This section is from the "Economics In Two Volumes: Volume I. Economic Principles" book, by Frank A. Fetter. Also available from Amazon: Economic
§ 1. The broader meaning of profits. § 2. Conception of pure profits. § 3. Dual character of investment profit. § 4. Enterprise and risk. § 5. Pure profit the most variable income. § 6. Meanings of cost. § 7. Superficial view of costs and prices. § 8. Costs adjusted to prices of products. § 9. A single factor of a single product. § 10. The genealogy of value. § 11. Money cost derived from price of products. § 12. Cost an expression of consumers' estimates. Notes On other meanings of profit and The source and cause of profits.
§ 1. The broader meaning of profits. The term profit (or profits) means broadly the residual share, the one noncontractual income in the business. It is what is left as a net gain to that person (or group of persons) who assumes the financial risk of the business, after paying off the claims of every one else for any uses or services rendered. Profit in this broad and popular sense is a complex of incomes from various sources and must fluctuate in nature (as well as in amount) from case to case for reasons that are accidental and personal.
We may see this in reviewing the examples above. In the small furniture shop profits includes all economic incomes in the business, whether from the investment or from the joiner's own labor. It is an inclusive term for the usances of tools, shop, materials, and land, and for the services of the owner, whether as investor, manager, or handworker. It embraces all the economic yields which by theoretical analysis can be carved out of it. As the business develops, profits, as thus used, means more or less according to circumstances which must be ascertained from the context. If the investor owns all his buildings and land, machinery, and sources of materials, and has no borrowed capital, then profits includes all that is left of cash receipts after paying wages (and salaries), but wages may be more or less according as the investor takes a more or less active part in the management. If in the one business the buildings, water power, lands, etc., are fully owned, and in another business with exactly the same product all these things are hired, profits in the former would be much greater. While the business is owned by an individual or by partners, profits may include whatever is attributable to the owner for his management; or a fair salary may be estimated for this, and only the remainder be counted as profits. Like complications, or even more troublesome ones, are found in the case of corporations. The one company owns all its patents, the other pays royalties; the one has all its capital represented by paid-up stock and the other has more or less of outstanding bonds the interest of which is a "fixed charge" to be deducted before counting the residual share of profits. The possible variations are endless, but these illustrations suffice to show that profit in any such general sense is not a scientific term for the purpose of studying the forms of income; it has not even a precise practical significance.1
§ 2. Conception of investment profits. Is there then, no exacter conception of profits possible? Among these various meanings is there one not preempted by another term, one which expresses a sort of income found in practical affairs, which business men are constantly trying to estimate and of which economists must take account? Let us try to express such a conception in this definition: Investment profit is the income attributable solely to the active capital-investment in the particular enterprise. The amount and rate of investment-profit is peculiar to each business and indeed to each investment. It is never an agreed price, or a contractual payment. It is the residual after the actual contractual dues have been paid, and the estimated value of the non-contractual labor, and the factor of management (such as the services of officers, etc.) have been deducted. The investment profit concept is most nearly exemplified in practical affairs in the bookkeeping of a corporation. Out of gross receipts must be paid all rents, interest, maintenance and depreciation of the plant, price of materials, wages, salaries of managers and officers, fees of directors, etc.; the residue is the amount which may be paid as dividends to stockholders (or added to surplus) without impairing the capital investment. § 3. Dual character of investment profit. Even investment profit usually is subjected to a comparison which divides it into two elements. We have seen (Chapter 26, section 4) that it is of the very essence of the active capital function that it takes the financial risk of the outcome. When therefore at the end of the year (or income period) it appears that a certain profit has resulted (say $1000), this is compared with the capital invested (say $10,000) and expressed as a percentage on the investment (thus 10 per cent). Now this in turn is compared with the rate of interest common on the safest loans (say 4 per cent) and the remainder is the amount (or rate) by which this active-capitalist investment exceeds the current rate of passive capital investments. This merely estimated division influences further choice of investment. The rate of interest is taken to represent about what capital can do by itself (or with a negligible amount of judgment and supervision - an abstract conception) and the excess above that is attributed to the successful act of investment. Thus, however far we attempt to eliminate the personal service element of management from profits, there always remains in any active capital income this one element of investing management together with the carrying of the financial risk. There is a dual character in investment profit; it is a capital-income and a labor-income, combined. The distinctive feature of investment profit, which fastens our attention, is precisely this excess (or deficit) of income in active-capital as compared with the normal prevailing rate of time-price, which can be secured by the most conservative passive investor. It is the hope of an income more than ordinary interest that is the inducement to active capitalists to assume the risk. We may call the amount realized more or less than the imputed yield of passive investment, pure investment profit, attributable to the exercise of the pure investment function. The amount may be expressed as a rate on the investment. This is the utmost point that has been attained in the analysis of the complex elements of "profits" as popularly used.2
1 See note, On other meanings of profit, at end of chapter.