The importance of measuring profit in business

Profit represents the surplus remaining after deducting all costs from total revenue. It serves as a key indicator of a business's financial health and success.

Reasons for measuring profit

• Most businesses aim to generate profit, with higher levels signalling strong performance and potential for growth.
• Businesses monitor profit regularly, comparing it to prior periods to evaluate improvement or decline.
• A drop in profit, even if the business remains profitable overall, prompts investigation into causes and corrective measures.
• Percentage changes in profit allow for straightforward comparisons over time, highlighting trends regardless of absolute figures.

Formula for percentage change in profit

$\text{Percentage change in profit}=\frac{\text{current year’s profit}-\text{previous year’s profit}}{\text{previous year’s profit}}\times 100$

Where:

• Current year's profit = Profit amount for the most recent period (£)
• Previous year's profit = Profit amount for the prior period (£)

A positive result indicates growth, while a negative value shows a decline.

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Worked example - Calculating percentage change in profit

A business recorded a profit of £110,000 last year and £118,800 this year. Calculate the percentage change in profit.

Step 1: Identify the values

• Current year's profit = £118,800
• Previous year's profit = £110,000

Step 2: Apply the formula

$\text{Percentage change in profit}=\frac{\pounds \mathrm{118,800}-\pounds \mathrm{110,000}}{\pounds \mathrm{110,000}}\times 100$

Step 3: Perform the calculation

$\text{Percentage change in profit}=\frac{\pounds \mathrm{8,800}}{\pounds \mathrm{110,000}}\times 100=8\%$

Step 4: Interpretation

This represents an 8% increase in profit compared to the previous year.

Different measures of profit and their calculations

Profit can be assessed at various stages, each providing insight into specific aspects of a business's operations.

Gross profit

Gross profit is the surplus after subtracting the direct costs of producing goods from total revenue. It focuses on costs tied directly to production, such as raw materials.

$\text{Gross profit}=\text{total revenue}-\text{cost of sales}$

Where:

• Total revenue = Income from sales, also known as sales revenue, sales, or turnover (£)
• Cost of sales = Direct costs associated with manufacturing or purchasing goods for resale (£)

Operating profit

Operating profit accounts for both production costs and day-to-day running expenses. A rise in gross profit alongside a fall in operating profit often suggests poor control over general expenses.

$\text{Operating profit}=\text{gross profit}-\text{other operating expenses}$

Where:

• Gross profit = Surplus after cost of sales (£)
• Other operating expenses = Indirect costs like rent, utilities, or salaries not directly linked to production (£)

Profit for the year (net profit)

Profit for the year, or net profit, is the final measure after deducting finance costs and other adjustments. It includes exceptional items, such as gains from investments.

$\text{Profit for the year (net profit)}=\text{operating profit}-\text{interest}$

Where:

• Operating profit = Surplus after operating expenses (£)
• Interest = Costs of borrowing, such as loan repayments (£)

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Worked example - Calculating different measures of profit

A business has total revenue of £250,000, cost of sales of £100,000, other operating expenses of £70,000, and interest of £15,000. Calculate the gross profit, operating profit, and profit for the year.

Step 1: Identify the values

• Total revenue = £250,000
• Cost of sales = £100,000
• Other operating expenses = £70,000
• Interest = £15,000

Step 2: Calculate gross profit

$\text{Gross profit}=\pounds \mathrm{250,000}-\pounds \mathrm{100,000}=\pounds \mathrm{150,000}$

Step 3: Calculate operating profit

$\text{Operating profit}=\pounds \mathrm{150,000}-\pounds \mathrm{70,000}=\pounds \mathrm{80,000}$

Step 4: Calculate profit for the year

$\text{Profit for the year}=\pounds \mathrm{80,000}-\pounds \mathrm{15,000}=\pounds \mathrm{65,000}$

Components of a statement of comprehensive income

A statement of comprehensive income, also known as a profit and loss account, summarises a business's revenues and expenses over a period, revealing overall profitability. Negative figures in the statement indicate losses.

Formula for profit for the year after tax

$\text{Profit for the year after tax}=\text{profit for the year before tax}-\text{tax}$

Where:

• Profit for the year before tax = Surplus before taxation (£)
• Tax = Amount owed to authorities (£)

Formula for retained profit

$\text{Retained profit}=\text{profit for the year after tax}-\text{dividends}$

Where:

• Profit for the year after tax = Final profit after deductions (£)
• Dividends = Distributions to owners (£)

How statements of comprehensive income are used to assess performance

Statements of comprehensive income provide a snapshot of financial activity, enabling businesses to evaluate progress and make informed decisions. Public limited companies (PLCs) are required to publish these for stakeholders, including shareholders, investors, and competitors.

Features and considerations for analysis

• Time period - Typically covers a full accounting year to avoid misleading data; shorter periods can distort results, especially for seasonal businesses (e.g., a gift shop earning most revenue during holidays).
• Comparisons - Often includes data from the previous year or up to five years to identify trends.
• Performance indicators - Revenue growth exceeding inflation suggests a thriving business; one-off events, like asset sales, are factored into profit for the year.
• Strategic insights - Helps detect issues, such as uncontrolled costs if gross profit rises but operating profit falls.