Profit (Edexcel A Level Business): Revision Note

Profit calculations

• Profit is the money left over after all costs have been accounted for

  • Profit is one of the main ways a business's financial performance is judged

  • It comes in several different forms, each showing a slightly different part of the picture

Types of profit

Statement of comprehensive income (profit and loss account)

• The statement of comprehensive income is an end-of-year financial statement that shows all of a business's income and expenses over the previous 12 months

• Each type of profit is calculated within the statement of comprehensive income

• The previous year’s figures are also shown for comparison purposes

Example statement of comprehensive income for Head to Toe Wellbeing Ltd

Profit margins

• A profit margin is the amount by which the sales revenue exceeds the costs

  • Profit margins can be calculated for each type of profit (gross, operating and net profit)

• Profit margins can be compared to previous years to better understand business performance

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

Gross profit margin 

• This shows the proportion of revenue that is turned into gross profit

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

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

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

$\mathrm{Operating}\mathrm{profit}\mathrm{margin}=\frac{\mathrm{Operating}\mathrm{profit}}{\mathrm{Revenue}}\times 100$ 

Net profit margin

• The net profit margin (also known as the profit for the year margin) shows the proportion of revenue that is turned into net profit before tax

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

$\mathrm{Profit}\mathrm{for}\mathrm{the}\mathrm{year}\mathrm{margin}=\frac{\mathrm{Profit}\mathrm{for}\mathrm{the}\mathrm{year}}{\mathrm{Revenue}}\times 100$ 

Ways to improve profitability

• There are several steps a business can take to improve profitability

Main ways to improve profitability

Raising prices

• If costs remain the same, raising prices will improve profitability, as the difference between the selling price and the cost is now greater

  • Raising prices is likely to have an impact on demand, so a business must understand the price elasticity of demand for its products

    • Where demand for products is price elastic, increasing prices will result in lower revenue - in this case, profitability will be reduced

    • Where demand for products is price inelastic, increasing prices will increase revenue - in this case, profitability will rise

Reducing variable costs 

• This may involve purchasing cheaper/alternative resources, negotiating with suppliers or purchasing in bulk

  • Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products

  • Buying stock in greater quantities may require investment in increased storage space, which will reduce the impact of the cost savings made

  • Businesses may also be able to reduce the waste of raw materials and components 

Reducing other expenses 

• Reducing staffing levels, relocating to cheaper premises or changing utility companies can reduce expenses

  • Reducing staffing levels may affect staff morale and negatively affect productivity

  • Relocation costs can outweigh some of the benefits of moving to a cheaper location

  • Replacing inefficient or outdated equipment may require staff training

Reducing one-off costs and interest charges 

• Delaying the purchase of fixed assets, entering leasing arrangements or restructuring borrowing can reduce costs 

  • Delaying purchases of new fixed assets (e.g. machinery or vehicles) may negatively impact capacity utilisation as a result of increased breakdowns and maintenance of the old equipment

  • The leasing of equipment (e.g. photocopiers) can reduce one-off purchase costs, but the business never owns these assets, which weakens the balance sheet

  • Restructuring borrowing can result in lower monthly payments but requires lenders to agree to new terms, which they may not be willing to do

The distinction between profit and cash

• Profit and cash are different financial terminologies

  • Profit is simply the difference between revenue generated and business costs

  • Cash is measured by taking into account the full range of money flowing in and out of a business

• A new business may have to pay cash on purchase for all its supplies until a good business relationship has built up a level of trust with its suppliers

  • A supplier may then give the business trade credit of 30 or 60 days

  • This means that the business can receive its stock now and only pay for it in 30 or 60 days, so the cash outflow is delayed

  • As the business sells its products, it receives money generated from the business revenue, and this represents a cash inflow

  • At the end of 60 days, the business will pay its supplier (cash outflow), but the firm may still have stock available for sale 

• A profitable business is likely to fail if it does not have sufficient cash

  • Cash-poor businesses will struggle to pay their suppliers

    • E.g. lifestyle retailer Joules fell into administration in November 2022 due to cash flow difficulties, despite reporting a profit only months earlier. The business was rescued in a £34 million deal by Next in December 2022, narrowly avoiding closure