The following points highlight the top eight roles of profit in business. The roles are: 1. Profits as ‘Surplus’ 2. Profits as Regulator of Efficiency and Effectiveness 3. Profits and Resource Allocation 4. Profits as Rent of Capital 5. Profits as Source of Capital 6. Profit and Innovation 7. Profit and Society 8. Profits and Economic.
Role # 1. Profits as ‘Surplus’:
The goal of every business manager is to generate a surplus above cost. In fact, business exists for surplus generation. Profits are only a measure of the surplus of business income over expenses.
Role # 2. Profits as Regulator of Efficiency and Effectiveness:
Profits act as a regulator of efficiency in business operations. Those who accomplish objectives with the least cost are able to make the maximum profits). In competitive conditions only profit-making companies are supposed to use their human and material resources better than others.
Role # 3. Profits and Resource Allocation:
In a competitive system the allocation of resources is determined by what consumers want to buy and how much they are willing to pay. If people demand more colour TV sets, its price will increase and its production will become profitable. So there will be transfer of resources from other industries to the colour TV industry.
Role # 4. Profits as Rent of Capital:
Profits may be taken as pay for use of capital. One of the purposes of profits is to compensate the numerous owners—proprietors, partners or shareholders—for the use of the capital they have invested in a business. Profits also must compensate them for risk-taking. If the business fails the capital may be lost.
Role # 5. Profits as Source of Capital:
A major portion of undistributed profits is reinvested in business for expansion and diversification. And one of the major sources of a company’s capital is its profit.
Role # 6. Profit and Innovation:
According to J. Schumpeter “profits become the key element in innovation in a dynamic, changing economy, profit-seekers are driven to bring forth new processes and products profits are the lure that keeps the economy seeking new and more efficient ways of meeting real and potential human wants.”
Role # 7. Profit and Society:
Profits, as we have noted, yield a socially desirable benefit to those who have capital to invest. Without profit there would be no reason for the existence of business in a private enterprise economy. Even in socialist countries profit is a measure of how a business is serving society.
Moreover, a major portion of business profit is taxed away. The revenue from profits is often used to finance many government programmes. The object is social improvement.
Profit is the basic criterion for measuring a firm’s success in a free enterprise system. In the ultimate analysis, the survival of a firm and the continued employment of management and labour depend on the firm’s ability to cover all of its costs initially and make a profit thereafter.
Despite the overwhelming importance of profits in a market-oriented economic system, profit still remains an ambiguous concept. Prima facie, the profits cannot be defined precisely. There is also controversy regarding the function that profits serve in the free enterprise system. Finally, there are several accounting problems connected with the measurement of profits.
We can examine the alternative theories that have been offered to explain the making of profits and then proceed to a general discussion of the measurement of profits and the distinction between the economist’s and the accountant’s concepts of profit.
Next we will focus on the impact of price level changes on asset valuation and profit measurement. Finally, we shall focus on profitability analysis that includes a discussion of breakeven analysis, contribution margin, the differences between new and old products, and the growing use of profit centres in many a large corporation.
Role # 8. Profits and Economic:
At the outset, we may note that profits play a very important (rather a strategic) role in a market- oriented, capitalistic economy. Economic profits (or above-normal rates of return) perform a signalling function—they provide valuable signals to sellers. Specifically, the existence of abnormally high rates of return in an industry provides the signal and the incentive for output expansion of that industry.
In fact, if one looks at the industries where the rates of return are the highest, one will generally find that the industries are expanding the fastest.
The rapid increase in the number of firms manufacturing computers during the past few years in the USA and Japan is a direct response to the extraordinary profits earned by existing firms. On the contrary, below-normal profits or rates of return in declining industries such as the steel or coal, illustrate how persistent losses lead to reduction in output and employment.
In the absence of measures of economic profits or losses, the market system would lose one of its valuable signals for change. Because of scarcity, economic resources must be utilized in a manner deemed most efficient by consumers and the possibility of economic profit or loss provides a mechanism that rewards efficient firms and penalizes those that are inefficient.