5.2 - Profit
The difference between revenue and profit
Revenue represents the total income a business receives from selling its goods or services. Profit, however, is what remains after all costs have been subtracted from this revenue.
Most businesses aim to generate profit as a key indicator of success, with higher profits signalling stronger performance. Businesses regularly calculate profits and compare them to previous periods to monitor progress. Declining profits can indicate underlying issues that need addressing, even if a business remains profitable.
General formula for profit
Types of profit and how to calculate them
Profit can be reported in different ways, each providing insight into specific aspects of a business's financial performance.
Gross profit
Gross profit is the amount remaining after subtracting the direct costs associated with producing goods (known as cost of sales) from sales revenue. Cost of sales includes expenses directly related to making the product.
Operating profit
Operating profit accounts for all revenues and costs from a business's regular activities, excluding one-off events. It deducts both cost of sales and operating expenses, such as administrative costs.
Profit for the year
Profit for the year includes profits or losses from non-regular events, along with financial costs like interest and taxes. This measure determines the funds available for dividends to shareholders.
If gross profit is rising but operating profit is falling, this typically indicates poor control over operating expenses.
Measuring and comparing changes in profit
Businesses track profit changes over time to assess performance, often using percentage calculations for accurate comparisons across periods. Declining profits, even if the business is still profitable, signal potential problems.
Formula for percentage change in profit
A positive result indicates an increase, while a negative result shows a decrease.
Worked example - Calculating percentage change in profit
A business recorded a profit of £60,000 last year and £75,000 this year. Calculate the percentage change in profit.
Step 1: Identify the values
- Current year's profit = £75,000
- Previous year's profit = £60,000
Step 2: Apply the formula
Methods to increase profits
Businesses can boost profits through various strategies focused on revenue growth or cost reduction.
Strategies for improving profits:
- Increasing prices - This works well when demand is price inelastic, meaning customers are less sensitive to price changes.
- Reducing prices - Can stimulate demand if it is price elastic, leading to higher sales volume.
- Reducing costs of production - Lowers overall expenses, though it risks compromising product quality.
- Using advertising - Aims to increase demand, but it involves high costs and no guaranteed results.
- Improving product quality - Enhances customer satisfaction, reducing costs from returns or unsold stock.
Profit margins and ways to improve them
Profit margins express profit as a percentage of sales revenue, allowing businesses to evaluate profitability relative to sales. They enable comparisons over time or across companies. Higher margins generally indicate better performance, though what counts as 'good' varies by industry—high-volume sectors like supermarkets often have lower margins.
Return on investment is another key measure of profitability.
Gross profit margin
This shows the percentage of sales revenue remaining after deducting cost of sales.
It can be improved by raising prices or lowering direct costs.
Operating profit margin
This measures profitability after accounting for all trading costs.
Improvements come from increasing prices or cutting costs of sales and operating expenses. Comparing this with gross profit margin highlights issues with overheads.
Profit for the year margin
This indicates overall profitability after all deductions.
High margins can attract investors by suggesting strong potential for dividends.
Worked example - Calculating profit margins
A business has sales revenue of £150,000, cost of sales of £80,000, operating expenses of £35,000, other profit of £8,000, net finance costs of £4,000, and tax of £9,000. Calculate the gross profit margin, operating profit margin, and profit for the year margin.
Step 1: Identify the values and calculate profits
- Sales revenue = £150,000
- Cost of sales = £80,000
- Operating expenses = £35,000
- Other profit = £8,000
- Net finance costs = £4,000
- Tax = £9,000
Gross profit = £150,000 - £80,000 = £70,000
Operating profit = £70,000 - £35,000 = £35,000
Profit for the year = £35,000 + £8,000 - £4,000 - £9,000 = £30,000
Step 2: Calculate gross profit margin
Step 3: Calculate operating profit margin