Profit2.3.1

By the end of this section the aim is:To be able to calculate; gross profit, operating profit, net profitTo be able to discuss the use of a profit and loss account to measure profitabilityTo be able to discuss ways to improve profitabilityTo be able to distinguish between profit and cash

• We know already that when a firm subtracts its Total Costs from its Total Revenue, any money left over is Profit.

• This is a simple enough proposition for most people to grasp but we need to dig deeper and look at the different ways in which businesses calculate profit.– Gross Profit– Operating Profit– Net Profit (aka Profit for the Year)

Profit

Gross ProfitGross Profit is the LARGEST of the 3 different figures.

Gross Profit is calculated by deducting the COST OF SALES from Total Revenue.COST of SALES is another word for the Direct costs of the business.

Simply put, it is the difference between how much revenue the firm takes, less the cost of making (or obtaining) the goods that they have sold.

Formula to learnGross Profit = Total revenue – Cost of Sales

Operating Profit

Operating Profit is the money left over from the Gross Profit once you have deducted the businesses overheads/ operating expenses (indirect costs).

Formula to learn:Operating Profit = Gross Profit – Operating expenses

Operating Profit is the figure focused on by business analysts when evaluating companies. If a business cannot make a reasonable operating profit, it has no chance of long term survival.

Profit for the Year (or Net Profit as it used to be called and is still often called) is the final sum of money that the business has left after it has paid all of its operating expenses and paid any interest it has to pay on loans. It is this money it uses to pay dividends to shareholders or keeps to reinvest in future plans.

It is calculated by deducting interest payments that have been made throughout the year from the Operating Profits figure.

Sometimes this is further developed by calculating the Profit for the Year after tax by deducting Taxation (usually Corporation Tax) from the figure too.

Net Profit (otherwise known as Profit for the Year)

Formula to learnProfit for the Year = Operating Profit – Interest payments

Puzzled? Look through the worked example for Ted Baker.

Think about how each measure of Profit is arrived at.

What exactly does each figure represent?

Calculation practise

Question 1Or

Question 2 (part b only)

Why does an understanding of

each measurement of profit matter to a

firm?

Gross Profit

Operating Profit

NetProfit

Is measuring the ‘value’ of Profit enough?

The Gross Profit or Net profit figure for a business is an absolute number. Is £100,000 a good amount of profit or not? What else might you need to know to decide if it is or not?How could you measure profit in a more meaningful way?

5 Whys and a How?

Measuring Profitability

Profitability Ratios

Gross Profit MarginThis measures

Formula to learn

Operating Profit MarginThis measures

Formula to learn

Measuring Profitability

Profitability RatiosNet Profit (Profit for the Year) Margin

This measures

Formula to learn

Using margins• Much more meaningful

than absolute numbers• Enables analysts to

compare businesses on a like for like basis

• Allows a business to compare there performance from one year to the next.

Calculate gross profit margin(%)

What was the profit margin for each of the 3 months?Which month had the highest profit margin ?Express answers in %

Calculate net profit margin (%)

Sept £ Oct £ Nov £Sales revenue

4,500 8,200 6,650

Gross Profit 1,600 1,300 1,250Expenses 350 290 420Operating profit

Interest 200 200 200Net profit Margin

What was the operating profit margin for each of the 3 months?

What was the net profit margin for each of the 3 months?Which month had the highest profit margins ?

Question practise

Complete the question activity on your A3 worksheet.