The difference between the income of a business and its total costs.
Profit= Total Revenue - Total Costs
Profitability
The ability of a business to generate profit or the efficiency of a business in generating profit.
Profitability relates the amount of profit to the size of the company.
Profitability % = Profit (£) X 100
Revenue (£)
Example:
A business makes £100,000 profit in a year by selling £700,000 worth of goods and services over 12 months. Calculate its profitability.
Answer: 100,000 X 100 = 14.3%
700,000
There are two measures of the size of the company:
1. Sales Revenue (adding up all the income over a period of time, typically a year)
2. Capital Employed (Share capital is the same thing. Involves adding up all the money that has been invested in the company by the owners)
Net Profit Margin
Net profit margin compares the amount of profit to the total sales revenue of the company.
Net Profit Margin Definition: This measures net profit (although operating profit can be used) as a percentage of sales (turnover). Net and operating profits are considered the best measure of a firm's profit, while sales turnover is an excellent measure of scale.
What is net profit and operating profit?
Net profit is profit made from ALL ACTIVITIES. Sometimes this is misleading as a business may make a lot of money by selling an asset that it owns.
Operating Profit is profit made from TRADING (i.e. the MAIN ACTIVITIES of the business). For example, it does not include money gained from a sale of asset.
McDonalds financial year 2006/7. The net profit before tax in this year was £319.2m. The sales revenue was £5698.4m and the capital investment was £2796.3m. What is the net profit margin for this year?
Answer: 319.2 X 100
5,698.4 = 5.6%
Example 2:
Calculate the net profit margin if a business has £53,000 in sales, variable costs of £12,920 and fixed costs of £21,000.
Answer: £53,000 - (12,920 + 21,000) x 100
53,000 = 36% Net Profit Margin
Whether a percentage is good or bad, can be determined by:
- Comparisons with previous years' figures
- Other businesses in similar industries or competitors
For example, a lowering of the % net profit margin could indicate that the business is having problems controlling its costs.
But an increase could show the business is becoming more efficient in controlling costs or is able to set a higher price.
Return on Capital (ROC)
ROC compares the amount of net profit to the capital invested in the company.
Return of capital Definition: Ratio showing net profit (operating profit if also used) as a percentage of capital invested.
Capital Invested: All of the money provided to the business by owners.
Example 3:
Calculate the return on capital employed if a business invests £6,000 in a new project and receives a return of £480.
Answer: 480 X 100
6,000 = 8%
Whether a return is good or bad may depend upon the opportunity cost. For example, a business may consider a return of 5% as too low, as it could have got 5% from the bank.
Methods of improving profits and profitability
3 basic methods to increase profit:
- Increase the price (to widen the profit margin)
- Decrease the costs (e.g. by sourcing cheaper suppliers, employing fewer people, cutting back on advertising)
- Increasing the sales volume (More advertising or product development)
An increase in the price will widen the profit margin (difference between the price and the cost) and each product sold will generate more profit.
- Most effective with products that are a necessity or have no close substitutes.
- If this is not true, then there is a danger that demand will move to competitors or rival products.
Decreasing Costs
If there are no changes in demand --> It will increase the total profit.
If changes in costs leads or a decrease in quality or efficiency --> Demand for the product will fall.
Could happen because inferior raw materials are being used or workers accepting a lower wage are less motivated and so less efficient than those being paid a higher wage.
Also by reducing overheads (Such as rent, office expenses and machinery costs) - the costs could damage sales. E.g. a retail outlet may be reluctant to move premises with a lower rent if the new location is less accessible to customers. In this case, the savings in costs may be much lower than the decline in sales revenue caused by the unfavourable location.
Other methods of improving profit/profitability
- Investment in fixed assets - Buying new equipment, buildings or vehicles can allow the business to EXPAND its scale of operation and possibly IMPROVE both the EFFICIENCY of production and the QUALITY of the product. As a result, the business could increases its profits by achieving higher sales volume, charging a higher price and cutting its costs.
- Product development - Introduce new, unique products in order to attract more customers. Could allow a higher price to be charged too.
- Marketing - Encourages customers to buy more of the business' products. (e.g. A clever advertising campaign or a sponsorship). Increases the value of the product to the customer, this enables a higher price to be charged. Although marketing adds to the costs of the business, these extra costs should be offset by the additional revenue generated, so profit should increase.
- Human Resource Strategies - Careful selection, recruitment and training of staff + Motivation Strategies --> Greater efficiency of the workforce --> Greater output --> Higher quality products --> Better customer service --> Higher profits
Profitable firms may be short of cash as:
- Its wealth may lie in assets rather than cash (High stock levels)
- Wealth will be in debtors rather than cash (Gives credit)
- Pay dividends to shareholders
- Repaying a long-term loan
Liquidity: The ability to convert an asset into cash without loss or delay.
A firm may buy an asset and expect to make a profit from it in the future. However, cash payments for this asset may lead to the firm being unable to pay suppliers or workers. This could lead to liquidation, forcing the firm to close and sell its assets in order to make these cash payments.
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