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A LevelBusinessAQARevision Notes5. Financial Management5.2 Financial PerformanceAnalysing Profitability

Analysing Profitability (AQA A Level Business): Revision Note

Exam code: 7132

Lisa Eades

Written by: Lisa Eades

Reviewed by: Steve Vorster

Updated on

Profit calculations

  • There are different types of profit in a business. They include:

    • Gross profit

    • Profit from operations

    • Profit for the year

  • Each type can be calculated and the results analysed to help infomr future business decisions

Gross profit

  • Gross profit is the difference between revenue and the costs directly related to production

  • It is calculated using the formula

Gross space profit space equals space Sales space revenue space minus space Cost space of space sales

Gross profit margin 

  • A profit margin measures the proportion of revenue that is converted into profit

    • Higher and increasing profit margins are preferable, as it means that more revenue is being converted to profit

  • Gorss profit margin is expressed as a percentage and calculated using the formula

Gross space profit space margin space equals space fraction numerator Gross space profit over denominator Sales space revenue end fraction space cross times space 100

  • Changes in the gross profit margin indicate how well managers are keeping direct costs low or encouraging sales

    • A rising gross profit margin indicates either increasing levels of sales revenue and/or falling cost of sales

    • A falling gross profit margin indicates either lower sales revenue and/or a rising cost of sales

Worked Example

An e-scooter manufacturer sells its products to retailers for £180 per unit. Variable costs are £72 per scooter, with monthly fixed costs being £82,000. It sells 2,200 scooters a month.

The business pays £240 interest on a mortgage each month. It paid corporation tax of £372,000.

Calculate the business's gross profit margin for the year.

[3]

Step 1: Calculate the gross profit per unit


equals space £ 180 space minus space £ 72 equals space £ 108  (1)

Step 2: Calculate the gross profit per month

equals space £ 108 space cross times space 2 comma 200 space scooters equals space £ 237 comma 600
 

Step 3: Calculate the gross profit per year


equals space £ 237 comma 600 space cross times space 12 equals space £ 2 comma 851 comma 200  (1)

Step 4: Calculate the revenue per month, and then per year

equals space £ 180 space cross times space 2 comma 200 equals space £ 396 comma 000 equals space £ 396 comma 000 space cross times space 12 equals space £ 4 comma 752 comma 000

Step 5: Calculate the gross profit margin

equals space fraction numerator £ 2 comma 851 comma 200 over denominator £ 4 comma 752 comma 000 end fraction space cross times space 100 equals space 60 percent sign  (1)

Profit from operations

  • Profit from operations is the difference between gross profit and indirect costs

  • It is also known as operating profit

  • It is expressed as a percentage and calculated using the formula

Profit space from space operations space equals space Gross space profit space minus Indirect space costs

Operating profit margin 

  • The operating profit margin shows the proportion of revenue that is turned into operating profit

    • It is expressed as a percentage and calculated using the formula

Operating space profit space margin space equals space fraction numerator Profit space from space operations over denominator Sales space revenue end fraction space cross times space 100

  • Changes in the operating profit margin indicate how well managers are keeping indirect costs low or encouraging sales

    • A rising operating profit margin indicates either increasing levels of sales revenue and/or falling indirect costs

    • A falling operating profit margin indicates either lower sales revenue and/or a rising indirect costs

Worked Example

An e-scooter manufacturer sells its products to retailers for £180 per unit. Variable costs are £72 per scooter, with monthly fixed costs being £82,000. It sells 2,200 scooters a month.

The business pays £240 interest on a mortgage each month. It paid corporation tax of £372,000.

Calculate the business's operating profit margin for the year.

[3]

Step 1: Calculate the total variable costs for the year


equals space open parentheses £ 72 space cross times £ 2 comma 200 close parentheses space cross times space 12 equals space £ 1 comma 900 comma 800  (1)

Step 2: Calculate the total fixed costs for the year

equals space £ 82 comma 000 space cross times space 12 equals space £ 984 comma 000

Step 3: Calculate the total costs for the year


equals space £ 1 comma 900 comma 800 space plus space £ 984 comma 000 equals space £ 2 comma 884 comma 800  (1)

Step 4: Calculate operating profit for the year

equals space £ 4 comma 752 comma 000 space minus space £ 2 comma 884 comma 800 equals space £ 1 comma 867 comma 200

Step 5: Calculate the operating profit margin

equals space fraction numerator £ 1 comma 867 comma 200 over denominator £ 4 comma 752 comma 000 end fraction space cross times space 100 equals space 39.29 percent sign  (1)

Profit for the year

  • Profit for the year is the difference between profit from operations and tax and interest costs

  • It is also known as net profit

  • It is expressed as a percentage and calculated using the formula

Profit space for space the space year space equals space Profit space from space operations space minus space open parentheses Net space interest space plus space Tax close parentheses

Net profit margin 

  • The net profit margin shows the proportion of revenue that is turned into net profit

    • It is expressed as a percentage and calculated using the formula

Net space profit space margin space equals space fraction numerator Profit space for space the space year over denominator Sales space revenue end fraction space cross times space 100

  • Changes in the net profit margin indicate how well managers are keeping borrowing costs low, minimising the level of tax paid or encouraging sales

    • A rising net profit margin indicates either increasing levels of sales revenue and/or lower tax or borrowing costs

    • A falling net profit margin indicates either lower sales revenue and/or higher tax or borrowing costs

Worked Example

An e-scooter manufacturer sells its products to retailers for £180 per unit. Variable costs are £72 per scooter, with monthly fixed costs being £82,000. It sells 2,200 scooters a month.

The business pays £240 interest on a mortgage each month. It paid corporation tax of £372,000.

Calculate the business's operating profit margin for the year.

[3]

Step 1 - Calculate the total interest costs for the year


equals space £ 240 space cross times space 12 equals space £ 2 comma 880  (1)

Step 2 - Add interest costs to the tax paid for the year

equals space £ 372 comma 000 space plus space £ 2 comma 880 equals space £ 374 comma 880

Step 3 - Add this to total costs for the year (see previous worked example)


equals space £ 2 comma 884 comma 800 space plus space £ 374 comma 880 equals space £ 3 comma 259 comma 680  (1)

Step 4 - Calculate profit for the year

equals space £ 4 comma 752 comma 000 space minus space £ 3 comma 259 comma 680 equals space £ 1 comma 492 comma 320

Step 5 - Calculate the net profit margin

equals space fraction numerator £ 1 comma 492 comma 320 over denominator £ 4 comma 752 comma 000 end fraction space cross times space 100 equals space 31.40 percent sign  (1)

Using profit margins to make financial decisions

Using the gross profit margin

  • Pricing and product mix

    • A high gross margin gives scope to discount or bundle products

    • A low gross profit margin signals the need for higher prices or cheaper materials and components

  • Supplier negotiations

    • A falling gross profit margin can be a trigger for discussions with suppliers for better raw material prices or a switch to alternative suppliers

Using the operating profit margin

  • Cost structure reviews

    • A falling operating profit margin highlights rising overheads (e.g. logistics, energy or wages) and may require managers to take steps to improve efficiency

  • Expansion or cutbacks

    • Steady operating profit margins support store openings or marketing campaigns, while falling margins may delay these plans

Using the net profit margin

  • Shareholder returns

    • Higher net profit margins make dividends more likely for shareholders

    • Smaller net profit margins require cash to stay in the business, rather than being shared with owners

  • Risk management

    • Low net profit margins leave less of a profit available to cover unexpected market shocks, so firms may keep debt low and focus on selling more

Putting the three margins together

  • If the gross profit margin drops but the operating profit margin is steady, the problem is likely with direct costs or pricing

  • If the operating profit margin narrows while the gross profit margin is fine, overheads are growing too fast

  • If the net profit margin falls while the operating profit margin is stable, financing costs or tax changes may be to blame

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    Author
    Reviewer
    Lisa Eades

    Author: Lisa Eades

    Expertise: Business Content Creator

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.

    Steve Vorster

    Reviewer: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.