# What is Profit?

## Definition

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 a year.

## Revenue

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.

## Costs

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 a loss.

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:

• Increase revenue
• Decrease costs
Both are perhaps more easily said than done and managers face tough decisions if they are to achieve either of these effectively.

## Raising Revenue

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?

## Cutting Costs

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?

## Tough Choices

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 purposes:

• 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 a dividend
• 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.'

 What is Profit? | Gross Profit | Net Profit | Ratios | Challenges