What is Profit?
Profit is basically defined as revenue minus costs. It is
the difference between how much the business gets from selling its
product and the amount it spent.
We will look at the profit and loss account (formally called the trading
and profit and loss account) and see how businesses calculate profit.
This account looks at a business over a period of time, usually
Revenue is the income of the business. When we look at the profit
and loss account, we usually call it sales or turnover.
A simple definition of revenue is:
Revenue = Price x Quantity
In other words, the value of the sales made by a business is equal
to the price of its product multiplied by the number sold. If a hairdresser
charged £11.00 for a haircut and sold 7 haircuts, her revenue
would be £77.00.
Also known as expenses, this is the money the business spends
on a variety of things. We focus on two types of costs - cost
of sales and overhead costs.
Cost of sales refers to how much was spent actually making
the product and focuses on the direct physical inputs (e.g. the
bricks and cement needed to build a house). These can be thought
of as direct or variable costs - as the business produces
more, it will have to raise its spending in these areas. Revenue
minus cost of sales is known as gross profit.
Overhead costs refers to other costs associated with business
activity such as wages, phone bills, etc. They are all important items
that are needed if production is to take place but they are not actual
raw materials or inputs. These are often referred to as indirect
or fixed costs - if production increases, these costs may
remain unchanged or increase slightly (depending upon the extent of
the increase in production). Revenue minus cost of sales and overhead
costs is net profit.
More, More, More
If revenue is greater than costs, the business is making a profit.
If, however, costs are greater than revenue, the business is making
Businesses want more profit as it can be used to expand the business
(see internal sources of finance) or to reward owners/shareholders.
There are two ways of increasing profit:
Both are perhaps more easily said than done and managers face tough
decisions if they are to achieve either of these effectively.
- Increase revenue
- Decrease costs
How will the quantity of products you sell change if you cut your
price? Will consumers rush to buy more as you are cheaper than your
competitors? Will they carry on buying the same quantity? Will they
see your product as cheap and inferior and buy less?
Will an advertising campaign targeted at a particular market segment
boost sales? What will be the effect on overheads?
|What might happen if you cut the pay of your employees?
What would be the effect if you made some redundant? Would efficiency
change if you stopped improving the technology you use? How might
your customers react if you bought cheaper raw materials? Can your
business afford not to run a website?
|As you can see, taking the decisions needed to boost
profit can be difficult and each choice will present possible undesirable
consequences. We can use the profit and loss account to focus on the
activities of the business and consider what might be causing problems
and what could be done to solve them.
Uses of Profit
Once a business has made a profit, it can be used for three different
- Payment of taxation - a sole trader or partnership will pay
income tax on net profit made. A limited company will pay corporation
tax. This is, of course, a legal requirement.
- Payment of owners/shareholders - sole traders and partners can
claim profit in the form of drawings. Shareholders can be paid
- Retained profit - the business can use the profit to finance
future activities such as expansion, marketing, etc or it can
save it as a reserve for a 'rainy day.'