing financial results include the analysis of indicators of profit from sales, net profit and profitability based on these indicators (Voitolovsky et al., 2020). Vorozhbit et al. (2018), Rodina (2021), consider the analysis of the marginal profit of the organization, which is also calculated without taking into account the economic profit. The indicators of economic and normal profit are also not used when monitoring the internal processes of the organization (Vorozhbit & Bakhireva, 2020). The world-famous EBIT (earnings before interest and taxes) indicator, used to compare the performance of companies around the world, is calculated through profit before tax and the amount of interest payable on a bank loan. This indicator is used to calculate economic profitability, but it does not meet the requirements of our study, since economic profit is calculated through accounting profit, reduced by all explicit costs. Interest on the loan and income tax are clear costs. A popular and very important indicator of return on equity (ROE) is calculated as the ratio of net profit to the average annual amount of equity. This indicator is also often used to determine the effectiveness of investment. The disadvantage is that the net profit includes the share of the profit received from the use of borrowed capital, while the borrowed capital is not taken into account in the calculation of profitability. The inclusion of indicators of economic and normal profit in the existing methods of analyzing financial results is necessary for evaluating the effectiveness of the organization's activities and the subsequent adoption of reliable management decisions based on the results of the analysis.

Calculation of economic and normal profit according to the accounting statements of the organization

The definition of normal profit in the works of various authors suggests that the minimum value of normal profit can be calculated by multiplying the cost of capital invested in the business by the average interest on bank deposits. The mathematical calculation of normal profit is related to economic profit. In particular "economic profit is calculated as the difference between the gross income (revenue) from the sale of products and the total (explicit and implicit) costs of the company" (Rodina, 2021, p. 120). Thus the formula of economic profit has the form:

Income - Explicit costs - Implicit costs = Economic profit (1)

or

Accounting profit – Implicit costs = Economic profit (2)

Maximova (2021), Shimko (2020) propose a similar algorithm for calculating economic profit and normal profit.

Normal profit exists in two cases: when the economic profit is a positive value, or when the economic profit is zero:

Accounting profit – Implicit costs = 0 (3)

in this case

Accounting profit = Implicit costs (4)

In this expression, "0" means zero economic profit. In such a situation, it is said that the company receives a normal profit, which is measured by the amount of implicit costs (for example, the average industry level of return on invested capital).

Explicit costs (accounting costs) are reflected in the statement of financial results of the organization. They are defined as the amount of external resources consumed by the organization, i.e. resources that are not owned by this company. For example, the cost of materials, fuel, wages to employees, depreciation of fixed assets, etc.

Implicit costs are determined by the cost of internal resources owned by the organization. Implicit costs are the amount of funds that can be obtained with an alternative use of assets. For example, assets can be sold, cash invested in a bank at interest, or assets can be leased. In the financial statements of Russian enterprises, the accounting profit corresponds to the amount of net profit. To determine the economic profit, it is necessary to subtract the amount of implicit costs from the net profit. Implicit costs can be calculated as the product of the average annual amount of invested capital (equity and debt) and the average bank interest on deposits (r):

Implicit costs of the organization = The average annual value of the invested capital · r (5)

The resulting amount of implicit costs reflects the amount of the normal profit of the organization:

Normal profit = Average annual amount of invested capital · r (6)

We consider it necessary to take the amount of both own and borrowed capital when calculating. Both types of capital are involved in creating the profit of the organization. The cost of capital is reflected in the balance sheet of the organization.

The simplest formula for calculating the minimum value of normal profit (6) is presented. To improve the accuracy of the calculation, it is necessary to deduct the amount of tax on income from investing funds at a percentage:

Normal profit after tax = The average annual value of invested capital · r – Tax (7)

Given the available data on alternative uses of the organization's funds invested in assets, this formula can be detailed by factors, depending on the direction of use of the organization's assets. For example, part of the assets can be leased, another part can be used to provide services, a third part is invested in a bank at interest, and a fourth part is invested in securities of other enterprises.

Analysis of the economic and normal profit of the organization

To determine the effectiveness of the business, it is necessary to analyze the profit indicators by comparison (Table 1). For the calculation, we use the minimum amount of normal profit, calculated on the basis of bank interest on deposits.

If an enterprise receives a positive value when calculating economic profit, then its accounting profit contains not only normal profit, but also the same economic profit obtained in excess of normal due to competitiveness and efficient business management. Such an enterprise can be proud of its success and compares favorably with other enterprises in the industry. If we get zero economic profit in the calculation, therefore, the company provides itself with an average percentage of the invested capital, the business is quite successful, but it is worth thinking about the possibilities of more efficient use of resources to reduce the cost of production or about ways to increase income, which would lead to profit growth, economic profit, and increased competitiveness. Negative economic profit indicates inefficient business management. This company needs urgent measures to increase its accounting profit to the level of normal profit or to leave the market. If an assessment of the effectiveness of an individual entrepreneur's business is carried out, the costs of the entrepreneur's salary should be taken into account in the explicit and alternative costs (Laskina, 2017). The indicator of economic profit can be supplemented by a relative indicator of the return on invested capital, calculated as the ratio of economic profit to the average annual cost of invested capital. The value of the profitability indicator greater than zero indicates the receipt of a positive economic profit. A value less than zero indicates an economic loss. A zero value is possible if there is zero economic profit and there is a normal profit.

Practical calculation and analysis of the effectiveness of the organization's activities with accounting and economic profit

We present the results of the analysis of various enterprises, using data on net profit from the financial results report and data on the average annual amount of invested capital (equity and debt capital) from the balance sheet. The lost profit (implicit costs), which is included in the concept of normal profit, is calculated as the interest income on the capital invested in the business (the product of the average annual value of the invested capital of the enterprise and the bank rate on deposits).

Table 2 presents data on the performance indicators of the Joint-Stock Company "Altayvagon". The main activity is the production of non-self-propelled railway cars, the provision of services for the repair, maintenance and alteration of railway cars.

Starting from 2018, the company's net profit is growing, and the normal profit for the study period is decreasing due to a decrease in the deposit rate and due to a decrease in the amount of invested capital. The economic profit in 2018-2019 is positive, which confirms the efficiency of doing business by the analyzed enterprise. Return on equity (ROE) in 2018-2019 is also high. The optimal value of this indicator is equal to the bank deposit rate multiplied by the difference between the unit and the income tax. For our study period, this is 5.2% in 2017, 6.2% in 2018, and 4.2% in 2018.

Practical calculation and analysis of the efficiency of an organization with an accounting and economic loss

Table 3 shows the performance indicators of the Limited Liability Company "Altayzdravnitsa" Sanatorium "Lazurny". The main activity is the activity of health resort organizations.

During 2017-2019, the organization suffers losses associated with low competitiveness. In 2018, investments in fixed assets were increased in order to expand the types of services provided, but due to high interest rates on loans taken out, the loss is growing. Accordingly, the indicators of loss of equity capital on net profit have a negative trend. The loss of invested capital in terms of economic profit is much lower, at about 6%. In the future, the company's management expects a return on the invested capital, but an active advertising policy is required.

Practical calculation and analysis of the effectiveness of the organization's activities with net accounting profit and economic loss

Table 4 shows the results of the analysis of the financial results of the closed joint-stock company "Volchikhinsky Brewery", engaged in the production of soft drinks.

According to the accounting statements, "Volchikhinsky Brewery" CJSC had a loss on the results of its activities only in 2018, however, taking into account the implicit costs, the company received an economic loss for all three analyzed years. The company produces high-quality products, but in the conditions of competition in the market of soft drinks, effective business is possible only with the constant updating of the range, the development of new types of products.