Profit
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.
Example 1:
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)
Increasing the price
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
Distinction between cash and profit
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.
Contribution
- Contribution looks at whether an individual product or activity is helping the business to make a profit.
- If the sales revenue of a product is greater than the direct costs, the product is contributing towards either paying off the fixed costs or making a profit (if the fixed costs have already been covered).
Contribution Per unit: Selling price per unit - Variable cost per unit
e.g. if a pen cost 20p to make and they sell the candle for £1.00. The contribution per unit is 80p (£1.00 - 0.20p)
Total Contribution:
Contribution per unit x Number of units sold
OR
Total Sales Revenue - Variable Costs
Profit using contribution:
Total Contribution - Fixed Costs
Breakeven Analysis
Breakeven Analysis is: A study of the RELATIONSHIP between total costs and total revenue to identify the output at which a business breaks even (i.e. makes neither a profit nor a loss).
Breakeven Analysis makes the following assumptions:
- The selling price per unit stays the same, regardless of the number of units sold
- Fixed costs remain the same, regardless of the number of units of output.
- Variable costs per unit stay the same, regardless of output.
- Every unit of output that is produced is sold.
Calculating a Breakeven Output
1. Using a formula
Breakeven Output: The level of output at which total sales revenue is equal to total costs of production.
Example: £10,000
£1.00 - 0.20p = 12,500 units
2. Using a Graph - Break even chart
What is the Margin of Safety?
Definition: The difference between the actual output and the breakeven output.
This is like the firm's 'safety net'.
Changes to the breakeven Chart
How to lower the breakeven Output
1. Lower Fixed Costs
e.g. Lower rent (move to an area which is cheaper) or Lower Salaries.
HOWEVER - Less footfall, decreasing salaries could decrease motivation, workers could leave, replacement workers may not be as good at their job.
2. Lower Variable Costs
e.g. Use cheaper raw materials, pay workers lower wages
HOWEVER- Decrease Quality, Decrease motivation of workers
3. Increase Sales Revenue
e.g. Increase selling price or sell more products
HOWEVER - A higher price can reduce demand, promotional costs in order to sell more.
Usefulness of Breakeven Analysis to a start-up Business
- A new firm can use breakeven analysis to calculate how long it will take to reach the level of output needed to make a profit. Is the business viable? Useful if likely to have cash-flow problems as business can predict its profit level . Can help gain financial support, such as a bank overdraft.
- Simple and straightforward way to prove a business plan will succeed financially. Can also show the margin of safety. For example, if sales forecasts are optimistic, the business can calculate how much sales can fall before it drops below the quantity needed to breakeven.
- This data can be used as a key element in persuading bank managers or investors to give financial support to the start up.
- Will be used to plan its expected results, a 'best case' scenario and a 'worst case' scenario - the MAX and MIN level of profit to be made. Can indicate the level of risk involved in the start-up.
- Allows a firm to use 'what if?' analysis. Show different breakeven outputs and changes in profit level that could arise from changes in price or fixed costs or variable costs. Business can ascertain most profitable price or if business is feasible. Can also be done on individual products/services.
Strengths of Breakeven Analysis
1. Can show the different levels of profit arising from the various levels of output and sales that might be achieved --> Can predict profit levels (if number of units sold is known) --> This can help the business to plan its future objectives and strategies.
2. The calculations are quick and easy to complete --> saving business time --> Possible Inaccuracy? --> But is a quick ESTIMATE before they decide whether to go ahead.
3. Can foresee future changes --> e.g. Higher wage costs or lower prices --> Examine impact on individual product in range --> May be successful now but vulnerable in the future (or vice versa)
4. Used to discover point where a particular target profit level is made --> Must calculate target profit output by adding the target profit to fixed costs.
Weaknesses of Breakeven Analysis
1. Information may be unreliable --> Based on forecasts --> Even with market research it is difficult to predict the number of customers who will buy from the firm --> Or actual production costs could change (esp. if there is a break down of equipment or shortage of raw materials).
2. Sales are unlikely to be exactly the same as output --> Likely that some output will remain unsold (esp. perishable goods) --> Wastage of raw materials
3. In practice, the selling price might change as more is bought and sold --> Or will the firm have a fixed selling price?
4. Fixed Costs may not stay the same as output changes --> At particular levels of output new machines and even new buildings may need to be purchased.
5. Analysis assumes that variable costs per unit are always the same --> Ignoring factors such as bulk buying
Price
Definition: the amount paid by a consumer to purchase 1 unit of a product.
A business must set a price that is:
- High enough to cover the costs of making the product
- Low enough to attract customers
Total Revenue
Definition: A measure of the income received from an organisation's activities.
Total Revenue= Quantity of units sold x Price per unit
Also called: Income, revenue, sales revenue, sales turnover or turnover.
Profit
Definition: The difference between the income of a business and its total costs.
Profit= Total Revenue - Total Costs
Ways to improve profit:
- Increase sales revenue
- Decrease Costs
Costs
1. Total Costs Definition: The sum of fixed costs and variable costs
Total Costs= Fixed Costs + Variable Costs
2. Fixed Costs Definition: Costs that DO NOT VARY directly with output in the short run (e.g. rent)
Fixed Costs: Machinery, Rent and rates, Salaries, Administration, Vehicles, Marketing, Lighting and heating
3. Variable Costs definition: Costs that DO VARY directly with output in the short run (e.g. raw materials)
Variable Costs: Raw materials, Wages of operatives/direct labour, Power
Wages and salaries?
Wages are paid to operatives who make the product - measured per hour - a variable cost
Salaries are paid to staff who are not directly involved in production - measured per annum - a fixed cost
Semi-variable costs
Semi-variable costs are costs that combine elements of fixed and variable costs.
Example: A worker may be paid a set wage plus a bonus for each extra item she produced.
The set wage is a fixed cost and the bonus is a variable cost.
Effect of changes in Output on Costs
The total costs are rising at a slower rate than output because only the variable costs are increasing as output increases.
When output changes by a certain %, the total variable costs will change by the same %.
Relationship between costs and price
In lots of industries, increases in costs are 'passed on' to consumers in the form of higher prices.
These costs could be raw materials for example.
Business theory says this would lead to a fall in demand (and possibly sales revenue).
But demand is less likely to fall if every business increases its prices. This is likely when all firms are affected in the same way.
All firms will want to try and maintain a PROFIT MARGIN.
Profit Margin is the difference between the selling price of the item and the cost of making/buying that item).
Welcome to Biz Nest!
I am going to begin posting about Unit 1 (BUSS1): Planning and financing a business.
This is AS Business Studies, with AQA exam board.
Chapter 1 - Enterprise
Key Words:
Business-
An organisation that is set up to provide goods and services to customers in return for payment. Often, the main aim of the business will be profit.
Enterprise -
Almost any business or organisation can be called an enterprise, but the term usually refers to the process by which new businesses are formed and new products and services are created and brought to the market.
Enterprise Skills -
Skills that allow an individual or organisation to respond effectively to changing market situations. They include problem solving skills, thinking and acting innovatively and creatively, and understanding the importance of risk and uncertainty.
Entrepreneurs-
Individuals who have an idea that they develop by setting up a new business and encouraging it to grow. They take the risk and the subsequent profits that come with success, or the losses that come with failure.
Reasons for failure:
1. Lack of finance
2. Poor infrastructure
3. Skills Shortage
4. Complexity of regulations
What is 'Opportunity Cost'?
Definition: The next best alternative forgone, i.e. the next best thing that you could have chosen but did not.
IT IS THE DECISION THE ENTREPRENEUR DID NOT MAKE.
Example: The opportunity cost of setting up a business might be the wage from their old job that an entrepreneur gives up.
Why be an entrepreneur?
1. The Government encourages entrepreneurial skills and enterprise (We did this in school - enterprise day)
2. The country has seen an increase in wealth. This gives people more business opportunities and it also means there is less risk.
3. Things are changing quickly, this allows for constant new opportunities to be available.
4. People now want more independence at work - to be your own boss.
5. A drive to make money
6. A desire to make use of a skill/talent you possess in a useful and profitable way
7. An attempt to provide employment or wealth to the local area.
How do Governments support enterprise/entrepreneurs?
