Measuring and Increasing Profits:
Video case study: How does McDonald's make such high profits when most of the food it sells is so cheap? Click on the photograph.
Profit: the difference between the income of a business and its total costs.
Profit = Total revenue minus Total costs
Profitability: the ability of a business to generate profit or the efficiency of a business in generating profit.
Profit is calculated in 'The Statement of Comprehensive Income' previously known as the 'Income Statement'.
Profit is calculated in 'The Statement of Comprehensive Income' previously known as the 'Income Statement'.
Measuring Profitability:
Three ways of measuring profitability will be considered.
Gross profit: Revenue minus cost of sales.
Gross profit margin:
Formula:
Operating profit margin: compares the profit made with the sales income of the business / branch.
Gross profit margin:
Formula:
Gross profit x 100
Sales revenue
Operating profit: Gross profit minus other operating expenses.
Sales revenue
Operating profit: Gross profit minus other operating expenses.
Operating profit margin: compares the profit made with the sales income of the business / branch.
Formula:
Operating profit x 100
Sales revenue
Net profit: Operating profit minus interest.
Net profit margin:
Formula:
Operating profit x 100
Sales revenue
Net profit: Operating profit minus interest.
Net profit margin:
Formula:
Net profit x 100
Sales revenue
Sales revenue
To assess the meaning of a profit margin, two comparisons are usually made:
Comparison over time. Is the net profit margin increasing (suggesting improvements in efficiency) or decreasing (implying a decline in efficiency).
Comparison to other firms or branches/divisions.
These comparisons are useful because they look at the business’s success (or failure) relative to other businesses.
It is much easier to make high net profit margins in some industries* than in others.
Comparison over time. Is the net profit margin increasing (suggesting improvements in efficiency) or decreasing (implying a decline in efficiency).
Comparison to other firms or branches/divisions.
These comparisons are useful because they look at the business’s success (or failure) relative to other businesses.
It is much easier to make high net profit margins in some industries* than in others.
*These industries usually sell fewer items at higher prices, so a high net profit margin is not a guarantee of higher overall profit levels.
Improving Profits/Profitability:
Many methods can be used.
Three main methods are:
Increasing Prices
Increasing the price will widen the profit margin.
Therefore each product sold will generate more profit.
This strategy will be particularly effective if the product is a necessity or has no close substitutes, as customers will be willing to pay the higher price.
BUT…this strategy will fail if the higher price leads to customers switching to rival products or just giving up on buying the product.
Reducing Costs
Three main methods are:
Increasing Prices
Increasing the price will widen the profit margin.
Therefore each product sold will generate more profit.
This strategy will be particularly effective if the product is a necessity or has no close substitutes, as customers will be willing to pay the higher price.
BUT…this strategy will fail if the higher price leads to customers switching to rival products or just giving up on buying the product.
Variable costs:
If the firm can cut its variable costs, the profit margin will increase.
This means that each product will generate more profit.
BUT…if the change in costs leads to a decrease in quality (e.g. inferior raw materials) or efficiency, the demand for the product may fall.
Fixed costs:
Profit will also increase if fixed costs, such as rent, are reduced.
BUT…not if the cost cutting leads to lower sales (e.g. locating the shop in a location with low footfall).
Increasing Sales
If costs and price remain the same, it is still possible to increase profits by increasing the volume of products sold.
If the firm can cut its variable costs, the profit margin will increase.
This means that each product will generate more profit.
BUT…if the change in costs leads to a decrease in quality (e.g. inferior raw materials) or efficiency, the demand for the product may fall.
Fixed costs:
Profit will also increase if fixed costs, such as rent, are reduced.
BUT…not if the cost cutting leads to lower sales (e.g. locating the shop in a location with low footfall).
If costs and price remain the same, it is still possible to increase profits by increasing the volume of products sold.
A business can achieve this by a number of methods, such as:
Increasing marketing
Developing new products
Improving quality
BUT…all of these methods will cost money.
