In all textbooks I've seen profits is written as: $$\pi=py-wL-rK$$ It is evident here that w and r are operational costs.

But unless there is no depreciation and the level of capital is to remain fixed, there is a cost of investment! Why is this not taken into account for calculating profits? Is it some sort of assumption of "steady state" involved?

  • $\begingroup$ Consider if the investment is in office space - how do you distribute that cost down to product profit if you can not directly link the two? In most accounting principles you separate P&L from your cash flow to better see performance. You would almost definitely have depreciation as part of the P&L, but the initial investment will only show in your cash flow statement (and of course the balance sheet as an asset). Many metrics exist that take investment into consideration, eg Return on Investment, ROI. $\endgroup$ – ssn Feb 27 '18 at 19:40

Both in Economics and in Accounting, there is the following fundamental principal: we have to subtract revenues generated in a given time period from costs incurred in the same time period (because this is what makes basic sense).

Now, "cost" is the value of productive resources absorbed into production, in the given time period. The total value of an "Investment" is not absorbed in the usual time period where firms record their profits (month, quarter, year). When we buy a machine, we use it for many years. So only a part of "Investment" is absorbed in a period (essentially what constitutes an "investment" and what an "(operating) expense" is based on this criterion exactly -whether it is fully absorbed in production in one time period or not). The total value of Investment done in say one year is an outflow in the Cash-Flow statement, but it is not a Cost in the Profit and Loss statement.

And, as you mentioned, that part of the Investment that was absorbed in production during the period, is reflected in the calculated Depreciation, which is chraged as a cost to the Profit and Loss statement.

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  • $\begingroup$ Alecos Papadopoulus, you are saying that we should only consider costs from the same period. Well, investment is a cost NOW, so why not added to profits as in profits = pq - wL - rK - investment To put it differently, say that I have a fixed cost of capital rK, and that it depreciates 5% every year. Say that I am in steady state so want to keep K fixed. For this, I need to incur in the cost of replacement of capital, via investment. This cost is every year! It is clear that the profit for shareholders IS LOWER because of this investment. Why is it then not included in the calculation of profit $\endgroup$ – SolowInLaw Feb 28 '18 at 20:11
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    $\begingroup$ @SolowInLaw Invesment in its totality is an outflow of cash, during the period it is realized, not a cost. I wrote that already. In general, Revenues do not equal collections/cash inflows, and costs do not equal payments/cash outflows. In your capital example, you seem to forget that depreciation is treated as an operational cost, it is the part of Investment that will be charged in the Profit and Loss statement and will reduce profits. $\endgroup$ – Alecos Papadopoulos Feb 28 '18 at 22:01
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    $\begingroup$ @SolowInLaw You need to look into accounting principles because you seem to mix up the terms. As already described in the answer, revenue is not the same as cash inflow, and costs are not the same as cash outflow. Investments are cash outflow (on the cash flow statement). Likewise Profits are not the same as returns (in the sense of investment returns). $\endgroup$ – ssn Feb 28 '18 at 22:29

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