Analysing Profitability (AQA A Level Business): Revision Note

Profit calculations

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

  • Gross profit

  • Profit from operations

  • Profit for the year

• Each type can be calculated and the results analysed to help inform 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

$\mathrm{Gross}\mathrm{profit}=\mathrm{Sales}\mathrm{revenue}-\mathrm{Cost}\mathrm{of}\mathrm{sales}$

Gross profit margin 

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

  • Higher and increasing profit margins are preferable, as they mean more revenue is being converted to profit

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

$\mathrm{Gross}\mathrm{profit}\mathrm{margin}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Sales}\mathrm{revenue}}\times 100$

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

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

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

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

$\mathrm{Profit}\mathrm{from}\mathrm{operations}=\mathrm{Gross}\mathrm{profit}-\mathrm{Indirect}\mathrm{costs}$

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:

$\mathrm{Operating}\mathrm{profit}\mathrm{margin}=\frac{\mathrm{Profit}\mathrm{from}\mathrm{operations}}{\mathrm{Sales}\mathrm{revenue}}\times 100$

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

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

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

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

$\mathrm{Profit}\mathrm{for}\mathrm{the}\mathrm{year}=\mathrm{Profit}\mathrm{from}\mathrm{operations}-\left(\mathrm{Net}\mathrm{interest}+\mathrm{Tax}\right)$

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

$\mathrm{Net}\mathrm{profit}\mathrm{margin}=\frac{\mathrm{Profit}\mathrm{for}\mathrm{the}\mathrm{year}}{\mathrm{Sales}\mathrm{revenue}}\times 100$

• 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 increasing levels of sales revenue and/or lower tax or borrowing costs

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

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 discussing better raw material prices with suppliers or switching 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 to be 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